This is our annual, for-subscribers-only, analysis of the gold and silver markets. We look at the market players, dynamics, fallacies, drivers, and finally give our predictions for the prices of the metals over the coming year.
Predicting the likely path of the prices of the metals in the near term is easy. Just look at the fundamentals. We calculate the gold fundamental price and the silver fundamental price (methodology described below) every day, and our data series goes back to 1996. Here is a graph showing the gold fundamental for three years.
We circled the date of our Outlook 2018 (we skipped last year). At that time, we called for the price to hit $1,450 by the end of the year. We were right about the fundamentals, and the price did eventually meet and exceed our call. Though about six months late.
Of course, the market price can diverge from the fundamental price, sometimes by a sizeable percentage and sometimes for a long period of time. And it tends to converge again sooner or later. Right now, the market and the fundamental prices are less than ten bucks apart. How far can they deviate? In the last decade, the peak discount has been over 25%.
Predicting the price farther out is much harder. The fundamental shows the relative pressures in the spot and futures markets, but only shows a snapshot. It does not predict how those pressures might change. For that, one looks at the dollar of course, credit, interest rates, other currencies, the economy, and even wild cards like bitcoin.
In fourth grade math class, Miss Jennifer didn’t want the kids to just write “42” (with due respect to Douglas Adams). She wants to see the work all written out. It’s not so valuable if we say “silver to $10” (or $100”), without saying why.
Below, we will show our “long division” work before getting to our bottom line numbers.
How Not to Think about Gold
It may seem odd to begin by discussing how not to do it. However, these approaches are very common and many people start with one of these approaches, such as price manipulation conspiracy theories, rumors, out-of-context-factoids, or mining production and manufacturing consumption data.
We have lost track of the number of prominent people who have published a hard date for some catastrophe to occur. These dates have all come and gone (we have been watching this page reschedule Armageddon every six months—it was just recently slated for Dec 31, but now postponed to June). Some of these guys have predicted dozens of the last zero hyperinflations. Despite their efforts, the dollar is still intact.
Our view is that the dollar is indeed dying, but it is not via the white hot thermonuclear blast of hyperinflation. It is by the cold drowning when even a strong swimmer, exhausted, sinks below the waves at sea. It is not going to die when “the sheeple wake up,” or due to some meeting of the G20, or a declaration of the IMF that the dollar’s reserve status is gone. That is not how it works.
These approaches are unhelpful. They can confuse long-term holders, and cause traders to make costly mistakes.
We have written a lot to debunk claims of price manipulation (here is our open letter to Ted Butler, which has so far not been answered by him or anyone else.
Broadly, conspiracy theories fall into a few categories. One, central banks are selling gold. Maybe, but what explains the even-larger price drop in silver since 2011? The banks don’t have any silver. So if gold was manipulated by central bank selling of metal, then silver should show us what a not-manipulated price looks like. And the gold-silver ratio would be closer to 10 than to 100.
Two, banks are short-selling futures naked. This would cause backwardation. It would also cause expiring contracts to move in the opposite direction than they actually do. When each contract expires, someone who is naked short would have to buy it with urgency. If there were really a massive naked short position, there would be a buying frenzy and the expiring contract would be bid up higher relative to the spot price. The basis would rise. The reality—and we show a graph of every expiring contract back to 1996 in our response to Mr. Butler—is the opposite. Falling basis.
Three is just what we have to call magical thinking. For example the bigger a trader’s position, the more he controls the price. How’s that supposed to work?
We would put rumors, Indian gold import numbers, and news into the same bucket. Even when factual, these items are the investing world’s equivalent of an attractive nuisance—they can lure you to financial harm. Most importantly, one should never trade based on what the Fed has done (increase the quantity of dollars) is doing (increase it) or will do (increase it some more). That is not what drives the gold price.
Finally, we come to the numbers for electronics and jewelry consumption, and mine production. We firmly insist that gold and silver cannot be understood by looking at small changes in production or consumption. The monetary metals cannot be understood by conventional commodity analysis.
This is because virtually all of the gold ever mined in human history is still in human hands (to a lesser extent for silver). No other commodity comes even remotely close. The World Gold Council estimates the total gold stocks at 188,538 metric tons at the end of 2017. We believe this understates the reality, perhaps by a large multiple. People have been hiding gold from their acquisitive governments and neighbors for thousands of years. Gold has always been the sort of thing that most people would rather keep quiet about. It defies any systematic inventorying process.
