Gold outlook improves

Feb 10, 2016·Alasdair Macleod

There is a conflation of three related events that materially alter the prospects in favour of a higher gold price.

The change in the outlook for US interest rates has probably put an end to the dollar's four-year bull run, it is clear that there is a growing likelihood of negative interest rates in the future, and the global banking system is no fit state to manage the potential challenges of 2016. This article walks the reader through the likely economic effects relevant to the future purchasing power of the dollar, and therefore prospects for the gold price.

On the 5th February, the price action in gold was significant. At about 9.40AM New York time, a seller dumped 10,000 contracts on the Comex market, worth about $1.2bn. The price fell from $1162 to $1145, a fall of $17. Having risen over the course of the week, it was vulnerable to profit-taking, so in principal it was a good time to take the price down in order to take the steam out of the market. However, from that $1145 level, gold quickly and unexpectedly rose strongly, gaining nearly $30 into the close. Furthermore, the gold price has continued to rise this week.

Of course, we don't know who the seller was, but he will be nursing some serious losses. If it was the US Government's Exchange Stabilisation Fund, the cost won't matter; what would matter is that an attempt to put a cap on the gold price was a dismal failure, and merely exposed a major change in market sentiment, from extremely bearish to growing bullishness. This is backed up by increasing open interest on the Comex market, a clear indication that a rising gold price is no longer driven solely by the closing of short positions, but new buying is now driving the market.

The change in sentiment is notable, and coincided with the Bank of Japan reducing its deposit rate to minus 0.1%. There is a growing realisation that negative interest rate policy (NIRP) could also be on its way for the United States, so we must digress from considering the gold price to explore the potential effects of NIRP.

The best way to understand NIRP is to regard it as a tax imposed by the central bank. There are now an estimated $7 trillion of government bonds with negative yields, costing the global private sector $7bn for every 0.1% of negative redemption yield. Commercial banks will also seek to recover the cost of negative rates on their loan books by increasing their charges to customers, including borrowers, as the banks in Switzerland have already demonstrated. So paradoxically, negative interest rates will not stimulate economic growth, instead they will be an extra cost to bond investors, savers and borrowers, discouraging the expansion of bank credit and genuine investment in bonds. The only beneficiary is the central bank, which collects the NIRP tax and inflates the asset prices on its balance sheet.

Such tinkering always ends in the tears of unintended consequences. It is a measure of how desperate the extraordinary measures considered by central banks have become. A rational central banker surely recognises that there are potential downsides to NIRP, but fear of deflation is likely to be his or her dominant emotive force.

NIRP certainly has the potential to trigger a return towards the Fed's inflation target of 2%. If the Fed introduces it, the prices of all commodities, being priced primarily in dollars, will go into a natural state of backwardation, potentially making the cost of physical ownership of commodities such as precious metals less costly than holding bank deposits.

The objective of NIRP is a price effect that can best be described as designed to change the public's preference from holding money in favour of buying more goods. This should not be confused with a rise in prices reflecting a higher quantity of money and credit in circulation, predicted by conventional monetary analysis. It is likely, as will be demonstrated, that prices will start rising independently from any change in the level of bank credit.

Buyers of commodities, such as gold, do not extinguish their money, unless a bank physically sells them the commodity off its own balance sheet. Instead, the commodity supplier ends up with bank deposit money transferred to its account, which it then distributes to defray operational costs, ending up as smaller deposits in the bank accounts of the employees of and suppliers to commodity importers and domestic miners. In the case of imported commodities, the deposits are recycled through the foreign exchanges to be mostly reabsorbed into the banking system, where they will be mostly extinguished.

Besides commodities, this is also true of the other cost components in the manufacture of goods and the provision of services. With an understanding that the bulk of deposits continue to exist when private sector buyers acquire commodities and raw materials, we can now address the likely price effect of NIRP. Price stability with a fiat currency depends on the public's overall money-preferences, relative to owning goods. If prices fail to rise in line with monetary expansion as has been the case since the Lehman crisis, people must increase their deposits, unconsciously increasing their preference for money.

