The gold bubble bursts!

There, I said it. I wanted to get that out of the way before a Pascometer or similar gold skeptic stole the punchline.

So, is it true?

In my view, no. There’s a simple reason for why not. Gold wasn’t in a bubble in the first place. A bubble is formed when people buy an asset simply because it’s going up. Fundamentals cease to matter and, when something comes along that finally pricks ebullient sentiment, a cascading reversal transpires.

The fundamentals behind gold are a little different to other asset classes. Gold has no yield so is impossible to value. But again, that does not mean it is a bubble. It only means that the fundamentals that drive gold are atypical. So what are they?

The overwhelmingly greatest influence over the gold price is the value of the $US. Gold is NOT a safe haven, except insofar as it guards against $US devaluation. Gold is a the $US’s alter ego, its shadow, its ultimate hedge. That’s pretty much all there is to it.

So, in a period when the value of the $US is under sustained assault in monetary and fiscal terms, gold’s fundamentals are strong, whatever price it’s at.

Right now, the $US is embarking on one of its epic rallies. Driven by both global economic weakness and the burgeoning European financial crisis, carry trades all over are reversing. And the $US, which is a safe haven, is rising and will keep doing so.

Thus, gold gets hammered. I learned this hard way, when trading gold ten years ago. When the gold market cracks, it cracks!

So, when will it reverse? The Prince’s charts this morning give a better guide than I can. I suspect the market can go some way lower.

Fact is, gold will not resume its climb until early-moving traders start to anticipate further quantitative easing in the US. For that to happen, there will need to be considerably more economic pain, enough that the nutters in control of US fiscal policy panic and get out of the way. Don’t forget, in my experience the gold market will signal it happening well in advance of you reading it in the news.

For these reasons, I expect the gold market to turn up whilst other commodities are still getting hammered by the (assumed) coming Western recession. Though, I’m getting well ahead of myself now.

There is only one fly in the ointment for the long-term gold bull market that I can see. That is, if the euro completely comes apart. That would return the world to King Dollar for a much longer period and may force gold to consolidate for much longer.

Houses and Holes
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Comments

  1. “gold’s fundamentals are strong, whatever price it’s at.”

    Gold has gone up 500% in the last decade. Are you expecting 500% worth of inflation to justify the current value of gold?

  2. I largely agree with you.

    Does anyone really think that the US Federal and State governments will ever repay their debt?. I suspect that the only viable way out is via money printing and hence by inflating away their debt. In this scenario one would expect the long term prospects for the US$ to be fairly bleak and hence the long term future for gold to be quite bright (all else being equal)

    That said, I think much of the new printed money is being used by the banks to bet on everything rather than using it for something useful (like funding real businesses). This gambling seems to cause so much of the wild fluctuations, so who knows what the real value should be?.

    In most casinos the house always seems to win, by ensuring that the the odds are stacked in their favour. I think many of the big players have out maneuvered the regulators so that they are now in charge of the casino. Now the only guarantee seems to be that the tax payer always looses.

  3. Are you saying gold is the alter ego only of US dollars, or of all fiat currencies? Part of my reason for holding is to prepare for the possibility of a sharp fall in the Aussie dollar.

    • Gold is theoretically static, whilst the fiat currencies are the elastic measuring tape.

      Have you ever tried to measure something with elastic? It doesn’t work too well.

      Hedging a loss of purchasing power in the AUD is not a bad choice IMO, but there are a lot of factors at play. Some believe that the AUD is in fact a bit of a correlation to the price of gold in that it is considered a ‘safe haven’ away from the USD.

      I call BS on that, but I do think it is unlikely that you will see a depreciation USD gold price and an appreciating AUD at the same time, unless the gold price is artificially suppressed.

      Always always always keep in mind that the price of gold is a PAPER price. It is leveraged, it is manipulated.