In any case, annual production is a tiny fraction of even this conservative number. The World Gold Council reported mine production has averaged 3,247 tonnes over the past three years. This is just 1.7% of then-existing stocks. In other words, it would take 58 years at current production levels just to produce the same amount of gold as is now stockpiled. In regular commodities, this same ratio—stocks to flows—is measured in months. We just don’t hoard wheat and oil for the long term, for obvious reasons. Nor even iron or lumber or other durable materials.
If total gold mining is 1.7% of gold inventories, then small changes within that 1.7% are not likely to have much impact on the gold price.
How We Think About Gold
The implications of this are extraordinary.
All of that stockpiled gold represents potential supply, under the right market conditions and at the right price. Conversely—unlike ordinary commodities—virtually everyone on the planet represents potential demand. If someone offered to pay you 1,000 barrels of oil, where would you put it? The same value of gold could fit in your pocket.
A change in the desire to hoard or dishoard gold, even a small one, can have a big impact on price.
There is no such thing as a glut in gold. Through rising and falling prices over thousands of years, the market goes on absorbing whatever the miners put out. Gold mining does not collapse the gold price, as oil drilling or copper mining does, when inventories accumulate. The whole point of gold is that inventories have been accumulating at least since the time of the ancient Egyptian Empire.
Why would people be willing—not just today, in the wake of the great financial crisis of 2008 and unconventional central bank response, but for thousands of years—go on accumulating gold and silver?
There is only one conceivable answer. It’s because these metals are money. Compare gold to oil. The marginal utility of oil—the value one places on the next barrel compared to the previous—declines rapidly. For oil, it falls rapidly because once your tank is full, you have that storage problem—assuming you even directly use oil at all.
People are happy to get the 1,001st ounce, and accept it on the same terms as the 1,000th or the 1st ounce. It doesn’t hurt that you could carry those 1000 ounces in a backpack, nor that you can find a ready market for it anywhere in the world, from London to Lisbon to Lagos to LA to Lima to Laos.
So if gold is money, then what’s the dollar? The dollar is a small slice of the US government’s debt. It is a promise to pay, though it comes with a disclaimer that says the promise will never be honored. The dollar is credit, whose quality is falling. What does that mean for our discussion of the gold price?
It turns it inside out.
We don’t look at it as most people do, that gold is worth $1,550. This is backwards, upside down, and inside out. It is like saying your meter stick is 143 gummy bears long. Instead, we insist that the dollar is worth 20 milligrams of gold. This is not merely semantics. It is a paradigm shift—easy to say, but harder to get your head around. The advantage of this perspective is that you can see the market much more clearly.
If you are in a rowboat, tossing about in stormy seas, would you say the lighthouse is going up and down? If you have rubbery gummy bears would you use them to measure a steel meter stick? Can you say that the steel is getting shorter, as the candy compresses? No, the lighthouse and steel are stable but the waves and rubber band are not.
When you say “gold is going up”, you can’t help but think you are making a profit. But if you say “the dollar is dropping” then you realize the truth. Sure the gold owner may have more dollars, but those dollars are worth less than they were. He should not be so tempted to spend down his gold savings, merely because the value of the dollar fell. The idea of spending one’s capital, of consuming one’s wealth, is a persistent them across our writings.
You cannot profit merely by holding gold. You can avoid losses (which is a good thing, of course).
We go further. We advocate that everyone calculates his net worth in gold, and measure profit or loss based on gains or losses in gold ounces. If you had 100oz and later you have 110oz, then you got richer. If you went down to 99oz—even if the price of gold is higher, and your gold is worth more dollars—you have suffered a loss. We encourage you to get into the discipline of dividing your dollar net worth amount by the then-current price of gold. Keep a record and track it every month or every quarter.
You can profit from holding silver, when silver goes up. We don’t mean its price in dollars, but in gold. For example, if the silver price begins at 400mg gold and it rises to 600mg, then you have made a profit of 200mg or 50%. It is about 360mg right now, and it was last at 600mg in 2012.
You can sometimes profit by going long the dollar. It is declining in a century-long downtrend, but that doesn’t mean there aren’t corrections along the way. For example, the dollar hit a low of 16mg gold in 2011. After that, its rally was impressive. Even with the recent decreases in its price, it’s still up 25% from that all-time low.
