US economic and precious metals outlook

I remain reluctantly bullish on gold, silver and platinum (and bearish of palladium). I fear we are entering a time of turbulence via geopolitical events, monetary policy tightening (during the greatest policy experiment perhaps in human history); a national, state and city debtastrophe, retail implosion (in a sector that employs millions) and an increasingly gig-oriented job market — that provides quite poorly for its paycheck-to-paycheck participants. The housing bubble 2.0 is beginning to sputter with almost as much leverage as 2007 in the speculative areas (flippers especially).

Further, I fear that the economic recovery did not manifest as hoped, and instead we’re seeing fudged metrics across the board (whether it is labor statistics that are double and triple counting the aforementioned gig jobs as separate people each getting a new job — when it is a single person with 2-3 jobs). We see funny data coming from Facebook where they are saying they have more users than the US census says we have population. We see enormous misallocations of capital as a result of these and other fuzzy numbers. At the end of the day we have a weak economy that is limping along, despite the record setting stock market saying otherwise as its returns grace the headlines on a near daily basis.

GDP growth has largely been predicated upon expansions in cost, not true increases in activity. Medical costs being one of the primary drivers, which are now rising at about 200% the rate of inflation by conservative measures. Compounding that problem is the fact that the FIRE (finance, insurance, real estate) component of the economy continues to occupy an outsized portion of GDP, creating a situation that has changed the lubricant for the engine of economic growth in to a drag.

So much wealth has been transferred vis-a-vis QE and this ongoing monetary policy experiment, from the working and middle glass to the very wealthy. This further creates an enormous strain on the largest input of US economic growth — consumption. Combining that with the overhang of student debt which is now approaching or exceeding $1T depending on the measure. We have a growing swath of consumers that can’t afford to engage in their namesake activity. And we just broke through record credit card debt in the US. So it’s safe to say we’ve pushed a lot of consumption forward without the means to keep that pace going.

Shifting gears to the central bank conundrum, a Warsh appointment at the Fed doesn’t do much to resolve the largest quandary in the institution’s history: how to unwind a 4.5 trillion dollar balance sheet before the next crisis — without causing the next crisis? Warsh’s own WSJ op-ed opined about his remorse and skepticism regarding QE. Will he be capable of unwinding what he admits he (and others at the Fed) barely even understand? It will be fascinating to watch. Makes buying VIX long dated calls look tempting if he is appointed and such an endeavor is undertaken. The current unwinding of the balance sheet is unrealistically slow unless they never intend to normalize.

What are the odds that this equity bull market, the second longest in US history by my calculation, continues unabated? I would imagine further strength in equities is required to keep the Fed determined to raise interest rates — and significant weakness could pause the tightening or even reverse it. Even if Warsh is at the helm, he would be under massive pressure from the administration to keep the economy looking better the closer we get to re-election.

That all said, I think we are navigating one of the most fascinating markets in my lifetime. It has evaded almost all logic and reason. So many much more gifted investors than me have missed a lot of this rally having been extremely skeptical of its durability and potential.

At this time I don’t see a lot of value in the US markets. Valuations feel stretched and equities priced to perfection. I’ve been allocating more capital in to emerging markets where the yields are higher, the valuations are more fair and there is some potential for hedging against US dollar weakness — which still concerns me over the intermediate to long run.

I plan to increase my own exposure to high quality silver miners based on my thesis that silver industrial usage will increase with larger demand for solar power, communications, computers, mobile devices and weapons systems (such as drones and missiles). Unlike gold, silver is used and quite hard to reclaim. Silver investing may also grow in time, but that isn’t the center of my thesis with silver. I suspect, instead, that investment will remain flat and the outsized portion of increased utilization will be non-reusable applications. That, and the fact that silver is generally mined as a secondary metal (incidentally rather than purposefully) at most mines, makes the opportunity a bit more bullish for me than gold.

It’s a very difficult metal to analyze, though. Thinly traded, often beaten up by large banks in concert (silver price rigging investigations have proven that several of the largest banks in the EU and US were working together covertly to suppress prices — and they saw minimal consequences for this activity).