      See this quote I stole from Jesse’s Cafe:

      “That day the U.S. announced that the dollar would be devalued by 10 percent. By switching the yen to a floating exchange rate, the Japanese currency appreciated, and a sufficient realignment in exchange rates was realized. Joint intervention in gold sales to prevent a steep rise in the price of gold, however, was not undertaken. That was a mistake.”

      — Paul Volcker, Nikkei Weekly 2004

  4. Gold is always in a bubble – sometimes a small, baby-bath type bubble and other times it is more zeppelin-like.

    There is only one reason to buy gold – because you believe others will be willing to buy it from you at another time and that you will receive something truly negotiable for it when that happens.

    • That ignores thousands of years of history that accrue to gold as asset of intrinsic value. I’m not an obsessed gold bug or advocate of gold standards at all but you can’t ignore all of that history.

      • HnH, when gold was the basis of currency, it made sense to acquire gold. But of course, gold was not always freely trade-able and its price had to be regulated in order to control conditions in the real economy.

        But gold is no longer negotiable as currency. Its value is not backed by the legal authority or taxing powers of any state. If you are selling gold, it is worth only as much as you are able to negotiate from a buyer. So when you buy gold, you are really only betting that others will be there in the future to give you currency for your gold….not always a bad bet, but still a bet, pure and simple.

          • HnH, Suppose had you bought a redeemable and/or exercisable bus ticket a few weeks ago. On the day it cost the same as an ounce of gold – US$1900. And then this morning you decided you didn’t need the ticket and returned it to the market for redemption, the deal being you get the daily market price of an ounce of gold – let’s say $1650 this morning. So holding the ticket for a couple of weeks has cost $250, and you didn’t get to go anywhere.

            I’m not sure how you would be feeling: like you’d been taken for a ride? Or had been hit by a metaphorical bus?

            The point is, when you buy gold, you can be confident you will be able to redeem it for legal tender, but you just never know how much.

            On the other hand, if you hold cash, you will be paid interest and will recover the time value of money, adjusted for inflation.

            Surely this is just about the relative risks entailed in the choices. At least when you hold an interest-bearing security, you can ALWAYS deduce a probable future market price. From that point of view, interest-bearing cash accounts are the least risky possible investment. By contrast, because gold delivers no income (in fact, it costs money to hold it), you can NEVER deduce its probable future market price. It is in this sense an intrinsically speculative investment.

            Even if the interest paid is less than the rate of inflation, a cash investment is still less risky than gold, and for the same reason: you can ALWAYS deduce its future nominal value and therefore calculate a rational probability-weighted and discounted value for any given time.

            By contrast, you can NEVER know
            what rate of discount/rate of premium to apply to gold.

            This is risk in its purest form.

            It seems to me the market has been pricing leveraged gold futures as if the relevant discount rate is the opportunity cost of not holding Treasury bills – that is, close to zero. That is to say, the risks have been radically under-priced, and now the market is adjusting very quickly.

          • @ briefly

            What you say makes a lot of sense, a good post.

            However, I think you dropped the ball on the last sentence “That is to say, the risks have been radically under-priced, and now the market is adjusting very quickly.”

            The bus ticket thing works the other way too. Not that it makes your argument irrelevant or anything.

            “At least when you hold an interest-bearing security, you can ALWAYS deduce a probable future market price.”
            Key word here being ‘price’. Yes, a nominal value. Zimbabwe bonds are excellent value, they pay you a 10% return on your 10 trillion dollar note?

            You make good points about gold as a commodity. So, trade it like a commodity then. You’ll be joining many others who do the same. But there are plenty of people who buy it as a store of value – they don’t need to buy a bus ticket with it, that is their ‘savings’.

            You speak of calculating the value of financial assets using probability – but you miss the point. Gold is a hedge against the failure of fiat currency. The kind of ‘probability’ thinking you do is like that of traders before the GFC. They got wiped out by that Black Swan. How are you prepared for a Black Swan?

        • So when you hand over a $50 bill, what are you handing over? Its mean’t to represent some transfer of wealth.

          Historically it saved you lagging a sack of silver or gold to a transaction.

          google ‘aureus’, ‘daric’, ‘stater’. The paper money should be nothing more than a promissary note.