At other times, you can profit by shorting the dollar with leverage, for example buying gold futures on margin. Suppose you have 100oz gold, or about $155,000 today. You need $4,950 cash to open a futures contract position. $155,000 enables you to buy 31 100oz contracts. In other words, futures offer 31:1 leverage. If the price of gold goes up $46.50, or 3%, then you profit $144,150 or 93oz gold. Not bad on a bet of 100oz, though of course the risk is extreme with leverage this extreme.
As they say on those shows on TV when they blow up stuff with dynamite, “now kids, don’t try this at home”.
How We Analyze the Gold Market
We think of the market as the coming together of 5 different primary groups.
- Buyers of metal. The end buyers (not intermediaries, e.g. jewelry manufacturers who make the gold products for the hoarders) are typically hoarders. So there is no particular price that is necessarily too high, other than whatever their notion of a fair price is at any given moment. The demand for gold for hoarding is monetary reservation demand.
- Sellers of metal. They are dishoarding, for whatever reason. They may think the price has hit a high enough level to attract their greed, or a low enough level to activate their fear. Miners are a subcategory of sellers, though miners are price takers (and a small fraction of the supply in any case).
- Buyers of paper (e.g. futures). These are speculators, with three key differences from buyers of metal. One, they use leverage. Two (for that reason and others) they have a short time horizon. Three, they trade for dollar gains.
- Short sellers of paper. Not nearly so big a group as popularly imagined, there are people who take the two lopsided risks of (1) shorting something with limited profit and unlimited loss potential and (2) fighting a 100-year trend. These people are nimble and aggressive and certainly their trades are short-term.
- Warehousemen, aka market makers. If few people are willing to bet on a rising dollar (i.e. falling gold price), then who sells gold futures? Aren’t futures a zero-sum game, with a short for every long? Enter, the warehouseman. He stands ready to carry gold for anyone who wants future delivery. If you buy a future, you are signaling that you want gold, not to be delivered now, but at some date in the future. For a profit, the market maker will sell it to you. How does he do that? He buys metal in the spot market and simultaneously sell a contract for future delivery. He doesn’t care at all about price, as he has no exposure to price. He responds to spread. Suppose he could buy gold in the spot market for $1,550 and sell it for Dec delivery for $1,581. That is 2%, not unattractive in this market.
It’s important to keep in mind that virtually all of the gold ever mined is in someone’s hoard. There is no such thing as a glut or shortage. However, the market can experience relative abundance and scarcity and the spreads of the warehouseman provide a good signal to see it.
If there is a big spread between spot and futures—called the basis—then this means two things. One, speculators are bidding up futures contracts. And two, the marginal use of gold is to go into the warehouse. This is a sign that gold is abundant to the market.
Normally, the price in the futures market is higher than the price in the spot market. This is called contango. Contango means it is profitable to carry the metal, which is to buy a metal bar and sell a future against it. However, the basis spread can invert and it has many times since the crisis of 2008. When it is inverted—called backwardation—it is profitable to sell metal and buy a future. Such decarrying is, by conventional standards, risk free (it’s not, see below). It should never happen in gold, as it is a sign of shortage and there is no such thing as a shortage in a metal which has been hoarded for millennia. Backwardation is a signal to the warehouseman to empty out the warehouse.
In backwardation, the marginal supply of metal is coming from the warehouse (carry trades are unwinding). Obviously, there is only a finite supply of gold held in carry. Thus, backwardation presages rising price.
This is the only way to analyze supply and demand fundamentals for the monetary metals. They are not consumed, and only accumulate over time. They have a stocks to flows (i.e. inventory divided by annual mine output) ratio measured in decades. As they’re not bought to consume there is no particular price ceiling.
The five market participants interact to form a constantly changing dynamic. It is this dynamic that we study when we look at spreads between spot and futures, and changes to these spreads. Monetary Metals has developed a proprietary model based on this theory, which outputs the Fundamental Price for each metal. This is updated every day.
We have published more on the theory.
As of the last writing of this annual market outlook, it was common belief that we are in for a period of rising prices and interest rates. We didn’t agree then, and we don’t agree now. The idea of rising rates is a bit less popular, now that the Fed has reversed itself and (so far) cut the effective Fed Funds rate by 80bps.
