Gold is trading around US$1,085 per ounce. That’s a five-year low, down over 40% from its all-time high in August 2011, and down over 8% this year alone.
According to Bloomberg, hedge funds are net short gold for the first time since records began in 2006. Sentiment is abysmal. To paraphrase the brilliant Jim Grant, gold, it seems, has never been more unloved.
Investors know all of this well. The question is why, and what does a temporary collapse in the US dollar price of gold signal?
The search for answers takes us on a journey through the inner workings of this most important and least understood market.
A new age of King Dollar
The first issue to consider is what we call the ‘numeraire’. That’s a French term used in maths and markets. It refers to the yardstick we use to measure other things.
If the US dollar is the numeraire, then gold is down measured in US dollars. But if gold is the numeraire, then it’s more accurate to say that gold is constant (that’s what a numeraire is) and the dollar is much stronger.
In August 2011, one US dollar got you 1/1,900th of an ounce of gold. Today one dollar gets you 1/1,085th of an ounce of gold. You get more gold for your money.
How you look at it depends on whether you believe gold or the dollar is the better long-term benchmark for wealth. I prefer gold, others prefer paper dollars — take your pick.
Support for this ‘strong dollar’ view comes not just from gold but also from every major currency and commodity in the world. Look at the list of things that are down against the US dollar over the past year: iron ore, copper, oil, natural gas, sugar, wheat, Australian dollars, Canadian dollars, the euro, the Japanese yen, and so on.
The only reason the Chinese yuan is not down also is that the Chinese have made a strategic decision to kowtow to US wishes. They maintain a US dollar peg as the ‘price of admission’ to the basket the IMF uses to calculate the value of its world money, called SDRs.
That decision is causing Chinese growth to fall off a cliff, but that’s another story. The point is this is not an age of weak gold — it’s a new age of King Dollar. Therein lies a tale.
An historic blunder
The last age of King Dollar started in 1981 with the combined efforts of Paul Volcker and Ronald Reagan to end the monetary confusion of the 1970s. It lasted until the US economy hit the wall in 2007.
Importantly, that age of King Dollar prevailed through Republican and Democratic administrations, and included the two longest peacetime expansions in US history, 1981–1989 (92 months), and 1991–2001 (120 months).
The US could afford a King Dollar strategy because it had strong, continual growth during the decades of the 1980s and 1990s. The rest of the world would benefit from weaker currencies that promoted their own exports.
The new age of King Dollar is different. Now we are in a period of weak growth, global debt, and currency wars.
When the US Federal Reserve and Treasury greenlit the strong dollar after 2012, they committed a historic blunder. They assumed, based on faulty forecasts, that the US was returning to trend growth and could afford a strong dollar, as was previously the case.
Instead, US growth has continued to disappoint. Now the US economy itself is flirting with recession because of this unfortunate mix of weak growth and a strong currency.
Meanwhile, the Fed has created asset bubbles (in stocks and real estate) and asset crashes (in gold, oil and currencies) under its misguided policies.
Deflation is looming
A foreseeable consequence of a strong dollar in a weak economy is deflation. Collapsing US dollar prices for a long list of currencies and commodities is the result.
The Fed is trying to offset this deflationary tendency with zero interest rates, but it’s not working. At best, the forces of deflation and inflation are cancelling each other out. At worst, deflation will start to win this tug-of-war in the months ahead.
There are also technical factors at play when it comes to gold. Once the US dollar price of gold sinks to a certain level, leveraged investors such as hedge funds hit their self-imposed stop loss limits and have to sell. Others who bought gold on margin may be forced out of their positions by brokers. Finally, some large selling has been coming from China in response to the stock market crash there.
Hedge funds losing money on stocks sell gold to raise cash to meet margin calls. When hedge funds are in distress, they don’t sell what they want, they sell what they can, and gold fills the bill.
All of these factors — stop loss, margin and leverage — add momentum to gold’s downward price movement.
The strong hands will buy
These trends are unsustainable. The Fed will have to blink when it comes to their much-talked-about rate hike, or else they will cause a global crash.
Look for the Fed not to raise rates soon. Perhaps not for years. The gold selling by weak hands in China and elsewhere will run its course. Once you’re out, you’re out. The strong hands are happy to buy at these depressed levels.
There’s nothing unusual about a 50% retracement in commodity bull markets. On the long road from US$200 per ounce to US$5,000 per ounce (or higher), a 50% pullback should be expected. If you take US$1,900 as an interim high, a pullback to the US$950 to US$1,050 per ounce area would be unsurprising. It looks like we’re just about there.
If the Fed maintains its kamikaze tight money mantra in the middle of a deflationary currency war, then gold and other commodities could go a bit lower. My expectation is the Fed will wake up to the damage it’s doing and reverse course — possibly even launching QE4 in 2016.
As this plays out over the next few months, look for commodity and currency markets to hear the message that the Fed will achieve inflation ‘whatever it takes’.
Once that message sinks in, gold will once again shine.
Strategist, Strategic Intelligence
James G. Rickards is the strategist for Strategic Intelligence, the newest newsletter from Port Phillip Publishing. He is an American lawyer, economist, and investment banker with 35 years of experience working in capital markets on Wall Street. He is the author of The New York Times bestsellers Currency Wars and The Death of Money. Jim also serves as Chief Economist for West Shore Group.