Trading silver is not for the faint of heart, either. I spent a few months trading small lots of silver mini contracts and found the volatility very difficult to execute against because the bid would just dry up during times of high selling pressure. Most of the silver miners are much more liquid than the futures, which is a bonus. But there are very few of them to choose from and even fewer worth investing in.

As always I hope my commentaries are constructive to those who make their way through them!

Full disclose: Long positions in emerging markets bonds, stocks, precious metals mining companies; short position against NASDAQ 100.

Gold’s 2015 performance in various currencies (chart)

The Brazilian Real was walloped and the dollar was clearly a standout winner. Gold’s relative underperformance shows against US dollars that the US dollar is still seen as a safe haven currency.

Until that changes gold will underperform as measured by US dollars. I think we’re closer a that point in time when we see positive price action then we were a year ago, but I can’t say for certain if the markets will agree until stocks move in to a bear market.

As seen in the start of 2016, when stocks were out of favor, gold caught a bid and moved higher each day stocks were sold off. Now that stocks are catching a bid, gold is selling off.

Whether or not 2016 is the year that stocks enter a bear market remains in question. I am inclined to think that we have only seen a prelude for the downside in stocks that could occur this year.

Gold continues tumble without outside catalyst

Producer prices were flat as was the US dollar index, but that didn’t stop a determined seller from pushing gold prices down this morning.

What is driving the selling pressure?

Most traders are paid to execute orders to maximize value.  That is to say, if you are selling a commodity you want to sell it for the highest price (or short it at the highest price) to maximize your profits.

What we’ve seen within the last several years is the opposite of that.  Regular dumping of gold (and silver) futures contracts with heavy volume at the lowest prices.  Huge lots executed at once — rather than distributed over the course of a day to achieve a volume average weighted price.

Are prices being fixed?

This leads the gold investing community to believe that there is malicious manipulation underway in these markets.  And with just about every other market in the world having been proven to be manipulated, such as LIBOR, foreign exchange, bonds, equities and other commodities — perhaps, just perhaps it’s not too paranoid of a theory after all.

A reason to sell so many contracts in to the market at once would be to push price down through sell stop orders.  

This action forces prices even lower and pushes many out of long positions.

Only the people pushing the sell button truly know their own intentions (or that of the institution they are employed by).  An outside observer of these markets is forced to draw their own conclusions.

How can so many claim to own the same gold?

The ratio of futures contracts to ounces of physical gold at the COMEX has risen to the highest levels on record.  Last checked, it was closing in on 250 gold futures claims per ounce of physical gold actually available.  This means that should there be a large demand for COMEX gold delivery, there may not be the gold available to fulfill the order — necessitating a cash settlement.

If one was seeking delivery to obtain physical metal for storage, this would force that party to seek gold elsewhere as soon as possible with that settled cash.  And given that so many parties seem to have claims on the same ounces of gold, that could prove to be an interesting setup for a phenomenal short squeeze that drives prices much, much higher.

Potential scenarios for the continued decline.

How this particular situation resolves remains a mystery, but I am inclined to speculate that we have two possible scenarios that could play out:

1: We are witnessing the beginning of the one of the greatest deflationary collapses the world has ever seen, as evidenced by commodity prices imploding, China’s economy in serious decline and recent volatility in equity markets.  If this is the case then it will be difficult to find a safe home for one’s money almost anywhere.

2: The precious metals markets’ prices are being guided lower in order to reduce the bid for what were once considered safe haven assets by many.  Eventually, if such a scheme is underway, it will unravel with prices going much higher.

Which of these scenarios is playing out remains to be realized.  

The former means the global markets are coming unglued at the seams and the global economy is crushed.  The latter would indicate that certain parties are concerned that a higher gold price could reduce confidence in other markets such as stocks and bonds.