In his theory of interest and prices, Keith Weiner describes the falling interest rate environment that began in 1981 when interest rates were above the productivity of the marginal entrepreneur. With each downtick in the rate, the incentive to borrow more becomes greater. At the same time, the net present value of each dollar of that debt is rising. It doubles with each halving of the interest rate.
Interestingly, the Bank for International Settlements publishes research on the debt of zombie corporations. BIS defines zombie as a company whose profits are less than its interest expense. In other words, it survives only by grace of ultra-low rates and ultra-loose credit markets. The last we saw, about 12% of the corporate debt outstanding is issued by zombies.
We don’t know what the right number is but even if it’s a fraction of that, it demonstrates that interest is above productivity for marginal firms. And if it’s anywhere near 12%, the margin is no thin line for a few outcast losers, but a big chunk of the market.
So what happens if the Fed tries to raise rates? Obviously, the zombies will collapse. Their employees will be laid off, putting them under pressure to default on their own creditors. And reducing their spending on everything from pizza to petrol. Which reduces revenues to firms which are not currently counted as zombies.
Rising rates is also the inverse of falling asset prices starting with—by definition—the bond. The so called wealth effect is put into reverse. If people spend more as they keep making capital gains (not to mention profitable trades), what happens when their portfolios shrink? They buy less, if not pizza, then Porsches and pinot noir.
If falling rates incentivize companies to borrow to buy their own shares, and in some cases to pay dividends, what happens when rates rise?
Credit demand is only generated with a downtick of the interest rate. Profit margins are soft but if the cost of borrowing goes down, then there may be a business case to open that next store, to develop that next strip mall, etc. If the cost of borrowing goes up, then it’s batten the hatches.
In 2014, before this rate hiking episode began, 6-month LIBOR was 0.32% (less than 33 basis points). Now it’s 1.87%, though down from its high of 2.8% a year ago. This was big increase in cost for business borrowers (to say nothing of governments). For every $1,000,000 financed in 2014, the annual cost of interest was $3,200 a year. It was up to $28,000 and has now subsided to $18,000.
Automakers in the US kept offering 0% for 72 months all through the Fed’s interest rate headfake. They needed to offer an incentive, if they wanted to sell cars. Rising rates gave them a bitter choice: either eat the additional costs or else pass the cost on to consumers and sell fewer cars. They ate the cost. It was not much of a choice. Perhaps they needed to sell those cars to generate the revenues to pay the interest expense on the debt they previously incurred to expand the capacity of their factories. A decision they made when ratds were lower.
The Federal Reserve does not have control over the interest rate on the long bond the way it has over the short end. This has particularly poignancy to the banks. The banks borrow short to lend long. They profit from the spread between LIBOR and 10-year Treasurys.
At the time that LIBOR was 0.32%, the 10-year Treasury was 2.2%. Banks were raking almost 2% from this trade. Today, the Treasury yields 1.i%, the same as 3-month LIBOR. Banks are getting crushed.
One call in 2018 that we got absolutely right:
“Something has to give. Or several somethings. We believe one thing that gives will be interest rates. They cannot rise very far, or durably.”
We want to be clear that a falling interest rate is enormously destructive. We are not proposing a monetary policy of cutting rates. We are simply saying that the Fed is boxed into a corner by its own past bad policies. We don’t think it wants a repeat of 2008, and it won’t so long as it has a way to postpone the reckoning. Even if the very postponement makes the inevitable reckoning worse in the end.
Falling rates creates massive capital gains for bond holders, and the rising bond price is propagated to other markets. These gains are not from rising productivity. They are from monetary policy, which cannot create wealth but merely the illusion of it (i.e. the wealth effect). These gains come at the expense of bond issuers, who are, in essence, short their own bonds. If you short something and it goes up, you incur losses (we acknowledge that this is not recognized in current accounting practice).
We will talk about rising vs. falling interest rates and its impact on the price of gold below.
Not the Drivers of the Big Price Move
Speculators view gold and especially silver as just a vehicle to ride, to make more dollars. They can pull the price pretty far, at least for a while. Like stretching a big rubber band however, it gets exhausting to keep up the force. Eventually if they’ve gotten the trend wrong, they must let go. At some point, fatigue sets in (not to mention the cost of the keeping and rolling a futures position). Here is a graph of the cost of rolling a futures contract, showing seven years.
