The Short Case for Dumping Gold Here

Key News

  • European Union policy makers have no “plan B” to help Greece, the bloc’s top economic official said, and Greek Finance Minister George Papaconstantinou said he’s not aware of talks of a possible rescue. (Bloomberg)
  • Greek vs. German 10-yr Bond Spread: Zoom-zoom!

  • Spain’s unemployment rate hit a nearly 12-year high of 18.8 percent in the fourth quarter of 2009 and is expected to climb further this year as billions of euros in anti-crisis spending winds down. (Reuters)
  • Spanish vs. German 10-bond Yield Spread: Rising!

  • South African credit contracted for a third consecutive month in December. (Bloomberg)
  • A firm dollar and concern over the pace and scope of credit tightening in China drove Shanghai copper down nearly 4 percent on Friday, following a drop in
    London prices in the previous session. (Reuters)
  • Copper futures (black) vs. Shanghai Stock Index (red) Daily:

  • Japan’s oil product sales last year fell at their swiftest pace in 27 years and consumption in December hit a 24-year low for the month. (Reuters)

Quotable

“No gold-digging for me… I take diamonds! We may be off the gold standard someday.”

                             Mae West

FX Trading – The Short Case for Dumping Gold Here

I just love the Mae West quote above. Funny thing is that many gold bugs cling to the belief (any many marketers who should know better validate said belief) that someday we may return to a gold standard. Until politicians are willing to give back the power that flows to them from spending money created out of thin air, it is highly unlikely we will ever see a gold standard. Going out on a limb, odds of that happening are slim to none.

Speaking of the value of gold; we agree with Mr. Soros that it is in bubble territory, as reported in the Telegraph yesterday. Yield competition to us is the key. If interest rates go up, globally—gold likely gets whacked. I know what you’re thinking—rates ain’t going up. In the industrialized world that may be true, but if China doesn’t break it would seem the emerging world rates are going that way. Australia is expected to hike next Tuesday.

What might be a real wildcard is a rate hike in the US for “technical reasons.”

Now that Professor Bernanke has regained his tenure, so to speak, he may be emboldened to follow the advice of a colleague—Professor McKinnon of Stanford University.

Writing in the Fall 2009 edition of The International Economy, Prof. McKinnon makes an excellent case for a hike in short-term interest rates as a way to kick-start interbank lending (Why Banks Aren’t Lending), which is the missing link between the cash sitting on the balance sheets of banks and the ability to get it to the real economy.

“The key point is that the Fed should raise short-term interest rates from near zero to modest levels—say 2 percent. Long ten- or thirty-year bond rates would be largely unaffected or could even fall. But in the current zero- interest liquidity trap, such a modest increase in short rates has distinct advantages.

“First, in the huge but still constricted wholesale interbank market, constraints on borrowing or lending at medium terms to maturity would be largely relaxed. Only then can general bank credit at “retail,” that is, to firms and households, increase. Surprisingly, retail bank credit in both the United States and Europe is still declining.

“Second, the sharp weakening of the dollar against the euro and other important currencies from March to October 2009 would be curbed, thus preventing a new dollar carry trade that diverts American bank lending to foreigners.

“And third, China, having led world recovery—or at least the Asian part of it—with a massive expansion of domestic bank credit and fiscal stimulus, could better rebalance its economy. It could become more restrictive with slightly higher interest rates without again being deluged with inflows of hot money from the United States.”

Many years ago, while toiling away in grad school, filling my head with academia, I had a Professor I really liked. His name was Dick Armey. The same, if you remember him, as former majority whip in the House—his second career. Professor Armey coined the following phrase, if I can remember it correctly: There is the invisible hand of the market and the visible foot of the government. Sorry professor if I messed that up.

The point is this: The market efficiently and without fanfare allocates resources to where they need to go based on incentives that makes sense for two parties making a subjective value for value exchange. The government’s attempt at this is clumsy and inefficient and usually results in nasty unintended consequences that only the market can later resolve.

I think Prof. McKinnon has it exactly right. If we want to continue to travel down the deflationary sub-capacity trail Japan has blazed for many years then leave Fed Fund rates at zero Prof. Bernanke. Otherwise hike short-term rates, kick-start the interbank lending market, let the market work, and get the heck out of the way.

So, how does this loop back to hurting the price of gold?

  1. Rate competition. Gold pays no interest rates. Rising rates tend to tarnish the appeal of gold (assuming of course inflation is not running fast ahead of lagging rising rates).
  2. Economic relationship with the greenback. Rising rates are likely to give the US dollar yet another boost. If the economic relationship between gold and the dollar remains intact, i.e. gold is priced in the world reserve currency—US dollars—and it must maintain relative global purchasing power in dollars, a rising dollar means the price of gold in dollars falls.

Gold (black) vs. Fed Funds Futures Weekly:

Granted, gold can and does play another vital role—safe haven. And in fact we saw gold prices and the US dollar moving together during the credit crunch for a time. But the problem is gold isn’t acting like a safe haven now. In fact there is a positive correlation between troubles in the European Monetary System and gold, i.e. systemic risk has risen and gold prices have fallen. This I think validates Mr. Soros view of a bubble in gold. It is now acting like a liquidity asset instead of a safe haven.

If you’ve been a reader of Currency Currents for a while you’ve seen mentions of my father-in-law, a real gold bug (who actually hid gold and silver in his walls years ago, if he does it now he won’t tell me where). Whenever I send him a chart, he purposely holds it upside down to give me grief. So, I can imagine him reading this little missive this morning. And I know exactly what he will do this afternoon, assuming he has some free cash—flip the chart over buy more gold with confidence.

And so it goes…

Have a great weekend.