Getting gold wrong

I generally don’t mind a bit of the AFR’s commodities commentator, Stephen Wyatt. But today he shows a complete lack of insight into the dynamics that drive the gold market claiming that:

Gold is behaving badly. It’s supposed to be a safe-haven asset but, just when the global economy looks like going to hell in a hand basket, the gold market collapses. It should have rallied.

The gold bugs are bemused, but they are nowhere near raising the white flag.

UBS analysts in a recent note to clients said: “Our core view on gold remains bullish. We forecast an average 2012 price of $2050. Most of the factors that pushed gold higher in 2011 are not going away.”

UBS says a compelling case for higher gold returns next year can be built on persistent sovereign stress, an expected recession in Europe, benign growth across developed markets, a relatively sedate outlook for competing asset classes, still low interest rates in the US and further rate declines in Europe.

Well, that may be great for gold, but if UBS is right it’s the kiss of death for equities and industrial commodities.

Right now, though, this gloom is not even working for gold. Something is wrong.

As the euro zone debt crisis deepens and developed economies hurtle toward recession, the gold price has slumped to its lowest level since September while the US dollar has soared.

The gold price tumbled almost 9 per cent to $US1560 a troy ounce at one stage last week and gold is still trading below $US1600. It broke down below its 200-day moving average for the first time in almost three years.

Rather than gold being the primary safe-haven asset, US dollars and US treasuries have become the preferred safe-haven asset classes. The US dollar’s position as the world’s reserve currency gives it the advantage of liquidity and in very turbulent times investors seem to prefer liquidity to less liquid assets, even if those assets are seen as safe havens, like gold.

This is really wrong-headed. Gold is a safe haven asset but of a particular kind. As I have said countless times, gold is the ultimate “undollar”. It is first and foremost a $US hedge. Here are gold and the $US indexed to zero since 1995:

I have been bullish on gold since 2000 for the simple reason that it was clear that the monetary and fiscal settings behind the $US were entering a period of sustained instability and the dollar was likely to fall in value as a result. The corollary is that crises that cause the dollar to rise will usually, as well, make gold fall (the exception being war).

But Wyatt’s misinterpretations aren’t done:

The gold bugs see its price fall as temporary and expect another bounce. They do not see any paradigm shift. They believe that gold remains an important safe-haven asset. They believe the selling is short term and driven by the need for cash.

And indeed the global economic outlook is not all that flash and should continue to support investment demand for gold.

There has been selling of gold by the big investment funds to take some profits and shift into more liquid assets. The selling has also been driven by the need for hedge/investment funds to raise cash to pay out investors who want to take money out of those funds.

But it is critical to understand that gold really is just yellow and heavy and in massive oversupply. The surge in the gold price is a massive asset price bubble.

It has been speculatively driven. One day the gold price will collapse.

Of course it will collapse one day. But it’s not some mystery when. Nor does it have anything, at all, to do with supply and demand. Gold will fall sustainably when stability returns to the $US, or, for that matter, to some other rising reserve currency that replaces it.

Until then, gold is not in a bubble. It’s fundamentals are instability in the structures that determine the value of the reserve currency. Though I think the above chart clearly shows that the market was overdue for a correction, one reason I called the top earlier this year.

The European crisis was never going to be supportive to the gold price. That’s a Wyatt straw man. As the safe haven flows of global capital head back to the US, gold will continue to get smashed. This is neither new nor mysterious. Only when markets get a sense that the Federal Reserve is set to respond to those flows, by loosening its own monetary policy, will gold recover. In my view, there’s a great trade ahead for gold in advance of QE3.

If, however, you think that the US recovery is real and can accelerate from here with a rising currency then the gold bull market is likely over.

It’s good to see the AFR offering some material online but let’s hope it improves from this effort.

Houses and Holes
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  1. If you are a weak had who cannot stand volatility, please sell your gold. It may drive the price lower and then I can buy it :¬)

    Merkel’s pro-deflation stance and central bank gold sales to cover their sorry asses is what’s behind this. Nothing to see here, move along. Gold is still up for the year.

  2. Wyatt is a consistent gold basher from years back. His writings on gold seem to echo the bank gold analysts of the 90s, Andy Smith and co, who articulately developed various theories as to why gold was worthless. Implicit in the argument was invariably the message that you (as a gold producing company) should visit the bank and forward sell your gold as they were making massive fees from that business. Wyatt doesn’t have the quasi convincing spiel or the obvious vested interest, but he is similarly blinkered.

  3. About Roubini- I’m a huge fan but his thoughts on gold are a bit off to say the least. He uses the straw man argument about there being no chance of us going back to a gold standard. Even if there isn’t a chance the fact that reserve banks and markets around the world consider it to be a store of wealth is enough to give it real value. He seems to be arguing against the evangelical Peter Schiff and James Rickard types who are hell bent on calling gold ‘money’ and who forecast 3000- 30,000 price ranges..

    It could be mounds or rare dirt, or widgets…it doesn’t matter. Its identity as a store of wealth is centuries old and if it’s the tallest midget in a height contest then so be it.

  4. D Merkel @ the aleph blog did a fun exercise on his blog earlier this week. He tried to model them based on interest rates but real interest rates.

    Other than precise fit what got me interested was the theory behind it where rather than inflation/deflation headge conspiracy, gold price was modelled as an opportunity cost against holding fiat money and a bet on real growth of the economy going forward. Ultimately the CB shenanigans of fighting the deflation will have to manifest in some other form of trustworthy asset.

    Another interesting read on the topic is a further link from Merkel’s blog to John Hempton’s post on the contrast between bonds and gold price. The comments section of the brief post have some interesting musings (with utmost respect to John’s analytical goodwill, hindsight proved some of his misgivings about the rationality and prices false. They further extended their gains as opposed to reversing)

  5. It’s a complete mystery to me how commentators find this dynamic so difficult to comprehend. USD rallies, gold slides. USD slides, gold rallies. It’s plain to see on a daily basis.