For long positions, look at the cyan line which is negative. For quite a while, it cost almost nothing to roll each futures contract, around 50 cents. But starting about two years ago, the cost went up. It is now over $6. A speculator had better expect a big price move, to be willing to pay that cost at each contract roll (six time a year).
This is one thing that goldbugs do not understand. They try to explain to mainstream investors the virtues of gold. But these investors don’t think it makes sense to pay to carry gold. Those who want more people to buy gold, and drive up the price of gold, should cheer that we pay interest on the metal. Now it pays to own gold.
If you want a durable move, it will not be driven by people who spend nearly $40 per ounce per year to hold their betting position. It must be people who change their preference from holding the government’s official money to holding money in fact.
Next let’s move on to inflation, so called.
We said it in Outlook reports years ago, and we reiterate now: we would not put capital in harm’s way betting on the thesis that inflation is going to jump up, and that this will cause the gold price to jump up.
For one thing, commodities continue to fall or remain near long-term lows. What kind of inflation is that? Or for that matter, car manufacturers offering 0% for six years as a desperate attempt to stimulate sales.
One thing needs to be said about rising consumer prices, which most people call inflation. Prices are driven by both monetary and nonmonetary forces. Keith shows in his theory of interest and prices that a falling interest rate tends to push commodity prices down.
However, prices are also driven by nonmonetary forces. When governments mandate more useless ingredients, prices can rise. How else to explain that gasoline is more expensive in California than in neighboring Arizona? Both states use the same dollar.
Prices drop due to efficiency improvements, and of course due to good ol’ fashioned competition from Korean-made washing machines.
It is unscientific to lump together two different causes into one concept, and use that concept as if it referred only to one of them. Unfortunately, eminent economist Milton Friedman declared that “inflation is everywhere and always a monetary phenomenon.” This false truism encourages fuzzy thinking.
So back to the question, if mandated Americans with Disabilities Act bathrooms reduce the floor area that restaurants can use to generate revenue, this may put a few restaurants out of business and the rest can raise their prices to serve fewer people, who are willing to pay more for food.
When ethanol mandates, state fuel taxes, and environmental compliance are rising, then so is the price of gasoline.
This is not a monetary phenomenon. It is not caused by the Fed.
It also has nothing to do with the price of gold. There is no reason to expect the price of gold to go up every time a local regulator increases the cost of producing products included in the consumer price index. And there is no reason to expect anything in particular to happen to the price of gold, either.
Be Careful What You Wish For
Many gold speculators would love the gold price to rise rapidly to $5,000 or more (we saw one gold dealer touting $65,000 in a talk at a conference). We would first like to point out $5,000 means the dollar drops to around 8mg gold. The whole world runs on dollars. Think what will be happening to people, pension funds, insurance, banks, farmers, employers, etc. if the dollar drops so much.
It is tempting to look around, see the fat cats driving their Ferraris to skyscraper rooftop bars, jetting around the world, wearing Swiss watches and Italian suits, and think “If only gold goes to $5,000 or $10,000, then that will be me.”
We don’t think so. If the price action happens slowly, say over 10 years, it will represent a steady erosion of the world’s capital base. Holding gold will keep you (mostly) safe from that erosion, but will not make you rich.
If it happens rapidly, it will be something else entirely. The collapse of 2008 was ugly, until central banks put it on pause. They agreed to an unfathomable Faustian deal with the devil. When the collapse resumes, it will make 2008 look like a dress rehearsal.
Those rooftop bars will be closed. There will be Ferraris for sale cheap, but with refineries and gas stations failing, getting fuel could be a challenge. Moving dollars out of your bank account to buy the fuel could also be a problem. The mood on the street will be ugly, and few people will dare openly flaunt their Ferraris openly. Even today, in the relative calm of the current boom, many municipalities are having a hard time keeping up vital services such as police and fire. They will find it much harder when they can’t keep getting more free money, while pretending that they are borrowing.
Something will inevitably happen to remind people that gold is not just for hedging inflation or speculating for dollar gains. To understand, put yourself in the position of a citizen of Cyprus in February 2013. On one Friday afternoon, you had what you thought was a few hundred thousand euros deposited in a bank.
And then, on Monday morning, you didn’t.
It turned out that the Cypriot banks had invested in Greek government bonds. They had long since lost your deposit but continued to operate in a state of insolvency. They eventually got to the point when they could no longer keep up the pretense. People who had their euros locked up in closed banks nervously waited. There were tight limits to withdrawals. And haircuts for depositors—losses shared with other classes of creditors. Virtually everyone on the island was in this vulnerable and terrifying position.
