Note that prior periods of USD strength have taken the wind out of gold’s uptrend. With the 150 day moving average and the long term uptrend sharing the $1600 that area looks like the most probable target for this consolidation.

But the recent ructions in global markets are threatening to derail these broadly held beliefs. Following is a chart of daily copper price with the gold price mapped against it. Note that while copper peaked in early 2011, the gold price has kept pushing to new highs. This perhaps reflects the disconnect between the primal movers for these assets. While copper is expected to preserve it’s value in real terms (the destruction of money meme) – there’s no getting away from the fact that it is an industrial commodity. Gold on the other hand is almost purely a speculative asset – meaning that it is only worth what the marginal buyer is convinced its worth – it has little utility value.

So with the tailwinds from global stimulus nothing but a sweet memory, and the threat to the world order alternating between debt concerns in Europe and the US, and with China pursuing its very own debt funded growth model, maybe it’s not so surprising that copper has been weak.  The question is really whether this weakness is a precursor to a deeper correction.

Notably this weakness is broadly matched by declines in the oil price and industrial commodities more generally.

Turning back to gold, it makes you wonder as to whether it can sustain its price strength if the rest of the market is crumpling around it. Certainly, should copper track lower the copper to gold ratio would be plumbing new depths in the absence of a similar move by gold.

This really does explain a lot. For example, ever wondered how bell-bottoms took over the world?  (Though what else would you wear with lamb-chop sideburns.)

Part of the fun of investing is trying to discern the next fashion. The real challenge is being able to translate that view into an attractive risk/reward investment. Too often it seems I get caught looking the wrong way.

For example, back in May, we noted the dark mutterings of a learned few about the US debt ceiling debate and suggested that there was a fair degree of complacency about the process to its resolution (“Chicken Little says the ceiling is fine”). While the note touched on the risk to the US dollar, the conclusion focussed on US Treasuries. Looking back across the two months, the clear winning strategy was to short the US$ against ‘real’ currencies and gold. Treasuries remain caught in swirling cross-currents that are just too difficult to untangle.

So what are the likely trends from here?

As the ‘sell USD’ meme has gone mainstream, the risk/reward probably favours a counter-trend move. Certainly, ‘safe haven’ sentiment is at extremes (here), capital flows are becoming concentrated in fewer stocks (here and here), and the climbing interest in protecting the downside even as volatility remains subdued (here), all suggest that the weak side is one where the USD rallies hard.

On the assumption then that the market is vulnerable to a USD rally – whether it is the result of a ‘resolution’ or not – what are the trades to consider?

1) Short gold – When I look at the relative underperformance of the gold miners versus the metal, I get the feeling that the ‘alternative money’ is due for a nasty sell-off. Note that the gold miners (HUI – blue line) have failed to make a new high while gold (black line) has pushed on through. This view is number 1 for good reason.

2) Short ‘safe haven’ currencies – we’ve been positive on the CHF since the start of the year (“Trends you can trust“), but with the most recent move it has got just plain ridiculous. While the Swiss central bank may have given up fighting the trend, the current mood leaves USDCHF particularly vulnerable to a sharp correction.

3) Neutral Risk assets – If we take the defensive posturing of money managers as a guide, the argument could be made that there are willing buyers for risk assets (equities and/or lower grade bonds) on resolution of the debt ceiling. While I’m not a buyer down the risk curve from a longer run valuation perspective, it’s unclear to me as to which way these asset classes can run in the shorter term.

4) Neutral Commodities – On the face of it, a stronger USD should hang heavily on the commodity sector. Still, commodities are more inclined to follow the breezes coming out of China, so the sector may not be as susceptible to movements in the big dollar.

The key insight of Didier and his comrades is that financial market prices tend to follow a power law as they accelerate into bubbles. Specifically, they fit a log periodic function to observed price movements to forecast the evolution of prices to a ‘singularity’ whereupon prices collapse.