This is why an increase in the quantity of fiat money and credit does not automatically lead to price inflation. Since the Lehman crisis triggered the last set of "extraordinary measures", checkable and savings deposits at the banks have grown from $4.7 trillion to $9.9 trillion, implying ordinary people and their businesses have more than doubled their preference for money, while prices at the retail level have risen less than the expansion of money supply would have suggested.

This has happened because deposit money is the other side of the expansion of bank credit. Now imagine what happens if the private sector collectively reverses this trend of money-preference even slightly, always bearing in mind that people act as both producers and consumers. We now have a situation where the population, both as producers and consumers, desire money less than before, relative to goods. Prices for goods would then rise, without a significant change in economic activity. In short, the private sector reducing its overall preference for money is the root cause of stagflation, and is a process which once started can easily spiral out of control.

We need not speculate about how far negative interest rates will have to go to trigger this effect, because if NIRP is introduced, it will be extended until higher prices are stimulated. One would expect the likelihood of NIRP to be anticipated in the foreign exchanges first, as speculators begin to discount the damage it will bring to the dollar's purchasing power. So it is notable that from early December there have been significant falls in the dollar against the euro and yen, which has accelerated over the last fortnight.

This ties in with a growing awareness that the US economy is stalling and that many corporate borrowers will lack the future cash flow to finance debt repayments. The Fed's increase in the Fed Funds Rate in December is therefore increasingly seen as a bad mistake to be reversed, obviously making NIRP much more likely. But for investors, the question now arises: how does one hedge a fall in the dollar, when the other major currencies, particularly the yen and the euro, are already pursuing NIRP? For these currencies, a modest fall against the dollar is a measure of a successful and competitive monetary policy. And if the Fed goes nap on NIRP, we can expect other major central banks to increase their negative rates even more. So selling the dollar for other currencies must have limited hedging appeal. The focus therefore is likely to switch to accumulating commodities, including energy.

There is another reason for people to want to change their money-preferences: their bank deposits face the growing risk of being exposed to bank failures. Small depositors are theoretically protected by state-sponsored deposit protection schemes, but larger balances could become very mobile.

We have seen bank share prices fall heavily in recent weeks, and credit default swap prices for certain banks have also been rising alarmingly. There can be little doubt that banks are too fragile to survive the bad debts that will be the consequence of even a partial slide towards debt liquidation.

This is why central banks first introduced zero interest rates, and are now experimenting with NIRP. But as already described above, logically NIRP acts as a tax on bondholders and the banks. The cost is passed on to their customers, so it is not the economic stimulant central bank economists believe. It is a racing certainty that some of the $5 trillion growth in deposits and savings in bank accounts since the Lehman crisis will begin to move into gold and other non-fiat currency hedges.

We had a foretaste of how serious this situation can become with the Cyprus banking crisis in 2013. It was a bungled bail-in that resulted in a flight of deposit money from the banks on the Eurozone's periphery into the safely of German banks. That safety-net is no longer there, because German banks are unsound.

Less publicised was the attempt by customers of bullion banks to exchange their unallocated gold accounts for allocated bullion accounts and to seek delivery of physical bullion. To diffuse a developing gold run on the fractional-reserved bullion banks, a bear-raid was mounted in the futures markets on gold by western central banks, in league with the bullion banks. The intention was to convince the public that gold is an invalid hedge against risks in the financial system, and to unlock the gold holdings in physical ETFs. This safety-net is not available this time either.

This brings us back to last Friday's price action, which failed to depress the gold price. We can't know for sure if it was a US Government sponsored action, but even if it wasn't, it failed to defuse the beginning of what looks increasingly like a new bull market for gold. Admittedly, for the last two years, a post-December rally has ultimately failed, but this one really does look and feel different.

A more accurate assessment of markets is that we are entering a bear market for the US dollar, whose purchasing power could not only unexpectedly fall, but continue to fall at an accelerating rate, as the likelihood of the introduction of NIRP for the dollar increases. If the gold price goes to $2,000, or even $20,000, it will be above all else a symptom of the failure of the dollar.

It would appear that finally we are approaching the destructive end of central bank monetary policies. We are about to discover the hard way, as desperation over the failure of monetary policy mounts, that when the state corrupts its own money it ultimately destroys it.


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