Please find the 12th edition of the annual "In Gold we Trust" report titled "Gold and the Turning of the Monetary Tides" below.
Q1 hedge fund letters, conference, scoops etc, Also read Lear Capital: Financial Products You Should Avoid?
Introduction
“Who is the best
Who holds the aces
The East
Or the West
This is the crap our children are learning
But oh, oh, oh, the tide is turning”
-- “The Tide is Turning”, Roger Waters
Key Takeaways
- The tide is turning in monetary policy: The Fed has convinced the markets of its commitment to normalizing monetary policy by hiking interest rates and contracting its balance sheet. This is going to put the credit-induced boom at risk and will sooner or later trigger a recession.
- A turning of the tide in the global monetary architecture: “De-dollarization” efforts continue to gather pace amid
growing geopolitical tensions. Gold is rediscovered as a supranational reserve asset by various central banks. A failure of monetary policy normalization or an escalation of geopolitical tensions may lead to a significant erosion of confidence in the US dollar-centric currency regime. - A turning of the tide in technological progress: Not every cryptocurrency is destined to shine bright. However, cryptos are clearly here to stay. Gold and cryptocurrencies are actually “friends”, not “enemies” as is often asserted. This is to say, they are best viewed as complementary rather than incompatible assets.
Much of what is currently happening right in front of our eyes provides evidence of an unfolding sea change in the global monetary order. As the US Fed turns from monetary easing to monetary tightening, with uncertain outcomes for the global economy, investors’ trust in currencies issued by central banks is eroding. Blockchain technology has enabled a much-hyped boom in cryptocurrencies as investors seek alternatives to the US dollar, once perceived as an invulnerable safe haven. These shifting tides in the monetary system are coming to pass in different ways, at different velocities, and at different levels of visibility. On the cusp of fundamental change, it is particularly important not to lose sight of the forest for the trees.
The global economic order was and is undoubtedly dominated by the US. The US produces the world’s largest economic output1, enjoys far-reaching diplomatic clout, and is an uncontested military hegemon, all of which testifies to its global dominance. On the currency front, the global balance of power is embodied in the long-standing US dollar-centric global currency architecture, which critical observers have warily referred to as an “exorbitant privilege”2
Confidence in the US dollar has evolved historically. The status of the US as a free market economy with strong property rights and a robust rule of law, deep and highly liquid capital markets3, and a hard currency under the gold standard, have propelled the country to a global leadership position. Moreover, the fact that commodities are traded and settled in USD is of particular importance.
However, faith in the US dollar-centric dispensation is not carved in stone. One measure of international trust is the proportion of global currency reserves held in US dollars. So far, it remains relatively static, as central banks tend to be cautious and deliberate and are not exactly prone to shooting from the hip. As Alan Greenspan pointed out, the price of gold is a useful indicator of global confidence in the US dollar as a reserve currency.4 Combined with the Dow Jones index one can calculate the well-known Dow/gold ratio which also serves as an indicator of the degree of confidence or distrust in the US-centric economic and monetary order.
By the end of the 1970s, confidence in the US monetary system had eroded substantially. The Dow/gold ratio hit an all-time low of 1.29x in January 1980, well below its median of 6.5x. Currently the ratio stands at 19x, in other words, it takes 19 ounces of gold to buy one share of the Dow Jones Industrial Average. Due to the abysmal economic environment in the 1970s and the assumed strength of the Soviet Union, it was not entirely clear at the time whether the West would prevail in the struggle against communism. To almost everybody’s vast surprise, by the early 1990s the US emerged as the only remaining superpower, apparently inviolable in every respect. The US dollar index reached an all-time high around the 120 level5; budget surpluses were rolling in; and by the turn of the millennium the Dow/gold ratio hit an alltime high.
Alas, prior to the Great Financial Crisis of 2007–2009 the Dow/gold ratio suggested that faith in US leadership had already begun to sag. The boom in equities and housing markets was driven by a major credit bubble; its eventual unwinding made clear that a high price had been paid for prolonging the “good times” of the 1990s by a few years. Contrary to the late 1990s, on this occasion the gold market sensed early on that something was amiss.
The Fed reacted decisively to the onslaught of the financial crisis. While the ensuing years of money printing pushed nominal share prices up, the reservations of market participants found expression in the performance of share prices relative to the gold price. Trust was finally fully restored to the markets in 2012 to 2013, after the ECB promised to intervene in the sovereign debt crisis in the euro area and the Fed announced that its monetary emergency measures would be tapered and eventually discontinued. Today, ten years after the crisis, the Dow/gold ratio seems to indicate that US economy is well on the way to regain its former strength.
Or so the story goes.
We will challenge this widely held view in this year’s In Gold We Trust report. We see numerous reasons to question the plausibility of this narrative.
For instance, there are continuing efforts to turn away from the US dollar. We believe this trend is on the one hand a consequence of increasing geopolitical polarization and tensions, as exemplified by the West’s confrontation with Russia, or more recently with Iran; while on the other hand, it is also a result of the ascendance of powerful emerging market economies such as China. Even though this process is not yet obvious to everybody, in our view the tide is turning in regard to the global monetary architecture.