I’ve been reading the pieces coming out of the observatory for a while. They appeal to my fatalistic nature, in addition to mirroring the trader’s wisdom that parabolic price rises tend to end in tears. (Note, I’d caution that forecasts can be subject to revision based on ‘new information’.)

One of the latest papers, “The Second Wave of the Global Crisis” (published 3rd July), has a satisfyingly specific target for the end of the ‘gold price bubble’ – 27 July 2011 (here for the full piece). Following is a chart from the paper. The thick black line that sits over the gold price illustrates this price acceleration and the forecast terminal point:

…the thin line indicates daily gold price between November 3, 2003 and May 26, 2011, whereas the smooth thick black line has been generated by the following version of equation (1) with parameters chosen by the least squares:

p(t) = 1978.2 – 734.8 (2011.573 – t)0.36 {1 + 0.024 cos[16.5 ln(2011.573 – t) – 36.3]}, (1b)

where p(t) is gold price at the moment t. Note that the quasisingularity moment (tC) here equals 2011,573, which corresponds to July 27 and suggests that the gold bubble should start collapsing before this date anyway.

Quickfire movements such as we have seen are uncommon enough events, though the most recent decade seems to have had its fair share. The last time that the Aussie was able to sustain this type of move without at least a reflexive correction was in the 70′s and the world was a very different place then…

Or was it? After Nixon ripped the USD from the last vestiges of gold convertibility in 1971 (some background here), the USD was pummeled relentlessly.

And in real terms

Now we are faced with a similiar dynamic. Whatever the why’s and wherefore’s, the USD has few friends. Expectations of its imminent demise are widely held.  Short positions dominate. Ultimately, consensus is its own worst enemy – the weak side becomes the counter-trend trade. But that is what drives a market correction not a change in trend. Looking at history, the USD could have a year or three of heavy weather before the trend is exhausted.

Still with the Aussie overbought, and overvalued by ~40% on PPP measures, we should pay attention to the breadth measures that are suggesting that volume continues to undermine this latest rally.

With the domestic economy having all the bouyancy of overripe cheese, I remain of the view that the AUSDUSD is at risk of a material correction on a global tightening of liquidity (as QE2 fades into the distance and China continues its tightening ways – note there is risk to this view as Japan has kicked it monetary stimulus machine back into gear). If the Aussie signals technical weakness, I expect to add to our short AUDUSD position (here).

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For clarity, the short AUDUSD position is part of a portfolio that includes long gold and oil positions (that generally benefit from weakness in the USD).  Also, as an Australian based investor, my equity portfolio is natively long Australian dollars.

Having said all this – it is what it is – a short AUDUSD position. And well out of the money at an exchange rate of 1.09…

3May10 - Added to the short position after the dollar reversed off 1.10. With weakness in copper, gold and equities starting to creep in – there is gathering momentum for a USD rally and risk selloff.

Preliminary estimates for March indicate that the index rose by 0.6 per cent (on a monthly average basis) in SDR terms, after rising by 1.4 per cent in February (revised). The largest contributors to the rise in March were increases in the price of crude oil and the estimated price of coking coal, while gold prices also rose notably. Most rural and base metals prices in the index fell in the month. In Australian dollar terms, the index rose by 1.6 per cent in March.

By my records the RBA’s A$ all-comers index was recorded in its last report as 101.9 for February – as against the current 101.6 reading in March. That would be a 0.3% fall not a 1.6% rise wouldn’t it?

It looks like the discrepancy arises as ‘preliminary estimates for iron ore, coking coal and thermal coal export prices are being used for recent months, based on market information.’ As these items are material to the calculation of the index, revisions in these estimates can give rise to ‘adjustments’ in previous reported levels. If March is higher than February, it seems it has as much to do with February being lower as March being higher.

All this implies that the RBA, based on intelligence from exporters, has ratcheted down its expectations for iron ore and coal price rises for the March quarter from just a month ago. Pity the RBA didn’t explain what is happening here.

