Apr 17, 2012
Inflation Expectations and Gold
I’m not going to bore you with the macro argument for investing in gold. If you want that there are thousands of links on Google going over it in grave detail. My purpose today is to highlight what has happened recently and what is happening now to make the argument that gold, SPDR Gold Shares ETF (AMEX: GLD) is a buy.
As the Central Banks Turn
In 2011 China began openly buying gold on the open market through deliveries off the Hong Kong exchange; 428 tons of it to be precise which reflects a 13 fold increase over 2010. So far in 2012 China has imported gold at a rate of 479 tons. It is also a well-known 'secret' that China has been buying all of its domestic production of gold for the past few years. Central Banks, in general, became net buyers of gold in the 2nd quarter of 2009 having accumulated more than 800 tons at that time. This does not count any of China’s accumulation as the People’s Bank of China has not updated its official gold holdings since their last announcement ignited the current buying.
Currently central bank ownership of gold is at its highest level since 2005, again without any of the additions by China since June 2009. Net buying for the year to date is on pace for ~225 tons of accumulation. Most of this accumulation is happening in Asian countries: Russia, Kazakhstan, Thailand, Turkey, Belarus, India and Mexico have all bought significant amounts of gold in the past three years.
The recent activity by emerging markets to defend their currencies against the storm of inflation being exported by the Federal Reserve and the ECB as they attempt to stave off the implosion of their banking systems due to their complete fiscal mis-management is what these countries are responding to. India, Turkey and Vietnam have all made headlines recently in different ways as they attempt to staunch the import flow of gold into their countries.
Vietnam, in particular, is desperately trying to launder gold out of their economy but also the U.S. dollar as they, along with the dong circulate freely. All of those countries have populations who revere gold as a store of wealth and import hundreds of tons per year. It is estimated that Vietnam has the largest per capita gold holdings in the world. Some estimate the private holdings in Vietnam top 1,000 tons making it the 8th largest gold hoard in the world.
Decrees from central banks will only drive demand into other avenues; it will not lessen it overall. This will protect the value of the domestic currency. India’s jewelry industry recently successfully fought the government’s attempt to limit imports of gold by staging a more than two week strike in protest of a doubling of the import tariff tax.
The Past is Irrelevant
So much of the argument against gold is centered on the past. The bull market is 12 years old, the short-term technical picture is bearish, etc. Keynesian arguments about CPI inflation being tame and asset prices deflating also miss the point. CPI is a measure of inflation past not inflation present or, most importantly, when looking at gold, inflation expectations.
Ever notice that on some days gold acts like a currency and other days like a commodity? Why is that? Why is it that on Monday the headlines will say that gold dropped on deflation fears along with the equity markets and other days it rose as a safe-haven asset along with bonds, which are supposed to be sold when people are buying equities? While our markets are becoming more volatile and more correlated as more capital is concentrated in the sub-millisecond time frame Thanks in part to high-frequency trading, these previous macro concepts are unjustified.
Gold is a currency that receives flows of money based on the view of bond traders to be able to profitably play the spread between short and long term inflation expectations. Gold’s role in the monetary system is as a hedge or defense against central bank inflation. So, when the stock market is down because it is over-valued in the short term, after a rally its move may not move gold. But when equities are sold because the central bank indicates it is going to tighten monetary policy then gold is sold as well.
The Present Deflation Scare
Currently the Federal Reserve is jaw-boning the markets; down-playing the amount of money it will print to keep the markets from imploding and attenuate the demand for gold during an extended period of zero-bound interest rates. But those are the headlines, playing on the hedge fund managers’ collective belief that the Fed knows what it’s doing and then applying flawed models for buying and selling day to day when the real trends in gold are created by what the real inflation spread looks like in the biggest and deepest markets in the world, the U.S. Treasury market and the U.S. Dollar interbank market.
This endless talking about QE3 is just that, talk. The Fed and the ECB have been printing via off-balance sheet, unlimited-rollover swaps between major central banks since they announced their coordinated efforts in November of 2011. Even the Greek default and subsequent CDS pay out was down-played into a non-event to feed this perception. But now Portugal and Italy are on the table and they are far bigger than Greece. If Greece necessitated two years of machinations, unprecedented coordination between 5 major central banks and multiple rounds of bond buying by the ECB, what will have to be done to sterilize Portugal and Italy?
The Money Shot
So, I have talked around how I see the gold trade, teasing you like the Fed teases us with its pronouncements every third day about the probability for QE. To me the inflation expectations of the bond market can be adequately described by the spread between the 3 month OIS swap rate and the yield on 10 year U.S. Treasury Inflation Protected Securities (TIPS). Taking that difference (3MO OIS minus the 10 year TIPS yield) creates the inflation expectation indicator (blue line) in the chart below.
So, while the gold bears last week were screaming that Gold was going to $1500 per ounce and the bulls were looking at their charts and hoping Gold would not break its 3 year trend channel or a major moving average, I was looking at inflation expectations for investments of gold.
There have been two significant periods of divergence in direction in the past year, mid-December and late March. Both of those periods were periods where the gold community screamed about manipulation and intervention in the gold market. I’m not willing to join that camp, though I don’t necessarily disagree with them at this point. At this point I focus on inflation expectations and ignore the noise which is all designed to confuse and distract you. Gold is the most politicized market in the world and too difficult for the average investor to attempt to make heads or tails of without clearing your mind of what it represents in the monetary system. The fundamentals for gold have not changed since the beginning of the bull market and do not look likely to change any time soon.