Gold may be closing in on a bear market bottom

As we approach extremes in bearish sentiment, the number of gold ounces promised per contract (on the Comex at least), relative strength and the dollar rallies on the promise of a tightening cycle — I think it’s important to take a moment and reflect.

Interest rates make a bad situation worse for debtors

The US government currently spends over 6% (about $250 billion per year) of its budget on interest alone.  If interest rates were to normalize this figure would swell significantly.  So the idea of a tightening cycle being a possibility without a significant (and deflationary) reduction in government spending is unlikely.  Even if spending were to be decreased, it would not be in time to reduce the deficit or debt burden.

Further, liabilities in the private sector are explodingStudent loans, car loans, credit card debt, mortgages and debt-driven share buybacks are all at unprecedented levels.  This is further evidence that the system at large is far too debt-dependent to move to a higher rate structure without a significant rise in insolvencies.

Leverage and volatility don’t mix well

Lest we forget the interest rate complex at large.  The biggest swath of derivatives in the world, hundreds of trillions of dollars of leveraged OTC instruments, are tied directly to it.  To give you an idea of its scale, the amount of interest derivative products alone dwarf the global GDP by nearly 7 fold.

Large moves in short periods of time render leveraged trades insolvent due to the trade turning against them.  If one is borrowing $9 for every $1 they put in to a trade, then if the trade goes against them by 10% they are wiped out.  More than 10% and they owe more than the $1 they put down.

This is precisely the risk present in the world of derivatives.  The only difference is the leverage is much, much higher than 10 to 1.

Another problem is that in a tightening environment that’s unilaterally led by the US central bank (when other central banks do not follow), deflationary shock waves may proliferate throughout the global financial system and wreak havoc on interest rate derivatives markets, emerging equity and bond markets, US corporate debt and ultimately global financial markets as a whole.

Sensitive markets showing stress

Corporate bonds are beginning to sell off. Emerging markets have been in a funk for some time as they were once the beneficiaries of QE.

Given the level of medicine applied, one would expect the patient (the global economy) to have either rebounded or died of an overdose. Neither has happened, but markets are essentially in the eye of the storm.  The troubles past are gathering speed again at a remarkable pace behind the scenes.

Consequences are continuing to climb

This time around it is not just the financial system at risk, it is many governments of the world and many of their respective central banks that risk insolvency.  We are witnessing the biggest bubble that has ever been blown in history.

No wonder there is so much effort in preserving such a bubble.  The result of its end is a mind blowing problem.  And that’s precisely why the rate normalization cannot happen.  We may see a push higher by 25-50 basis points.

Policy road fork ahead

Such a hike, however, will in all likelihood pale in comparison to how the Fed manages its maturing balance sheet of bonds.  A new round of QE-like activity will likely emerge as those funds that mature are put to use to purchase longer dated bonds to re-stimulate debt markets in a variant of operation twist.

As equity markets finalize what appears to be their ultimate topping formation, I assume that we will witness another sharp move downward.  The Federal Reserve appears to be more sensitive to the gyrations of financial markets than the economy at large.  As a result it will likely pause and possibly even reverse in to this new variant of operation twist.

Ultimately this is bullish for gold

I believe we will have already formed the bottom in precious metals and begin to see a resurgence in prices once the stock market has topped and the Federal Reserve is no longer willing to tighten.  Whether the gold price tests the $1,000 level is still on the table, but I don’t see much further downside from here based on these assumptions.