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Still, there is no denying the strength of commodity prices and the Australian dollar – it’s as if the Japanese crisis gave the reflation trade a much needed fillip. Per the RBA’s latest numbers for March:

Note that base metals lagged gold in this latest shunt higher. Whether this is indicative of a growing belief that inflation is destined to take hold of the global throat is, at least to my mind, counter-intuitive given that we are heading into the tail of QE2. It seems more reasonable to expect rising uncertainty about continued loose money – with debates about interest rate rises in Europe, credit tightening in China and the impending pulling of the Fed’s bid.

Still if it’s the spectre of inflation haunting markets, think we can expect gold to continue to outperform its poorer cousins in the industrial metals complex – ultimately we revisit the relative lows of 2010 – much the same way that gold continued to thrash copper in the late 70′s and early 80′s.

Finally, the idea that this latest thrust higher is anything but monetary in origin is just fanciful. Granted the world economy has regained some of its poise, but the leading indicators are still turning over and suggest that the marginal user of commodities is fighting inflation by contracting credit (see latest global PMI data here). For valuations of metals and mining companies to be justified, we need the expansion to continue.  We need Chinese equities to signal a return to the good times. Now one might argue that the recent outperformance of EEM versus the S&P500 is signalling exactly this.

Heck, it isn’t convincing me. I’m happy to stick with the playbook – we’ll remain defensively positioned into the end of the stimulus. It’s a time tested strategy (see here for our test of the Albert Edwards playbook).

In any event, the strength in markets gives us reason to test our assumptions – cause based on these, our expectation is that we will experience a reasonable correction as we head into the end of QE2.  Last weeks selloff did not tick this box.

So how to characterise the information flow over recent weeks:

1) The economic growth cycle looks to be peaking – per OECD leading indicators (here) – this is consistent with a tightening of money in China and the final wave of stimulatory action in the US.

2) But, more importantly, monetary stimulus stepped up a notch with the response of the Japanese authorities. Perhaps there is a growing consensus that more monetary stimulus is inevitable – whether as part of the refinancing of the European periphery or by the US itself.

If it is expectations about more monetary stimulus driving the recent price action, then this should be reflected in a relative outperformance of real assets – think precious metals, energy and commodities in general – versus financial assets – bonds of all ilks and defensive equities. As a quick proxy consider the outperformance of the CRB against LQD since the Jackson Hole speech:

The CRB has certainly bounced hard over the last week and may yet retest its highs. And while we are here, we can push a little further down the risk curve via the relative performance of JNK as against LQD:

On the face of it, JNK does seem to do pretty well for itself when the Fed is actively buying securities. It too has enjoyed a steepling bounce recently though is short of its highs.

Also, those currencies that are home to the QE stimulus efforts should underperform.

It’s clear that Gold, as measured against US dollars, has barely stopped for breath as it has ridden the easy money train. The ‘hard asset’ Australian dollar may not have kept pace, but has certainly benefited from trade. While the carry trade pair of choice, borrowing in Japanese Yen to buy the AUD has been flatlining since the risk selloff last April.

Zooming in to the period since Bernanke visited Jackson hole the same trends prevail – XAUUSD beats AUDUSD that beats AUDJPY. And on even closer inspection, the same trends are replicated over the recent bounce. These charts seem to indicate that it is the US in particular that is driving the appreciation of real assets.

Conclusion

Recent price action suggests that capital flows have taken on some of the character of a flight from easy money – and particularly the US variety. Whether this is the moment when the ‘governments are debasing our currencies’ meme goes mainstream is beyond my reckoning.  If it is, then we can expect gold to lead real assets in a substantial spike higher.

Probably more likely though is that this thesis needs further testing – for example, as the expiry date for QE2 draws closer and the debate about further QE rises to the fore, then uncertainty should creep into the equation. It is for this reason that we remain under our target weighting in gold and energy in particular. We continue to expect volatility across risk markets as the first half of 2011 draws to a close.  Hang tight.

