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Archive for February, 2011

11
Feb

THE INFLATION GHOUL KEEPS GOLD IN THE SHADOWS

   Posted by: Mr. Gold    in Uncategorized

One of the common misconceptions about gold prices is that they correlated tightly with CPI numbers. Any such trade is doomed to fail, as much as an equally mono-dimensional bet on long term yields on the back of a central bank’s interest rate decision. Both relations fail to factor in the market anticipation ex ante, the way these expectations have already been priced in (“is the interest rate decision chasing runaway price pressure” vs “is the interest rate hike offsetting future price pressures”) and the time lag. In fact, over years, gold prices have exhibited a much tighter (inverse) correlation to M2 growth – which takes into account both visible and shadow money creation (growth of money creation through expanding collateral acceptance). Gold is telling us much more about a broad-based purchasing AND investing power of specific currencies, rather than some adjustable, narrow consumption index with all its comparative intricacies between “core” and “headline”.

In this light, the price action since the beginning of the year has been particularly demonstrative. While the spread between regular treasuries and inflation-protected bonds in most countries points to increasing inflation expectations, gold has relinquished some of the last year’s gains. Those gains had come in two large waves. First around the Greek crisis in May – in anticipation of a near term monetary response offsetting the longer term grind of disinflationary austerity measures. The second wave was triggered by Bernanke’s speech in August and subsequent QE2 anticipation from September onwards. As we noted last week, the price impact of this event on the economically inert gold has been less pronounced than the appreciation in many other commodities, including base metals and agros.

Yet last year’s flight to quality was also characterized by a consistent rush into the perceived safety of ever-lower yielding sovereigns, most notably the Bund. The actual advent of QE coincided with the peak of that Bund rush. Yields have now mostly rebounded from their cyclical lows. And gold has recently been affected by ETF redemptions. A more granular analysis across various currencies is necessary to understand to what extent the leading indicator of inflationary pressures has now largely fulfilled its role.

We do this by comparing the differential in yield increase between regular Treasuries and inflation-protected bonds among the 10 economies which offer such products. Not surprisingly, we find that among the developed economies it is the UK which has registered the highest jump in yield spread between gilts and inflation protected securities (21bp, as of last Tuesday). The Eurozone bond markets are far from uniform (Germany 19bp, Italy 13bp and France 11bp). Australia has seen a 13bp increase in yield spread, US 5bp and Canada only 2bp.

It appears that much of these trends are mirrored by the way in which the FX market treats the respective gold (or losses) for investors whose wealth is denominated in the main currencies. In fact, as of last Tuesday, gold in UK pounds has lost most since the beginning of the year (-7.21%), followed by losses in Euro (-5.65%), US dollar (-3.60%), Australian dollar (-3.32%) and Canadian dollar (-3.43%). In other words, the “dollar” currencies have been the weakest performers vis-à-vis gold. It also appears that these economies’ increase in real yields happens to mirror real economic activity, rather than increased inflationary pressures.

Some scoff at GBP’s renewed strength – possibly predicated on the expectation of further increase rate hikes in future. Others point to China’s relentless upward (buying) pressure on deeper bond markets outside the dollar zone. The fact of the matter remains that the FX market is beginning to do the job of the gold investor both in the UK and in the Eurozone, bidding up the currencies whose monetary authorities may be forced to adopt a more hawkish position. The reduced risk aversion may even further accelerate the yield rebound in Germany.

But there is one outlier – where inflationary pressures do not cause the market to bid up the currency. The Australian dollar – eternally affected by the Japanese money flows – is currently suffering from China’s own growth trajectory jitters. Aussie’s relative weakness ensured that gold price losses down under have been limited since the beginning of the year, despite the fact that the 8bp rise in 10 year (inflation-protected) yields has been outpaced by the 21bp jump in regular treasuries. This positions the Aussie somewhere around the equally inflation-prone Italy, which however is being protected from stronger price pressures (and imported inflation) by a robust Euro. Should the emerging market (and China bearishness) prevail in the near future, and RBA continue with its counter-cyclical interest rate policy enshrined since the days of Governor Macfarlane, then Australian commodity producers could soon reap big benefits in terms of weaker (nominal) currency and concomitant margin expansion. Sooner or later, the gap between the nominal and real value of the currency will close – but in the near term, the Aussies may be in a sweet spot.

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3
Feb

SWEET REVOLUTIONS?

