Gold’s Message to Central Bankers

Downtrend stacks coins,on the financial stock charts as background. Selective focus
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Memo to central banks — stop trying to do something.

The market no longer sees you as the solution to the world’s problems. It has finally woken up to the fact that you are the problem.

The latest central bank to do something stupid was the Riksbank, Sweden’s central bank. Overnight, it sent borrowing costs even more negative, from -0.35% to -0.5%. The market tanked.

Sweden is apparently worried about deflation. Hence the deeper dive into negative territory. But negative rates will not end deflation. They will exacerbate it. I’ve explained this a number of times before. Put simply, keeping interest rates low keeps zombie companies alive which ensures excess supply of ‘stuff’.

An excess supply of ‘stuff’ against stagnant demand (because low interest rates aren’t encouraging increased demand) leads to falling prices.

It’s so simple even a dolt like me, sitting at home in Melbourne, can work this out. But for some reason the world’s central banking fraternity can’t see it. Clearly they have their heads some place not conducive to even the most basic thought processes.

The Riksbank’s brainlessness contributed to the Euro Stoxx 50 index falling nearly 4% overnight. Investors savaged European banks, as the Financial Times reports:

Financial stocks suffered another day of heavy selling. The Stoxx 600 European banks index dropped 6.5 per cent to hit its lowest level since the eurozone debt crisis, and losses for US institutions contributed to sharp declines for the S&P 500 in morning trading.

Investors are worried that policymakers’ adoption of negative borrowing rates will become prolonged, further distorting the financial system and limiting the ability of banks to extend loans to the broad economy profitably.

“Markets have evidently lost their belief in the powers of central bank policy,” said Andrew Law, head of Caxton, a longstanding macro hedge fund. “Markets have lived on the basis that central banks were there to provide liquidity and support, and that this would be enough.”

That’s the key phrase behind this bear market sell-off. That is, ‘markets have lost their belief in the powers of central bank policy’.

The selling in Europe continued into the US session. Both the Dow and the S&P500 were down over 1.2%. The Dow is now perilously close to the August 2015 panic low. If the selling continues tomorrow (Friday’s session) then you can bet this bear market has a way to go.

As a gold investor, I’m not really complaining. Gold was a major beneficiary of the turmoil in Europe. It put in the biggest one-day rally in I don’t know how long. At one point, it traded as high as US$1,260 an ounce.

As I write, it’s trading around $1,244 an ounce, up around 3.8%.

But Aussie based gold investors will be happy too. Gold denominated in Aussie dollars surged $63 an ounce, or nearly 4%. It currently trades at $1,752 an ounce.

So what’s going on with gold?

Put simply, the market is moving back in to the asset class after shunning it for years. Here’s what I wrote to subscribers of Crisis & Opportunity on Wednesday:

What are the fundamental reasons behind gold’s strength?

I don’t believe that gold is an inflation hedge. It’s a reflection of confidence in the financial system, and confidence in those who manage it. I also see it as a form of financial insurance.

When confidence is high, the need for insurance is low. When confidence is low, as it clearly is now, the desire for insurance increases. Hence the rising gold price.

And then there’s this scary statistic doing the rounds right now. According to JP Morgan, there are US$6 trillion worth of government bonds offering negative interest rates. I repeat, $6 trillion.

That’s a retardation of the laws of finance on a huge swathe of assets. Gold, often criticised for yielding nothing, suddenly looks good. If the Fed tries to do something as stupid as pushing rates negative, the gold price will explode.

Well, if it jumped nearly 4% on the Riksbanks’ actions, can you imagine what it would do if the Fed went negative too?

In Aussie dollars, gold is now just below its all-time highs. As you can see in the chart below, it recently broke out of a long term trading range. That was the signal for the bull market to have another leg up.

Source: StockCharts

In short, the recent price action for Aussie dollar gold is very bullish. But before you scramble to run out and buy gold, keep in mind that these bullish price break-outs nearly always correct back towards the breakout area. Which in this case is AU$1,650.

The other thing to keep in mind here is that gold is acting in unison with global currencies. Nothing ever happens in isolation in global markets. Everything is connected.

In this case, the market sees gold as a currency. Have a look at this next chart. It shows gold (in errr…gold) plotted against the Japanese yen (in black). Look at the correlation. In recent days, gold and yen have both soared.

Source: StockCharts

What you’re seeing with gold is a reflection of the huge moves occurring in global foreign exchange markets. Japan’s move to negative interest rates, announced on 29 January turned out to be a debacle. The market has completely rejected the Bank of Japan’s logic.

All I can say is thank goodness that China is offline this week. No news is good news. In saying that, China proxy Hong Kong had a shocker yesterday, with the market there down nearly 4%.

With central banks becoming increasingly impotent, it’s hard to see what will bring about a change in sentiment. Compared to government bonds, stocks are good value. But with a slowing (and highly leveraged) global economy, earnings for stocks could fall sharply too.

This is what bear markets are made of, dear reader. Fear, uncertainty, and total lack of confidence. But don’t despair. This is exactly the sort of environment you need. It pushes stocks into the good value and long term buying range.

But to benefit from the bear you need to protect your capital. So don’t go throwing money at the market or ‘averaging down’ on current losses. Sit back and wait for evidence that the market has bottomed.

With Aussie stocks crashing to new long term lows, there is no sign of a bottom just yet.

Greg Canavan,

For The Daily Reckoning

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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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