          Hmmm wonder why Bretton Woods was convened?

        • When you hold USD, you are really only betting that the Federal Reserve will not debase and erode the value of that currency. Not always a bad bet, but still a bet, pure and simple.

          • This is not the case. You will generally earn interest and have a near-absolute perpetual certainty of recovering your principal value. If there is inflation, generally the interest rate will reflect this.

            If some official interest rates are now exceedingly low, this is because investors are willing to temporarily forgo income for deep liquidity. This is a measure of deep risk-aversion in debt markets. (If you look outside the AAA-rated official rate world, you can find the same risk-aversion is constricting the availability of credit for all kinds of borrowers, including some of the world’s largest sovereign economies.)

          • “Real interest rates in the US have been negative for a decade.”

            You mean that cash has an ongoing annual holding cost.

            The same applies in australia depending on your tax rate.

          • Your point was that gold is just a bet that others will recognize the value of your gold and be willing to exchange it for currency that can in turn be exchanged for goods and services. Exactly the same applies to fiat currency. It’s just trust. You hope that others will continue to value your fiat currency at the same level as when you acquired it. If not, the fact that you recovered your principal value will be irrelevant.

            I’m sure it’s a great comfort to Zimbabweans that interest rates generally reflect higher inflation.

        • You’re correct. But as recent history shows, money isn’t backed by anything tangible anymore either.

          So in the worst case scenario, what can you trust. Something that can be printed up at will? Or something that can’t?

          Ultimately we all know that the debt can’t be paid back. So where does that leave us?

          • briefly, you said:

            “You will generally earn interest and have a near-absolute perpetual certainty of recovering your principal value.”

            I don’t disagree. However, the concern is not so much that you’re not going to recover your principal, it’s that your principal won’t be able to buy you anything even if you do recover it in full.

            Where nearly all developed economies have promised to either lower or keep nominal(nevermind real) interest rates at ZERO – sure you will recover your principal, but you won’t be able to do anything with it.

  5. “Fact is, gold will not resume its climb until early-moving traders start to anticipate further quantitative easing in the US.”

    I reckon the converse applies. It is starting to sink in that effective monetary and fiscal easing is off the table in the US, bringing gold’s run to an abrupt end. All the talk of hyper-inflation and the debasement of the currency has been seen for what it is: pure folly.

    Soon it will dawn on people that Keynes was right. The ultimate price-determining force is aggregate demand. No matter how much liquidity there is in the system, if people will not draw cash and spend, it remains as a merely latent force. Money does not by its mere existence propel economic activity and therefore cannot influence the prices of goods and services. It follows that further monetary easing by itself will not drive economic expansion.

    Our problem is that not all available factors of production can be productively utilised. Manufacturing capacity is idle. The available labour supply is cannot abe profitably engaged. Excess capacity exists in the many parts of the services sector (construction, telecoms, retailing, transport, banking). This is the 3-dimensional reality of the global economy and it is about to get a lot worse, with or without further monetary
    relaxation.

    • I”m not sure the hyperinflation argument alone is necessary to suggest that gold will go up. QE2 had no effect on the broad money supply (M3) but gold has still gone up. Maybe it’s just the meme thing that H&H has talked about and traders clinging to their 2nd year macro textbook and the money multiplier.

      OR, I just think that in the back of people’s heads they know the days of the USD being the SOLE reserve currency are numbered and we’ll witness the end of this undollar/dollar dichotomy and the secular bond market in a few years. So where do you park vast sums of money and begin diversifying?

    • So are you saying that you think the US can repay its debts without resorting to money printing and inflation?.

      If so, how?. What are the alternatives?
      They could default, which would send gold skyrocketing. They could severely cut services and raise taxes, but I think this would be very unpopular and electorally difficult to implement (especially given the current political environment). In this case I think gold would really drop in value. Or they could inflate their debt away with more money printing.
      In the end the money printing option is probably the least painful for them.