Also most relevant for the price of gold is the turning of the tide in terms of monetary policy. We find it quite remarkable that the gold price (in USD terms) bottomed out exactly at the beginning of the current rate hike cycle. When it became clear in 2015 that administered US interest rates would soon be raised, many market participants and observers sotto voce predicted a precipitous slump in the gold price. In the same year, we pointed out to our readers that rising interest rates could actually prove to be positive for the gold price. Market developments in recent years are testifying to the fact that this assessment was correct.
In addition to hiking interest rates since late 2015, the Fed began reducing the size of its balance sheet in Q4 2017, a process that has been dubbed “quantitative tightening” (QT). From our perspective, most market participants are currently massively underestimating the likely consequences of the QT process. The “everything bubble” which we discussed at length in last year’s In Gold we Trust report6 is at grave risk of bursting as more and more liquidity is withdrawn. The monthly contraction in Fed assets is gradually ratcheted up and will reach USD 50bn per month from October 2018 onward. In total, the balance sheet is to be reduced by USD 420bn in 2018 and by USD 600bn in 2019. However, we believe this monetary normalization plan is unlikely to survive a significant decline in even one, let alone several asset classes (equities, bonds, real estate).
While the Fed is attempting a retreat from monetary accommodation, “monetary surrealism” remains alive and well elsewhere. The QE programs of other major central banks continue, although the proponents of cautious disengagement have become more plentiful there as well. In fact, the ECB has already cut the monthly volume of its net asset purchases twice, and it is widely expected that they will be discontinued this autumn, to be replaced with mere reinvestment of funds the central bank receives for maturing bonds on its balance sheet. This U-turn is long overdue, as the balance sheets of many central banks increasingly resemble those of highly speculative hedge funds. The following chart illustrates that the Bank of Japan (BoJ) in particular is quite far ahead – in a negative sense – of other central banks in terms of its leverage as well as with regard to the ratio of its balance sheet to GDP.
One consequence of our seemingly ever more surreal monetary system is a rapidly growing interest in cryptocurrencies. By the close of 2017, when the bitcoin price set new all-time highs almost daily, even the mainstream media were practically tripping over each other with positive news reports proclaiming the investment merits of digital currencies. The hype over cryptocurrencies generated competition for media attention previously focused on gold - at least for a certain time period, as the following chart illustrates (one could almost read it as a measure comparing the volatility of cryptocurrencies with that of gold):
We have been covering the topic of cryptocurrencies during the past three years. Cryptocurrencies continue to gain traction and relevance, which is why we will once again focus some of our attention on the development of this sector in this year’s report.7 In particular, we will investigate whether cryptocurrencies and gold are incompatible or complementary assets. We have the feeling, that the years to come will definitely bring a technological turning of the tides.
What does the current mixture of multifarious trends imply for gold? Despite rising interest rates, monetary policy normalization, and a still solidly performing stock market, gold held its ground last year. Admittedly, the gold price isn’t really going anywhere at the moment. It is still dancing the cha-cha-cha – “one step forward, one step back, one step sideways”.8 Naturally everybody wonders how much longer this will continue.
How will gold react when the recent headwinds turn into tailwinds? What will happen to the gold price when equity markets stumble, the Fed feels compelled to halt or even reverse its monetary policy normalization program, serious inflation or recession worries begin to crop up, or the US dollar-centric currency regime itself is called into question? Will gold then abandon the chachacha, find its stride, and take off like a scalded bat after the midnight quadrille?9
US monetary policy has to deliver now, that much is certain. The Fed’s monetary policy remains of immense relevance – and not only due to the status of the US dollar as the senior global reserve currency. The Fed was the first central bank that attempted to overcome the financial crisis with a zero-interest-rate policy and QE. Central banks around the world eventually followed suit, embarking on a global experiment that made guinea pigs of us all. The Fed is also the first central bank to tighten the interest rate reins and reduce the size of its balance sheet. Market participants are complacent and their expectations that the Fed will fully implement policy normalization as envisaged are extremely high.
The current – albeit superficial – stability of financial markets depends on the faith of market participants in central banks, in their monetary philosophy, and thus ultimately in the maintenance of the US dollar-centric global monetary order. If the Fed fails in its normalization efforts and the US falls into recession – which is our expected scenario – a severe loss of confidence in central bank-administered monetary policy seems likely to ensue. It is highly doubtful whether the current global monetary architecture will be able to withstand such a profound loss of confidence unscathed.
With all this in mind, we have chosen the image of the turning of the tide as the leitmotif of this year’s In Gold we Trust report. As inhabitants of a land-locked country, a changing of the tide is a fascinating metaphor to us. We neither want to be dragged into the sea by the high tide nor do we want to be left high and dry by the low tide, so we will take a step back and once again take a critical look at the big picture and examine the gold sector with our multifaceted and sober-minded analytical approach. We would like to invite you to join us on our annual journey as we piece that picture together, and we hope you will enjoy reading our 12th In Gold we Trust report as much as we enjoyed writing it.
Yours truly,
Ronald-Peter Stoeferle and Mark J. Valek
See the full PDF below.
