First Gold, Then Stocks

Gold ingot resting on a stocks and shares graph representing investment or banking

Well, yesterday was a pretty heavy day if you were loaded up with gold stocks. I’ll have more on that in a moment.

But first, let’s look at the reasons behind the savage selloff in bullion. It’s all about the apparent end of central bank stimulus. Or at least the end of stimulus from the European Central Bank (ECB), and the prospect of higher rates in the US.

We’ve known about the potential for higher rates in the US for some time. But news that the ECB is thinking of tapering its €80 billion per month asset purchasing program came as a bit of a surprise, and contributed to gold’s sharp fall yesterday.

Here’s a question for you though: Are central banks ending their wild monetary experiments because the global economy is now back on track? Is monetary policy returning to a semblance of normality because global growth is normalising? Or is there some other reason for central bank reluctance to continue their experimentation?

My guess is that there is another reason: The need to protect the banks.

The global economy is hardly firing. The International Monetary Fund (IMF) just came out and warned about a global economic slowdown. As CNN Money reports:

Uh-oh. The International Monetary Fund says the U.S. economy is losing momentum.

The IMF said the American economy will expand by only 1.6% this year, down from 2.6% in 2015. The latest forecast is 0.6 percentage points lower than what the fund predicted just three months ago.

The downgrade is mostly down to sluggish second quarter U.S. growth, the fund said in its latest World Economic Outlook.

This doesn’t sound like the kind of environment where you need to increase interest rates to curb breakneck growth and ward off an imminent outbreak of inflation!

Moreover, the IMF backed that up with concerns about the now-astronomical levels of global debt, which, at 255% of GDP, is at record highs.

So why the need to raise rates now?

Well, it’s becoming increasingly obvious to central bankers that their unorthodox policies are now hurting, rather than helping, the banks.

It’s no coincidence that the ECB communicated a pullback on their QE program soon after Europe’s largest bank, Deutsche Bank, got into trouble. One of the main factors weighing on banks’ profits margins is low to negative interest rates. This deprives them of the ability to earn a decent ‘spread’ between what it costs for them to obtain funds versus what they can charge to lend.

Not that this is the source of Deutsche’s problems; but, if it could earn a better return from its bread and butter banking operations, it might be able to internally generate more capital and take some pressure off the balance sheet.

And we know that, in the US, the banks are not fans of ongoing low rates. Just ask Jamie Dimon, boss of JP Morgan, one of the largest banks in the world. From Bloomberg, back on 12 September:

JPMorgan Chase & Co. Chief Executive Officer Jamie Dimon said the Federal Reserve should increase interest rates — sooner, rather than later.

“Let’s just raise rates,” Dimon said Monday during a wide-ranging discussion at the Economic Club of Washington. “The Fed has to maintain credibility. I think it’s time to raise rates. Normality is a good thing, not a bad thing. The return to normal is a good thing.”

A bank boss doesn’t say that unless a rate rise is good for business.

So where does that leave us?

Lower rates for much longer than necessary have left the global economy weighed down by record debt levels. A highly leveraged global economy is now very susceptible to rising interest rates.

And while banks have profited from this increase in debt (after all, the debt sits on banks’ balance sheets as an asset!), with rates so low, they now struggle to make a decent margin on these assets.

For better or worse, then, central banks think that if banks do well, the economy will do well, too. Maybe. We’ll soon find out if that is the case.

My guess is that the financial system will struggle to cope when it no longer receives regular hits of the monetary drug. This will cause major headaches for central bankers. They will find themselves in a genuine trap of their own making.

Which brings me back to gold. Yesterday’s US$40 per ounce price plunge was nasty, but not altogether surprising. And I’m not just saying that. Back in mid-September, I did warn my Crisis & Opportunity subscribers that gold could soon break below support at US$1,300 an ounce, and possibly trade down to US$1,250 an ounce.

Importantly, I said that this would not call into question the longer term upward trend. Rather, it would represent a good long term buying opportunity as plenty of traders panic out of the yellow metal.

This is the important point to keep in mind. In the short term, the price of gold is very much influenced by the positioning of traders in the futures market.

Going into this week, hedge funds were exceptionally bullish on gold. Their ‘net long’ position was 262,000 contracts, with each contract representing 100 ounces of gold.

As soon as support around US$1,300 an ounce gave way, it triggered a huge amount of sell orders, which is why the price fell so sharply.

The good news is that the selloff will have removed a lot of short term bulls from the market. I expect that the ‘net long’ position, when next reported, will have fallen significantly. This restores balance to the market and positions gold for another move higher.

I’m not saying that will happen right away. It takes some time to recover from large selloffs like the one we witnessed yesterday. I think it will be a few weeks at least before confidence returns to the gold market.

The bigger question for me, though, is this: Was the correction in the gold price a leading indicator of what is soon to happen in the broader market? More on that tomorrow…


Greg Canavan,
For The Daily Reckoning

Greg Canavan
Greg Canavan is the Managing Editor of The Daily Reckoning and is the foremost authority for retail investors on value investing in Australia. He is a former head of Australasian Research for an Australian asset-management group and has been a regular guest on CNBC, Sky Business’s The Perrett Report and Lateline Business. Greg is also the editor of Crisis & Opportunity, an investment publication designed to help investors profit from companies and stocks that are undervalued on the market. To follow Greg's financial world view more closely you can subscribe to The Daily Reckoning for free here. If you’re already a Daily Reckoning subscriber, then we recommend you also join him on Google+. It's where he shares investment research, commentary and ideas that he can't always fit into his regular Daily Reckoning emails. For more on Greg go here.

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