Postscript – Bruce Krasting at Zero Hedge succinctly looks at the question of ‘measuring the success of QE2′ (here)

The US has been leading the way – from the JP Morgan Global PMI Report report (here)

The US PMI rose to an eighty-month high in January, while its counterpart in the Eurozone hit a nine-month peak. The UK PMI rose to its highest level since (UK) data were first collected in 1992. Meanwhile, the China and India PMIs crept higher from December’s three-month lows and an expansion was signaled in Japan, albeit only slight, for the first time since last August.

Only Australia and Greece were on the contracting side of the ledger. On the face of it, this ‘fundamental’ demand should throw a supportive bid behind commodities – and may help explain why the major miners have caught an updraft over the last couple of days. (Chart from Investment Postcards from Cape Town here)

Yet it’s reasonable to ask whether it is only fundamentals driving commodity prices.  While it might well be argued that base metals have at least paid some attention to the ebbs and flows in industrial production, the relative strength in gold suggests that there may be more to the story.

Similarly, supply constraints cannot explain the entirety of the recent rise in foodstuffs:

Bernanke (at the National Press Club here) claims that higher commodity prices are the result of emerging world demand and supply constraints. This is true – at least in part.  Certainly, weather patterns over recent times have not been conducive to agricultural production nor for the supply of some industrial commodities. And yes, emerging world demand has been strong since early 2009.

But this is too simplistic an explanation as it ignores the role of government and speculation in driving commodities prices.

Without exception, ‘fundamental’ demand has been strong due to government stimulus efforts. Most particulary, the rise in emerging world demand was intimately tied to the launch of China’s huge monetary stimulus in 2009. This trend has reached its end.  China is tightening money – and other emerging economies have been applying their own capital constraint measures. The fall in the Baltic Dry Index may be partly inspired by oversupply, but fading ‘fundamental’ demand is also at play. It is no coincidence that Chinese equities have also caught a cold.

The reversal of stimulus policies reflects a need to slow price rises.  For example, food prices are said to comprise 35% to 40% of disposable income in China, and are higher in other emerging economies. Higher food prices will inevitably squeeze demand, and more ominously, lead to unrest. It’s notable that at the same time Bernanke was making his speech, UNCTAD was hosting a conference on Global Commodities with the explicit aim of “calling for attention to climbing, volatile prices” (here).

The point is that there is a limit to the price that emerging markets can pay for commodities – and the evidence suggests we are close to that point.

So if China is tightening money, we might reasonably expect commodity prices to start easing – in anticipation of declining demand from emerging economies. Yet copper tops US$10,000/t, Brent breaks US$100/bbl and cotton makes new record highs. This raises a question as to who is buying – and increasingly over the last decade, the answer has been investors.

Investment demand for commodities is something that we have looked at before (here and here and here) so we won’t labour the point. Suffice to say, the current run-up in the prices of some commodities has all the hallmarks of classic price distortion away from fundamental demand (aka ‘bubble’ behaviour).  As seasoned traders will oft be heard to say – the prices have gone parabolic – meaning that speculative fervor has taken over. With the herd increasingly headed in the same direction, it will take progressively less and less to tip the balance in the other direction.

Conclusion – Just like the grotesque in Dorian Gray’s closet, high commodity prices are the non-to-hidden price we must pay for a forever young global economy. With QE2 itself passing into its twilight age, the risk/reward of being long commodities doesn’t look too flash – with diminishing upside and plenty of room on the downside. Emerging markets are already signalling weakness and the commodity currencies are showing all the signs of exhaustion. While we may not have called for the last rites just yet, the priest is in the parlour.

Disclosure – no position in base metals, long energy and agricultural equities, and nibbling at gold again.

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Postcript

• The Short Side of Long has a neat summary of current commodity markets in its “End of Month Commodity Report”
• Zero Hedge published a Standard Chartered report on “The threats of inflation” (here)
• and Nomura’s September 2010 report “The coming surge in food prices” (here) has a top 25 countries vulnerable to rising food prices

Managed money longs have declined through the July 2009 lows and are threatening to revisit levels last seen in March 2009.  (Note the boxed area in the charts reflects the period since gold bottomed in October 2008.) And to put that into a longer context, following is the net positions in the old format CFTC reports.

