Gold Heads for a Blowoff

October 13, 2012 at 09:14


It’s difficult for anyone with as sceptical a view of human nature as mine to advise people to be be anything other than permanent hoarders of cash. Yet I resist the temptation. Right now, I believe, we are going in to a long period when holding currency and bonds will turn out to have been the wrong thing to do. I have a framed French assignat note from 1792 on my desk; it’s a good reminder of what can happen to apparently liquid wealth.

Considering all the risks in the world, I understand why someone with money can turn into an autistic recluse, refusing to come out of hiding until people they like have been elected. That basically describes the behaviour of the banking system and corporate treasuries in the developed world. Having been told for more than four years that the taking of speculative views is the devil’s work, they have been refusing to take any views at all. That’s worked out pretty well; holders of the better class of government bonds have profited from the flight away from other assets.

Think about this: among all the issues, real and consultant-manufactured, in this US election season, the risk of inflation has not made an appearance. There’s been lots of talk about the middle class, but not the classic threat to the value of the money they hold.

There is a lot of talk about how “we” can’t waste any more of the taxpayers’ money on wars, welfare, healthcare costs, subsidies for the wealthy, and so on. Notice, though, that there’s much less talk, even on the anti-Wall Street side of the national divide, of not wasting the depositors’ money.

The political class has begun to wake up to the effect that the enforcement of strict lending standards and capital ratios has had on growth and voter satisfaction. Financial regulators are told to be independent of political influences, but they’re not, of course. The people who vote for their budgets want money pushed out into the economy, and that’s what they’re going to get.

Even (initially) gentle rises in bond yields will begin to have a punishing effect on the banks, insurance companies, and corporate treasuries. The cash hoards are going to be spent much more quickly than monetary economists and securities analysts think. Why take less than 2 per cent for 10-year bonds, when you can buy another company with a much higher return on equity? Why not profit from low nominal rates by building up some commodities inventories?

The long-term bull market in the prices for industrial commodities has paused in the middle of this year, but this correction seems to be coming to an end. The banks’ lending rates have been hammered to the floor, and the inspectors are being told to ease off on forcing asset liquidations. The last people to understand this, it seems, were the attendees at Basel bank regulatory meetings, but even they are getting the picture: it’s time to get that velocity of money circulation moving again.

That means that a hyperbolic, 1979-1980 style blowoff in the gold market is becoming much more likely. From the time of the gold price low in the autumn of 1999, the demand for gold has been supported by a gradual shift from net central bank selling to net central bank buying, and from the interest of more or less professional investors. The broader public has not really been drawn into any gold mania, as it was in the late 1970s.

An interesting signal of this acceleration of the long-term rise in the price of gold has been the recent outperformance of gold shares relative to the metal. Up to now, gold shares have tended to disappoint, but since the spring, the price of gold shares has been going up much faster than the price of the metal. In the third quarter, for example, the dollar price of gold rose by 10.9 per cent, while the broad XAU index increased by 21.7 per cent.

But we don’t have the sort of bubble in gold stock demand that you see in a real mania. The money flows into gold stocks have been modest, and valuations relative to the cash flows, or the net asset value of gold reserves, are still fairly low. There hasn’t been any flood of dubious junior mining stocks based on pieces of moose pasture in Northern Ontario or desert in Nevada. No doubt that will all come, or some early 21st century version of those 1970s phenomena, but not yet.

I’ve noticed that gold manias, or, if you will, crashes in the value of paper money, tend to occur in three phases. Initially, there’s a gradual, creeping devaluation of a currency, which can take a decade or so to gather force. Then, there’s an initial inflating of the gold bubble, or deflating of the currency value. That’s more or less what we saw between 1972 and 1974. Then a pause, and pullback in gold’s price momentum, followed by the seemingly unstoppable rise. That came from 1978 to early 1980.

All manias come to an end, of course. The one that’s ending now is the seemingly insatiable demand for developed country sovereign debt.