US dollar index rally stalling, long term trend still down

With all of the fervor over the US dollar index rallying close to 100, a reality check is in order.  According to financial media reports the Euro is collapsing, gold is a barbarous relic that’s lust its luster, oil is falling and the commodity complex itself is imploding.  Readers of this blog may remember that on November 1st of 2014 I wrote about the possibility that such a situation may play out in 2015.

Opportunities may exist in battered markets

Sentiment for other major currencies, energy, precious and non-precious metals could not be much worse than it is now.  Cautious contrarian investors may find opportunities in the extreme negative sentiment. Certainly many natural resources companies have much more attractive valuations now than they did several years ago.  Commodities themselves may also offer more value at these price levels than they did in previous years.  Both as a hedge against inflation and a bet that resource consumption will increase in years to come.

Meanwhile US dollar trend followers may pile on to what appears to be a massive multi-year rally in the US dollar index or short other currencies, commodities and similar assets.  There already exists an enormous amount of speculative betting on the dollar surging higher and other dollar priced commodities and foreign currencies tumbling.  This positioning leads me to believe that we may be closer to a high in the US dollar rally than a base to move higher from.

united-states-currencyThus far the US dollar index on a long term technical basis appears to have made a series of lower highs and lower lows stretching back to the rally in the mid-1980s (see above chart) which began as a result of massive interest rate increases by the US Federal Reserve.  In order to break this downtrend the index would have to rally beyond 120 and sustain itself there.  Only then would I feel that the US dollar has decisively entered an uptrend. That has not happened yet.

The range bound US dollar index

As of the last 10 years we find the US dollar index trading within a range between 72 and 100 (see chart below) which may continue for some time if there isn’t an outside catalyst.  Ultimately I believe the US dollar index is headed for a lower low when the current rally stalls further and then reverses lower.

10yUSD

One must remember that the US dollar index is a trade weighted currency basket that measures the dollar vs. the Euro, Yen, Pound Sterling and does not necessarily directly reflect the purchasing power of the US dollar other than when buying these currencies.  In addition, the US dollar index has enjoyed its current rally largely on expectations of a widening interest rate differential between the US Federal Reserve and other central banks.

Will the September hike come to fruition? Is it meaningful?

The Federal Reserve has repeatedly delayed its much anticipated interest rate hike, setting expectations that such an event may occur this September — and only if economic data fits their ever moving target.  Given the mix of economic data (both good and bad), combined with the backdrop of a significantly weaker Euro and the US dollar beginning to impact multinational companies earnings, I would be surprised if the Federal Reserve set its sights on a heightening cycle.  Perhaps a few increases to placate the financial media.  But a significant normalization of interest rates would likely have catastrophic effects on multiple asset markets, including mortgages, bonds, stocks and interbank financing.

Fed and interest rates thru 2009Up until 2008 the Federal Reserve largely followed the US Treasury 3 month bill rate — rather than vice versa. This meant that interest policy was apparently largely set by the 90-day Treasury Bill market.  See the chart above for a visualization of this trend.

Where there was once rate guidance there exists only volatility

Below you will find a chart of the 3 month Treasury bill rate graphed from 2000 to present.  In that chart one can see that the same dynamic may no longer exist. That is to say that the 3 month Treasury bill rate is extremely volatile and has been since 2008.  Is this an unintended consequence of quantitative easing and zero interest rate policy?  Is the Federal Reserve now without guidance from this critical interest rate setting market?  Or is the paradigm shift one where the Federal Reserve will now lead where the markets once did?

IRX-2000Much as the rate heightening cycle in 2004-2007 set off a powder keg of insolvencies related to highly leveraged speculative bets imploding, I believe any similar rate heightening cycle this time around will have equally disruptivbe, if not worse, consequences. But it’s anyone’s guess at this point.  As you can see we are largely in uncharted territory.

Has gold finally bottomed?

Let me start by saying I think it’s hard for anyone to call a bottom.  Many experts do, and often they do so with the guidance of charts, fundamental analysis and other informed speculation.  I am no expert, but I do think we’re finally seeing a turn in the precious metals markets based on two critical factors.