The reversal in open interest is also threatening the trend.

We could argue that this is a reflection of tighter global money on a relative basis.  The increase in reserve requirements for China’s banks came into effect last week and the repo rate dutifully went beserk (here – Merrill over Matter has been following this).  Other emerging economies have been ratcheting up currency controls to slow circulation of USD.

Until there is evidence to the contrary, we’ll assume that this is a correction rather than a change in trend. The strategies being employed by developed world governments are based on a socialisation of the debt overhang.  As a result, government credit is deteriorating and the path of least resistance is to keep money loose. These trends have a ways to go.

It’s interesting then that copper has been dragging its feet. It’s possible that a top is in, but we haven’t seen a decisive move:

Mind you, the copper price bottomed after gold in 2009 (the copper low came in late December 2009). To place the current rally in context, following is the old format report:

Open interest tells a similar story – though the record levels in open interest is also interesting. Is this an acceleration in the financialisation of commodities? As we’ve discussed before, the introduction of the retail investor to the copper markets logically exposes it to greater volatility – especially to the downside.

]]> http://www.datadiary.com.au/2011/01/24/us-futures-positions-gold-lower-copper-peaking/feed/ 0 http://www.datadiary.com.au/2010/11/10/devaluing-the-us-intelligent-design-or-evolutionary-accident/ http://www.datadiary.com.au/2010/11/10/devaluing-the-us-intelligent-design-or-evolutionary-accident/#comments Wed, 10 Nov 2010 10:47:56 +0000 Rohan Clarke http://www.datadiary.com.au/?p=3803 I’m a conspiracy theorist at heart, partly because it adds a little spice to my otherwise safari-suit wearing ways, and partly in the hope that our leaders are smarter than their actions sometimes suggest. With the near universal condemnation of Ben Bernanke and his FOMC chums, it’s left to us conspiracy theorists then to once again defend the Chief’s honour.

Back in August 2009 (here), we suggested that the US power elite had been sharing the sauna with the aim of orchestrating a devaluation of the US$. (It’s interesting to revisit the commentary of the time – an Op-ed piece by Warren Buffet (here) and an exploration of the future dollar decline by Curtis Mewbourne at Pimco (here).) The suspicion is that we are still playing to the same script.

QE2 is aimed at devaluing the US$

We have been told by Bernanke that the Fed’s buying of Treasuries is aimed squarely at reducing the ‘risk free’ rate and in turn boosting the price of risk assets. Aggregate demand should benefit via lower mortgage repayments and a wealth effect, or so the argument goes.

Now if you consider what this means, Bernanke is pretty clearly saying that he is seeking to create asset price inflation – or put another way, devalue the dollar relative to these assets.

Why?

The Fed Chairman is running scared of outright deflation (an appreciation of the US dollar relative to real assets). This is the lesson of the Depression as far as Bernanke is concerned. QE2 is therefore primarily about dollar devaluation – with real economy benefits arising as it “promote(s)  financial conditions supportive of recovery” (here).

Does it work?

Recent price action across risk markets suggests that the Fed has been pretty successful in getting the market to buy into its plans – even before they were officially announced, let alone actually started.

But the fear is that all this buying of risk hasn’t really changed anything. The fundamentals are still poor, the banks under-capitalised, the risk rally is all an artificial construct. When the Fed stops buying or, worse still, some undefined time before then, risk pricing will peak and reverse.

This is a persausive argument.  Still the Fed must know this, it is a pretty simple proposition.

So this is where ‘external’ dollar devaluation may come to the fore. If the dollar is devalued relative to its international peers, then QE2 may in fact deliver a permanent change.