      Money printing will also cause some of the nations the US see as partially responsible for the global trade imbalances (i.e. China) to share some of the pain by experiencing severe inflation.

    • I agree with most of what your saying, but I think the markets have priced in the EU being rescued which I think is part of the gold selling going on. If I look back in history before a big correction this selling happens, and like we’re seeing other commodities also sell off.

      I think were in a situation where the big money investors have a total lack of trust in all financials and hence the rush back to the USD. They don’t trust the politicians, bankers, and markets IMO.

      Since gold is still used by CB’s you can still use it to acquire currency even if it’s only an SDR, but I’m sure there are other real currency trades. The non US CB’s also don’t value gold at USD 42 like the FED/US Treasury, but I don’t know the details of their trades. Maybe someone out there in MB land does?

    • Nah. They’ve passed the gauntlet on to the Europeans. After all China was getting annoyed with all the printing and recently made the statement that it was planning to dump T-bonds.

      This is a baton race. The printing agenda has just been passed on. There is just a short delay before normal service resumes.

  6. From what I understand the money printing required to actually generate inflation with QE3, QE4 would need to be absolutely staggering in scale and even then, I’m still not sure how it would get out in to the system and not just sit in bank reserves (as briefly pointed out).I guess default would be an option in the end, I’m not sure.
    But you don’t need to know if it’s going to be hyperinflation or a default to suggest that the US government’s cost of borrowing is going to increase beforehand (and likely the USD’s refuge status).

    Another undollar/dollar killer would be if merging markets disengage from currency wars and inflation, raise their rates and stoke domestic demand at some point.

      • I think money printing is the mechanism by which the US hopes to become competitive again (as discussed previously by H&H and others here at MB). By devaluing their currency and hence the cost of goods and services originating in the US they hope to regain competitiveness.
        Money printing also has the added impact of causing inflation in developing countries and hence it should increase pressure on these countries to allow currency appreciation and hence further improve US competitiveness.

        I suspect US diplomatic efforts to get China to allow the Yuan to appreciate have not been that successful, so the US have started exporting inflation to try and break the currency peg.

        If they keep printing then the money ends up in the system somewhere and it will eventually lead to inflation (with a lag that will cause different problems later on). At the moment the banks seem to think that gambling with the money gives a better return than lending it to real businesses. From the banks point of view they have nothing to lose. If they win the bet they make money, if they lose they generate conditions that lead to more printing.

        The real loser in all this is your average tax payer who ends up bailing out the bankers. I think the best solution would be for governments to bailout (extend new but strict credit terms to the average borrower) and let the banks fend for themselves. It will never happen of course as the people who have the power to make such decisions are all former bankers who have too much of a personal interest at stake.

  7. Nice post HnH.

    Pretty vicious sell off. Looks like Gold has bounced nicely off the 200MDA, would have made a nice trade if spotted at the time.

    briefly said:
    “But gold is no longer negotiable as currency. Its value is not backed by the legal authority or taxing powers of any state. If you are selling gold, it is worth only as much as you are able to negotiate from a buyer. So when you buy gold, you are really only betting that others will be there in the future to give you currency for your gold….not always a bad bet, but still a bet, pure and simple.”

    It’s as much a bet as keeping dollars in a bank account and expecting it will be there or have retained it’s value tomorrow.

    During uncertain times like this I’ll take the thousands of years of history that Gold provides over relatively new fiat currencies.

    • “During uncertain times like this I’ll take the thousands of years of history that Gold provides over relatively new fiat currencies.”

      I agree. Although my biggest question regarding gold is what portion of the market are genuine investors that seek gold as a store of wealth (i.e. those that are willing to take possession of physical gold) compared to those that seek to use it as a vehicle for gambling (arbitrage)?.

      My fear is that with all the printed money the big players are sitting on, the latter group is getting bigger and bigger relative to the former.

      Maybe there needs to be some sort of “gambling” tax to level things out.