   Posted by: Mr. Gold    in Uncategorized

The turmoil in Egypt and its open-ended character have obviously not stemmed the market’s relentless slide towards ebullience. While some oil trading may betray anxiety over the unrest spreading to crude producing nations, OPEC’s spare capacity will most likely put a damper on any signs of panic. But it’s the broader commodity complex that is showing signs of exuberance. With copper at all time highs, unprecedented pre-planting tightness in cotton market and an ominous cyclone threatening to level Queensland’s sugar cane long before Brazil’s crushing season, it is understandable that gold has been on a back burner of late.

In fact, a more careful analysis of the commodities’ relative performance reveals that the seeds of the yellow metal’s poor showing were planted in the summer of 2010. Since August, silver, corn, wheat, cotton, coffee and later soybeans have all registered significant gains over gold. It is easy to intuit from the charts that what slowed down this process prior to the QE2 announcement was the Greek shock last May. This picture emerges from gold’s underperformance in comparison to industrial metals, the less successful of which (lead, zinc and aluminum) are now closing the spread which gold opened last May. Meanwhile, other metals are towering above the precious metal for reasons ranging from structural supply constraints (tin) to fund bullishness (nickel).

From the macro-economic perspective, we are heading back to the 2006-2008 setting. During this period, most commodities registered record spreads over gold. Copper, aluminum, zinc and sugar triumphed in 2006, followed by lead, nickel and cocoa in 2007, while platinum, tin, the grains (corn, soybeans, wheat) and the energy complex (oil and coal) in 2008. Palladium is an outlier, still anchored on the squeeze peak in 2001.

The financial crisis reversed this trend in 2009 and 2010. Gold’s spread over other commodities peaked first over its sister precious metals (platinum and silver) towards the end of 2008, followed by industrial metals in 2009 and agricultural commodities around summer 2010. Each of these peaks represented the highest relative gains that gold has registered over competing commodities since the beginning of the century. However, the pendulum never swung into gold favor with the vehemence recorded by some of the product specific bubbles observed previously – zinc in 2006, nickel in 2007, wheat and coal in 2008. The fall from these peaks was a lot more painful than whatever slow burn that gold was subject to on a pullback.

It appears that gold’s low volatility and its inert character as an economic input positions it just as well to detect currency debasement as it does to illustrate market overconfidence with respect to specific commodities. Most analysts watch spreads such as oil to gold, copper to gold, silver to gold or platinum to gold. But the broader set of comparisons reveals some intriguing trends, given that gold is uniquely non-mean reverting (I leave eternal arguments about silver aside). As gold lacks the ɳ to measure the return to trend, it serves as a useful benchmark to measure wealth, with many other commodities mean-reverting to gold’s value along the leverage cycles.

How is this lesson relevant now? In some metal/gold ratios there is currently no spread at all – it is therefore difficult to bet on direction. Chances are that further PMI improvements could push aluminum and oil above gold in the near term. But other commodities are beginning to show signs of unprecedented exuberance. Ratio of silver to gold hit a multi-decade high at the beginning of this year, but has ebbed since. Currently it is coffee and cotton whose ratios are at multi-year highs over gold. The cotton boom has been many years in the making and shortage eventually developed in May 2010. It is true that wet weather hampered harvesting in China and that higher oil prices are making substitutes (such as polyester) pricey. Yet both Australia and Brazil have now both expanded acreage devoted to cotton and by the second quarter of this year the speculative phase of this boom may be over. Coffee is another interesting example. Although we are in Brazil’s “off-year”, the country’s crop is expected to be strong. It will not, however, entirely offset the losses in the northern Andes where unusually heavy rains left the crops afflicted by fungus.

But coffee showcases another interesting feature. In fact, its two-year Rsq to gold is the highest among commodities after precious metals (higher even than copper) and so is coffee-to-gold beta. Do people sip coffee while handling gold jewelry? With the exception of the Greek episode, the overall correlation between the two commodities has been surprisingly high throughout 2010. Since more tightness reappeared in copper’s front contracts, coffee now also constitutes the only major commodity with a front contango and deep backwardation afterwards. And now the aromatic drink is registering a record spread over gold. Would it mean that the spread will begin to tighten again in gold’s favor?

But the one commodity to watch is sugar. We are still far away from sweety’s record high over gold in 2006 (which was unimpressive by agro standards). Sugar has had a good run since last summer and has closed on gold’s spread. If, therefore, we use gold as a litmus test, then sugar is not yet overheated. For the next two months, the market is almost entirely dependent on Indian exports. And let us not forget that last month the demonstrators in Algeria protested against sugar prices. There could be more to come. The sweet taste of democracy?

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