Those few Cypriots who had previously bought gold, found they could easily get on a boat and go to the mainland where conditions were better. We spoke with a gold bullion dealer in Nicosia, Cyprus. Very few had bought gold. Most did not realize their peril (or did not want to see it).
The virtue of owning gold, for Cypriots, was not in the hope its price would rise. It was more elemental than that. Gold is not someone else’s liability. It is a lump of metal, which means that it cannot default. It is not subject to a negotiation of the International Monetary Fund, the European Central Bank, and the European Commission. Unlike the so called Troika, gold will not sell you up the river.
If you own it on Friday, you still own it on Monday and it gives you the freedom to do as you please.
Events are coming that will remind people of this. We think these reminders are likely to be very pointed. When hundreds of millions of people in Europe, South America, and even North America eventually, wake up one day to the reality of losses on what they had assumed was money safely in the bank, the buying pressure in gold and silver will be truly ferocious. Notably, the selling will not be comparable. There will be some fools who are eager to book their illusory profits as the price rises. But most won’t trade their metal for bank deposits of unknown provenance and unknowable risks.
We will come to a time of exponentially rising price combined with exponentially rising backwardation. That is, the gold futures market will cease to work.
It will be a time of woe, though a bit less horrible for those who own gold compared to everyone else. Not a time of 108th floor bars, $50 cocktails, and jetting off to London for the weekend.
We emphasize that the endgame of the dollar is not imminent. We will continue to update the picture as events inexorably play out.
In 2015, we published an article about the coming collapse of the Swiss franc. We were early (though we did not say the collapse was necessarily coming in 2015). This collapse, when it comes, will shake up the monetary system. The yield on Swiss bonds is negative for all durations.
Gold closed the year 2019 at $1,517 and the Monetary Metals gold fundamental price was just a few bucks below that.
Silver closed at $17.82. The Monetary Metals silver fundamental price closed a few pennies under that. Here is a graph of the market price overlaid with the fundamental (we are skipping the gold chart, as we showed gold, above).
As with gold, the fundamental price rose this year. In silver, the increase is about 10%.
Fundamentals can and do change. So what do we expect this year?
How Not to Predict the Gold Price
In the Outlook 2016, we addressed the belief that the money supply (i.e. quantity of dollars) drives the price of gold. Short answer: it doesn’t. In Outlook 2018, we showed that interest rates are not correlated with the price of gold.
Both of these ideas are very popular. If you think about it, the first one is obviously wrong. The Fed is always increasing the quantity of what it calls money. The gold price goes up, sideways, and down. The second just does not work either. The price of gold shot up during the period of rising interest rates in the 1970’s. Since 1981, the interest rate has been falling. During that time, the price of gold has gone up, sideways, and down.
These supposed correlations just don’t work.
That said, there is a connection between interest and gold. It’s just not a simple correlation. We will address that below.
First, we want to comment on two things that have many buzzing today. One, the fall of the dollar cannot be measured in euros, pounds, yuan, etc. These currencies are dollar-derivatives! When they go up, it does not indicate the dollar is going down. It indicates that the risk-on trade is back on. It indicates a boom, where market participants are borrowing dollars to exchange for other currencies to buy assets denominated in those currencies. This can either be to profit from a higher interest rate, or in the hopes of capital gains.
You cannot infer that because the euro is on a tear, that this means the dollar is going down and therefore gold will go up (just as the dollar cannot be measured in terms of euros, gold cannot be measured in terms of dollars).
The other is bitcoin and other cryptocurrencies. It is often argued that the buying of bitcoin will somehow displace or lure people away from gold. In 2018, we argued why we did not believe so. Now in 2020, somehow it does not seem so necessary to spell out this argument.
We end this section by noting with amusement, that one of the usual suspects is now calling for a “signal failure”, so called, in the gold market. “The gold cartel is going down,” they assert. We hope by now that few people trade based on these sorts of claims.
This is the gold market equivalent of the Great Pumpkin in the Charlie Brown Halloween special show.
Retail vs. Institutional Buying
The price of gold shot up roughly June through August. At the end of May, gold traded for about $1,300. By the end of August, it was well over $1,500.