The US dollar and gold have rallied together as of late.  This doesn’t often happen, especially at multi-year highs in the dollar.  But it has for the past couple of days.  And during very large US dollar rallies.  As you can see in the chart below, for the past six months when the US dollar rallied, gold and silver were sold.

US dollar chart

This is a convincing indication that the precious metals markets are looking beyond the myopic view of the US dollar index (which really only measures the Euro and Yen weakness/strength vs. the US dollar) and seeing that rising risks demand a safe haven.  It may also indicate that the US dollar rally is beginning to lose its luster.

We also saw that the tax loss selling last year did not push gold and silver to new lows, or break down the miners further.  This is a very powerful indication that sentiment bottomed out in the October/November bloodbath that was likely a capitulative event.

I am not ready to say that we are turning right now, but I do think that there is a good chance of it.  In essence, if the precious metals markets can look beyond the dollar, or better yet, the dollar can begin to give back its rally from late 2014, we will be in for a year of renewed strength in precious metals, and their miners.

US dollar short vs long

The US dollar trade is as crowded as a trade can get and so many are short Euros and Yen that any unexpected surprises will roil the forex markets.  But gold and silver are telling us that doesn’t matter.  That they can look beyond forex and see that the risks are strong enough to warrant a significant bid (and most likely short covering — we’ll see the COT tomorrow).

Gold chart (daily)

From a technical standpoint I’d like to see gold trade above $1,260.00 on a sustained rally (closing the week on Friday above that level would be critical).  Ideally this price action would occur by the close of the second week of January, 2015.  After that I believe we’ll see some short covering and less aggressive posturing from the sellers counting on another waterfall capitulation in prices.

If gold can make its way back to $1,400 by the end of the first quarter of 2015, then I do believe we’ll see the momentum chasers come back to the table and start driving prices higher through leveraged speculation.  This may also renew the appetite from Asian buyers for physical bullion as the low prices have turned from a positive to a perceived negative as of late.

Central bank intervention for profit retention?

Today we read about Kweku Adoboli, the UBS equities trader that allegedly went rogue and lost the firm $2B in Q3 profits.  We also learned about the ECB effectively using extraordinary measures to prop up insolvent EU banks.  A rumor also floated through the blogosphere that Mr. Adoboli was shorting large amounts of precious metals, specifically silver, through ETFs.  What one has to wonder, given the timing of these events and the downdraft in metals prices today, is if the ECB and/or SNB is helping to support UBS by pushing down metals prices so they can exit the short position with less of a loss to report on their upcoming earnings announcement.

This sounds like a conspiracy theory, right?  I would have thought so, too, many years ago.  However, given the recent and direct Swiss central bank intervention in the Franc and precious metals markets, the dire situation in the EU threatening the monetary union and its currency was well as the threat of a global double dip recession, it seems more than possible that central banks are beginning to exercise their power in the precious metals markets more overtly.

Psychologically it’s a very effective technique.  Hit metals hard on days that they would ordinarily rally to push weak (see leveraged) hands out of the market.  Try to inflict as much technical damage as possible (although at this point no severe damage has been inflicted — but if this continues it will be).

The question is how long could such manipulation last, if that is in fact what’s going on here?  I would personally doubt that such interventions can have staying power — at least not yet.  The SNB hit on precious metals did not last very long, and when priced in Francs gold rallied to a record high.  The previous sell-offs we’ve seen have produced a large amount of buying appetite around $39.00.

Today that seemed to be the case.  I was buying some silver CEFs (closed end funds) when the price hit $39.49.  I felt that a lot of buyers would begin to bite with more conviction as that has been the bottom end of the technical trading ranging silver has been within for the past few weeks.

There is some chance it could break down to $36.00, of course, but with a stop around $38.75, I’ll take a small downside risk given that the upside potential seems to be  about 33% in the short to intermediate term.  Good luck investing and trading, everyone.  And be careful out there.  The sharks are circling.