The US$ as the reserve currency

Since gold convertibility was abolished (here), the US$ has been considered the world’s sole reserve currency.  This means that everything that can be bought and sold is ultimately valued in dollars. The dollar itself has no intrinsic value. It is not a liability of the US government. It is not backed by any commitment to redeem it for gold or some other asset. It is nothing more than a benchmark against which everything else is measured. The dollar has value as the ultimate unit of exchange because we have all agreed that it has.

Extending this concept, the US dollar can also act as a store of value. Notwithstanding that it has no intrinsic value, if the unit of exchange has a relatively stable value relative to other assets, then in itself it can become a home for capital – particularly if it has a deep and liquid market in government debt. There is an implicit contract between the world’s governments – to keep the US dollar relatively stable over time. QE2 is designed to undermine this contract.

Is QE2 then debasing the currency?

A little history here – when the sovereign used to stamp its crown on coins, it did so to warrant that they had a specific gold content, or intrinsic value. This meant that folks did not have to assay the precious metals – contained in the coins – that were effectively being used as a medium of exchange. As Locke was to argue in the 17th century in ‘The Natural Value of Money”, it also implied that the sovereign had a contract with the people to ensure that the value of its coinage remained relatively stable over time. This meant in turn maintaining the metal content in the coins – something that kings were periodically prone to forgetting by reducing the content or debasing their currency.

Now Ben Bernanke recently made the point that under QE2, the Fed is not printing money (via Pragmatic Capitalism here). It’s also been noted that the Fed’s purchases of Treasuries do not directly or immediately lead to an increase in the money supply and are unlikely to lead to inflation. The country remains mired in a deleveraging hangover, and a return to debt fuelled growth is not on the horizon.

Taken at face value then the Fed’s actions are not debasing the currency.

But looked at through the lense of a foreign holder of US$, the issuer of the reserve currency does indeed look very much like it is intending to reduce the value of its currency. Whether its the US dollar being used as the funding currency in carry trades in offshore markets or its simply unleveraged capital seeking higher returns offshore, the exodus from the US dollar has been real outcome of QE2.

Conclusions

The US consumer has been living beyond their means for too long. Reducing the dollar’s buying power is the traditional way to spread the pain of the adjustment process to a lower standard of living. The Fed Chairman wants to avoid deflation in US asset markets. He seeks to achieve this by artificially elevating their prices. That by doing so he also undermines the stability of the US dollar as the world’s reserve currency is a good thing from his perspective.  A lower dollar against its trading partners will act as a catalyst for more permanent changes to the US economy.

Having said all this:

1) Do not mistake the buying of risk assets as ‘fear of inflation’ as a result of ‘money printing’. It is not credit-driven inflation that is motivating those running from US cash. It is the explicit goal to devalue the US$.

2) There is no current alternative to the US$ as reserve currency – at least in terms of trade flows, if not in terms of store of value.  Articles worth reading in this context by the Governor of the PBoC (here) and Barry Eichengreen (here) and via Washington’s blog (here). If the US$ is being used as a funding currency in carry trades, then expect the depreciation to continue to be volatile as this leverage gets whipped about by the actions of those that have a vested interest in seeing the currency one way or another.

3) The US government and its quangos might have control of the steering wheel, but there are plenty of others in the backseat that have something to say about this. Brazil’s strident criticisms of the ‘currency war’ speak to this.  So do the rampant property markets in Hong Kong and Singapore. While China continues to raise rates, tighten reserve requirements and otherwise impose controls on capital in the face of US$ driven liquidity.

4) Chances are the US will continue to depreciate anyway. Let’s assume that QE never took place. The Treasury would still have its $1.2 trillion to finance. The Fed would still have it’s zero cash rate. The market would still be faced with the US twin deficits – the current account and the governments.  The currency would still devalue relative to other currencies.

None of this is to say that I actually believe that QE will solve the problems facing the US. From the view down here, they look intractable. It’s simply to argue that there must be more to the Chairman’s logic than “we’ll keep buying until everything goes up”.