During this period, there was no change in the gold basis. See this chart showing mid-May to mid-September. It shows not the price of gold in dollars, but the price of the dollar in gold (which is inverse). There is a big drop, from 24.3mg gold to 20.3mg, or about 16.5%.
Rising price of gold without rising basis means the move was driven by the buying of metal, not of futures. This was fundamental buying, not leveraged speculation.
Yet, by all accounts, dealers were getting customer sell-backs. The price moved up, against retail selling. If it was not driven by futures speculators, then that leaves only institutional investors. We can say that we are seeing institutional interest in gold in a different way than we have seen since 2012. However, we don’t prefer to make arguments based on un-referenceable conversations.
Instead, we can point to one category of institution whose buying is public. Central banks. We caution against reading too much into it. For example, some say that the central banks plan a return to the gold standard. We see no evidence for this. But the fact is that they have been buying more. And so have other institutions.
Here is a graph showing the lease rate paid by bullion banks (bid) and paid by businesses who need to lease gold (offer). These are calculated based on what we call “zero arbitrage”, meaning there is no profit to the bank and no premium charge for credit risk.
Still, the graph is telling. Since the global financial crisis, the lease rate has been in a downward trend. Without knowing the specific players, we can be sure of one thing. As the profit to lease out their gold falls, the central banks must be finding it less attractive to do it. And we know that in 2018, central banks such as Poland continued the trend of withdrawing their gold from London and New York, to bring it home to their countries. Aside from the risk of invasion, the primary reason for them to put it in London or New York was to access the gold market. If they do not plan to sell, then this means leasing.
While most people focus on the price implications of these withdrawals (price to skyrocket, of course!) we look more at the implications regarding leasing. There is little reason (literally) to lease gold for 5 or 10bps.
The proof is in the pudding: we have rising price, flat basis, and retail selling. If there is another theory that explains these three observations, we are all ears.
What Drives the Gold Price
Excluding speculators, people buy and own gold for the long term because it is money. Nearly all of the gold ever mined in human history is still in human hands (which is how you’d expect money to behave). So of course lots and lots of people own some. If we want to try to predict the price, we want to look at change at the margin. Will those who own now have a reason to sell? And will those who do not own it have a reason to buy?
The first question is: why does someone own money? Basically, it’s because he does not want to be a creditor. There are two reasons for this: risk and interest that compensates savers for taking risk. Let’s first look at risk.
To own a paper dollar bill, one is a creditor of the Federal Reserve. If you think that the Fed’s paper is risk free (which it is defined to be by modern finance), then you have no reason to own gold. If you look at the Fed’s balance sheet, and wonder what happens as its cost of funding goes up and at the same time the yield of its portfolio remains flat and the value of assets is declining, then you see risk and hence have a reason to own gold.
To deposit that paper bill in a bank is to add bank credit risk on top of Fed credit risk. Once upon a time, the banks paid interest on deposits. But even now after some rate hikes, the banks are not in a position to offer much, as their margins are compressed.
An increased awareness of risks in the banking system causes people to buy gold, and hence the price rises.
Now let’s look at payment to creditors, otherwise known as interest. Everyone has a price he demands, in order to give up his money and extend credit. If the interest rate offered to him is below this preference, he will not want to lend.
Central banks have a prime directive: to make it cheaper for the government (and its cronies) to borrow, so it can spend in excess of revenues. It seems such a simple exercise. Just buy government bonds. Push up the price of the bond, and that means the interest rate goes down (rate is a strict mathematical inverse of price). Unfortunately, they set in motion a dynamic system characterized by resonance and positive feedback.
To picture resonance, watch this video of the collapse of the Tacoma Narrows Bridge. The wind gusted at the resonant frequency of the bridge structure.
To picture positive feedback, watch this video of a guitar lesson on how to make that sound at the beginning of Foxy Lady by Jimi Hendrix (you have to hold the guitar up to the amplifier in just the right way).
The central bank may be able to push down the rate of interest, at least initially. However, they have no control over the time preference of savers. Normally interest is above time preference. But if they push interest below, then the violated savers will take action. Suffice to say that in this state, they prefer to hoard commodities rather than buy the bond offering interest that’s too low (read Keith’s theory of interest and prices for the full detail). If gold is legally permissible to be hoarded, then it’s the best good for hoarding. “Money is gold, and nothing else,” as JP Morgan said in 1913.
