The Deflation/Inflation Conumdrum (November 25, 2008)
Gold was bound to rise once the selling abated . . . and each day it remains in $800+ territory, the technical picture and the yellow metal’s good fortunes improve.
In recent Gold Briefs I have discussed a variety of factors and forces that contributed to gold-price weakness over the past half year:
- Selling of commodity index positions, positions that often included gold and other precious metals, by hedge funds and other institutional players in order to raise cash, increase liquidity, cover big losses in equity and other asset markets, or simply wind down and return initial cash contributions to their investors. Importantly, gold was sold not because it was singled out as an unworthy holding but because it was simply a component in the indexed baskets of commodities held by the funds.
- Selling of gold by some wealthy investors and some funds to meet margin calls or cover losses on other investments gone bad. This contributed to the apparent correlation between world equity markets and the price of gold in recent weeks.
- Technically triggered sales of gold and commodity index positions including gold by program and momentum traders and speculators — including some bullion dealers — in response to and reinforcing the downward trend.
- Selling of central bank gold deposits by a few large banks in order to raise capital and improve liquidity. (see October 22nd “More on Gold Lending”).
- Also, the decline in commodity prices — especially the price of oil and gasoline — in recent weeks has diminished inflation expectations and dampened demand for gold as an inflation hedge.
The latest data on COMEX, TOCOM (the Tokyo Commodity Exchange), and Exchange Traded Funds suggest that the October-November wave of sustained liquidation of long gold futures positions has abated and may have come to an end with the emergence of some fresh buying and a decline in short selling.
This recent abatement in selling pressure reflects, at least in part, the exhaustion of gold positions (including commodity index positions). Much of what funds and other institutional participants had to sell has now been sold. Their vaults are nearly empty, so to speak — and, to the extent that these were actual physical positions, the gold has moved to stronger hands.
Also, importantly, I believe that some or all of the short-term “bridge” gold loans from central banks to bullion-dealing banks have been repurchased by the dealers and returned to the central bank lenders.
The rise in gold above $800 also reflects expectations of more interest rate cuts here in the United States and in other major economies and the increasingly quantitative reflationary/expansionary monetary policy by the Fed.
Meanwhile, booming physical demand from the household sector buying bullion coins and small bars continues apace.
The Inflation/Deflation Conundrum
The Citigroup rescue over this past weekend, by far the biggest bailout of any bank to date, has also been a plus for gold in the past few days, with many wondering if Citi was so close to the brink what other banks are next in line for demise or costly rescue. One headline suggested “Citigroup rescue could be a sign of more to come.” And the Citigroup life preserver — with $20 billion in new capital and potentially another $306 billion to cover risky assets — was costly indeed, with monetary and inflationary consequences down the road.
In a still more expensive set of initiatives to jumpstart bank lending to consumers and small businesses, the Federal Reserve and U.S. Treasury announced today (Tuesday, November 25) plans to pump another $800 billion into the banking system. Together these programs are more than authorized last month by Congress to bail out the banks and Wall Street firms. The Fed said the money would come from an increase in it’s reserves — in other words it is creating new money.
Most economists — in and out of government and across the political spectrum — believe these emergency measures (and possibly more to come) are necessary to revive the failing economy and prevent a spiraling decline into deflation and depression. A few economists — myself included — are worried about the mounting financial cost that has the potential to reach several trillion dollars and longer-term economic consequences.
Gold bulls are separating into two camps — inflationists who see gold as a hedge against future inflation and a decline in the U.S. dollar’s purchasing power . . . and deflationists who see gold as a deflation hedge as money seeks safe harbor in cash and cash equivalents like gold. (See my November 20th Gold Brief for more on the economics of gold as a deflation hedge.)
I believe we will see a longer, deeper decline in business activity than most, lasting into late 2009 or, more probably, 2010 — and likely to be accompanied by some of deflation, particularly in commodities, food, autos, and a variety of consumer goods. To be honest, deflation has been with us for some time already, first in real estate markets, then on Wall Street, more recently in oil and commodity markets, and, as anyone shopping for the holidays will soon notice, in many retail stores.
But as the economy revives — as it must with massive and unprecedented Federal government stimulus — prices for many goods and services will shift from reverse to forward . . . and inflation will replace deflation as all those trillions of dollars come home to roost.
China News
In the news last week were two small items from China with potentially big consequences.
First, government media reported that China’s central bank, the People’s Bank of China, is considering increasing gold reserves nearly seven-fold from the current 600 tons to 4,000 tons (roughly half the amount held by the United States) to spread risks in its huge foreign exchange holdings China has emerged as the world’s largest and fastest-growing holder of foreign exchange reserves recently totalling more than U.S.$1.9 trillion. Clearly, the gold market could not accomodate purchases of this magnitude — but it does suggest that China central bank may be an important buyer in the future.
Second, the Shanghai Gold Exchange announced that it would henceforth allow individual investors the opportunity to trade its kilo contract with the option of taking delivery via the exchange. The continuing liberalization and opening up of the gold market to individual investors has great potential over the longer run.
China’s cultural affinity for gold — in conjunction with rising incomes and the growth of the middle and upper classes — certainly bodes well for high gold prices over the next five to 10 years. It has been pointed out that if China’s per capita demand for gold equaled that of Hong Kong, the country’s total gold demand would be about 4000 tons, an amount that is more than current global demand in total. While this is unimaginable, if only because rising prices would choke off demand everywhere including in China, it underscores China’s certain growing role on the demand side of the global gold market.
I’m off to China next week, where I’ll be speaking at the China Gold and Precious Metals Summit in Shanghai. I’ll be meeting many of the leading executives and officials in the country’s growing gold community — and hope to share with readers of NicholsOnGold some of the insights gleaned from my discussions.
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