  8. Bubble – No Bubble – Doesn’t matter. There’s just a price a prayer & a stop loss.

    There’s just too many variables & ‘If’s’ to see clearly to any depth of this crystal ball…. well for me at least. Especially when it’s all being so muddied up by all the cronies. Does anyone know who’s going to pull what stunt next & the real timing of any such stunts? History will tell which hypotheses are right in this (new) paradigm. & as price action dictates – there will be winners & losers. May none of us lose our shirt.

    I’d rather speculate with price action than stick myself with the dogma of any premise built on the backs of these fickle ‘elites’. Or from any school of economic theories. They’re not all going to be right!

    Be Flexible of Mind, Nimble of Heart, Fast of fingers, Don’t marry any ideas have an action plan built on paranoia & Use the Charts Young Skywalker! The Charts!!

    • +1

      LMAO. So true.

      “Be Flexible of Mind, Nimble of Heart, Fast of fingers, Don’t marry any ideas have an action plan built on paranoia & Use the Charts Young Skywalker! The Charts!!”

      You are a poet sir!

  9. I think everyone is complicating the situation, Treasury’s are the most crowded trade in history, the stampede out of Treasuries will make history, where do you think this money will go?

    • Agreed.

      We need to keep in mind the three main reasons, IMHO, that PMs just just tumbled so badly:

      1) it was news of a EURO problem that sparked a run TO the USD – ie. it was not a US problem –> such that, if/when news of the next major US “problem” arises, people will run OUT of the USD…

      2) CME has packed a punch every time, and was very well timed in the middle of the non-Euro flight

      3) PMs are still highly leveraged, such that it is still more of a “play” than a safe-haven

      IMO, changes in those three factors will see changes in the way PMs are treated from here-on in.

      My 2c

      • Good post H & H. Well said.

        BurbWatcher:
        “2) CME has packed a punch every time, and was very well timed in the middle of the non-Euro flight”

        – plus there was a Shanghai metal exchange margin hike

        “3) PMs are still highly leveraged, such that it is still more of a “play” than a safe-haven”

        – disagree. The paper market is highly leveraged and is currently the price mechanism and is not a safe haven. The physical market is not leveraged and is not currently the price mechanism and is the ultimate safe haven.

  10. 1) It is, in part, a US problem. If the US goes into recession so does half the globe and the $US rises on risk off.

    2)CME did not move this time until after the crash on Friday night, though they did move progressively through August.

    3) Agree

  11. “Gold wasn’t in a bubble in the first place. A bubble is formed when people buy an asset simply because it’s going up.”

    Why then do people buy gold? All those I know buy gold because they expect it to go up in price against the fiat money they will require to pay their taxes and living expenses. They buy it simply because they expect it to go up – a bubble according to your definition of the word. There would be no point if they bought it merely to maintain it’s price in fiat terms. Notes under the mattress would be better than that – no transaction costs.

    • Gold doesn’t go up – fiat goes down.

      In other news, the Pascometer thus spake:

      “It’s tempting to see gold’s fall as the beginning of the pop – but it probably isn’t.”

      Now I’m really worried 🙂

    • My point is that the fundamentals underpinning the value of the $US are shaky, therefore gold has value. That’s why people buy it. When those fundamentals ease away and the price still goes up, it’s a bubble…

      • It’s a relative matter.
        Saying people buy gold because fiat is expect to fall is simply another way of saying people buy gold because they expect it to go up.
        Are bubbles measured relative to something else?
        Perhaps you are alluding to the preservation of purchasing power. Gold lost more than 80% of its purchasing power between 1980 and 2000.

      • “There can be no other criterion, no other standard than gold. Yes, gold which never changes, which can be shaped into ingots, bars, coins, which has no nationality and which is eternally and universally accepted as the unalterable fiduciary value par excellence.” Charles De Gaulle

        Note: No nationality, universal acceptance and fiduciary value par excellence.

        Which leads to: “Gold would have value if for no other reason than that it enables a citizen to fashion his financial escape from the state.” William F. Rickenbacker