The last time interest was below time preference was in the 1970’s. And boy did the gold price rise during that decade. Not because the interest rate was rising per se, but because interest was below time preference. Alas, as interest rose, so did time preference. Like a ratchet.
We are looking at a spread—interest to time preference—and it cannot be measured directly, as there is no economic data series for marginal time preference or the marginal saver.
Notwithstanding the Fed’s recent toying with higher rates, we are still in the same falling trend ongoing since 1981. Each downtick in the interest rate may push it below some dollar holder’s time preference. These marginal dollar holders may buy gold.
From the crisis through 2011, the prices of the metals ran up due to the inflation trade: “Oh my God, they are printing money to infinity! Buy gold and silver before they go to the moon!”
Then, that trend ended. While the money supply certainly did not collapse, supply and demand fundamentals caused lower prices in one commodity after another. Copper, for example, peaked in early 2011. Oil had an epic collapse. Wheat dropped through the end of 2016, though it’s bounced a bit since then.
The next several years were a period of despair alternating with hope as the prices of the metals fell and fell, and then rallied. It took from August 2011 when the price of gold hits its peak just under $2,000 until December 2015, when the price hit its trough a bit over half that level.
Since then, we think most chartists would agree that the gold price is in an uptrend. But the question is: where to, from here?
The central banks have been fighting mightily to keep the current boom going. It has been going so long now, that it has to be a record length without a bust. We have been saying for many years that this requires the interest rate continue to drop. The Fed briefly tried to disagree, but has now been forced to concede. We believe that they are now in the position, known in the game of chess, as zugzwang, at least regarding the gold price.
If they continue to succeed for a while longer, they are pushing the interest down even further. As it falls below the time preference of more and more savers, more and more of them will turn to gold in preference to dollars (let alone Swiss francs or euros with negative yields). This will drive up the price.
If they fail, then risk (or the perception of risk) will begin skyrocketing. People will turn to gold as the financial asset without counterparty risk. This will drive up the price.
We believe it is likely that gold will trade over $1,650 during 2020. We would not bet against it trading higher, perhaps much higher.
One factor could accelerate this. If the speculators perceive the risk of a price drop to be reduced, they will buy futures in mass quantity and drive the price up further (though eventually setting up the dynamics for a drop, later).
Now we get to gold’s wayward little brother. Who would have thought we would see gold well over $1,500 with silver around $18?
Well, as has been noted many times by many analysts, institutional investors prefer gold and many will not touch silver. Thus we have a gold-silver ratio over 85 at the end of the year.
Unless you think that silver has been demonetized by the market—and hence that the gold-silver ratio can rise to any arbitrary level—one thing is for sure. The ratio is pretty close to its top end. Suppose it were to return to its peak around 100. Then at $1,650 gold then silver would be $16.50. It was just there a few weeks ago.
On the other hand, two things seem highly likely. One, some institutional investors realize that silver is the relative bargain. Their usual reluctance to own silver when the gold-silver ratio is at a normal level may be reduced at this extreme. Two, if the price of gold continues to rise, then retail savers will stop selling and resume buying. These folks will have less reluctance to buy silver than institutions.
Thus, silver is more likely to move to the upside than to the downside, as measured in gold—i.e. the gold-silver ratio is likely to fall.
In this scenario, if the price of gold is $1,650 and the ratio reverts even partway to its historical mean—say 70—then this gives us a silver price around $23.50.
The fact of this upside won’t be lost on institutional or retail savers, or futures speculators.
We assess less than a 20% chance that the prices of the metals decline from here, and remain depressed for an extended period. And a 20% chance that the prices explode to a much-higher upside than the numbers we discuss here. The most likely scenario is a moderate and gradual continuation of the uptrend from here.
To anyone who does not yet own gold or silver, we offer the same advice as always. You should own some, period. Without regard to price.
And we think that buying gold or silver now is likely to turn out to be a good deal.
We will continue to chronicle the changing dynamics in the Monetary Metals Supply and Demand Report every week. Subscribers will be the first to see any shift when it occurs. And of course if we see signs of a credit crisis, we will write about it.
It is important to note one caveat. As with equities, fundamental analysis does not help you time the market. Timing is not what we are trying to do. We are doing something that has become unfashionable.
We are interested in valuing the market.
© 2020 Monetary Metals LLC. All Rights Reserved.