The Odd Couple – Treasuries and Gold
By Lee Jackson, published December, 2011
The following is an excerpt from Issue XIV of the free weekly financial newsletter The Opportune Time:
Since Issue XIII, global risk assets fell, as the optimism around the most recent European Union (E.U.) summit faded, and policymakers from the Federal Reserve (Fed), the United States (U.S.) central bank, did not hint at further economic stimulus. As we enter the second of the final ten trading sessions of 2011, many assets have work to do if they are to finish the year higher. As of the end of trading yesterday, the Standard and Poor’s 500 Index (S&P 500), the most commonly used benchmark for U.S. stock market performance, was down just over 4% year-to-date (YTD). Against the U.S. dollar (USD), the euro (EUR) was down a little more than 2.5% YTD. If a risk-on rally materializes, we could see U.S. stocks, the EUR, and other risk assets, finish the year higher. However, I see no catalysts on the horizon for such a rally, as global leaders appear unlikely to mitigate European debt crisis fears in the near future.
Two assets that have performed well in 2011 are Treasuries, or U.S. government bonds, and GOLD. 10-year Treasuries have returned more than 13% YTD, and gold more than 11% YTD. In general, investors consider gold a hedge against inflation, a phenomenon typically bad for bonds. Bonds oblige their issuer, or the borrower, to pay the lender certain amounts of money over a specific time schedule. If inflation rises, the bond loses value, because the money being repaid loses purchasing power. The reverse also is true. Hence, in theory, bonds perform poorly when gold appreciates. Years like 2011, when benchmark 10-year Treasuries and gold return approximately the same amount, are fairly uncommon. So why did 10-year Treasuries and gold perform so similarly this year?
As I have discussed in the past, arguably the most important driving force of the world economy today is debt deleveraging. Leading up to the financial crisis, consumers, primarily in the West, accumulated unsustainable debts. The debt manifested primarily in the form of mortgages, and the excessive leverage and credit growth in the real estate sector drove housing prices to unsustainable levels. When home prices began their descent, many banks and financial institutions, Fannie Mae, Freddie Mac, and Lehman Brothers to name a few, suffered significant losses on their mortgage loans. The losses rendered many firms insolvent, and in some cases, governments guaranteed the obligations of troubled parties. In essence, debt was transferred from the financial institutions exposed to bad mortgages to the governments.
The problem is debt only can dissipate via deleveraging, which is a painful, but I emphasize necessary process. The only ways to clear bad debt from an economy are for borrowers to repay less than they owe (default), and sometimes for borrowers to have a solvent party repay their debt for them (bailout). Please note, for simplicity, I define default to include borrowers inflating away their obligations and using other methods to decrease the value of the money they owe. Of default and bailout, bailout sounds like an easier way to deleverage, because the borrower’s friend picks up the tab.
The problem is, as I alluded to before, bailouts only sometimes qualify as deleveraging. Imagine having a friend, who would pay off your credit card whenever you could not afford the bill. How your friend obtains the bailout money is important. If your friend uses cash to pay off your credit card, then your debt is repaid and deleveraging occurs. But, if your friend swipes their credit card to pay your credit card bill, then your debt is repaid, but you effectively have stuck your friend with your original problem. Unfortunately, in the West, relatively few nations log consistent current account surpluses, and governments had few reserves to bail out their economies in 2008. Sovereigns swiped their credit cards, or issued government bonds, to pay off the debts of the financial system. The crisis seemingly abated, because markets viewed governments as more creditworthy or able to manage the debt than banks. In fact, three years ago, most people considered government bonds risk-free assets. But as time passed and obligations grew, debt burdens became too large for some of even the world’s most creditworthy borrowers to manage. Iceland, Dubai, Greece, Portugal, Ireland, and you know the rest, all lost control of their debt levels.
As we have witnessed in Europe over the past almost two years, large debt levels crimp economic growth, and efforts to deleverage crimp growth even further. As growth slows, inflation eases, and disinflation often occurs. In some cases, deflation can occur, as the Fed reported happened in short instances in the U.S. following the financial crisis. The tendency toward slower economic growth and disinflation benefits bonds, which usually suffer in inflationary environments. As we saw this year, growth concerns in the U.S. during the summer, and in Europe today, have caused Treasury bond prices to soar.
If gold’s tendency is to rise during periods of inflation and to fall during periods of disinflation, why would the yellow metal rally alongside Treasuries this year? In my view, the answer lies in the distinction between price and monetary inflation. Price inflation refers to cost of living increases that result from too much demand and/or too little supply. On the other hand, monetary inflation results when central banks create money, diluting the value of their currency and elevating asset prices. Central banks control the size of the monetary base, or the amount of currency and bank reserves, and thereby influence the extension of credit and the growth of the broader money supply. The monetary base also is known as the M0 money supply, which is the narrowest commonly used measure of the money supply.
As shown in the chart to the left, the U.S. monetary base has ballooned since the financial crisis. The Fed’s quantitative easing (QE) programs and its decision to keep the benchmark U.S. short-term interest rate near 0% for the foreseeable future have fueled a record boom in the size of the monetary base. From a historical standpoint, monetary inflation is off the charts. Today, gold, a real asset, serves more as a safe haven from monetary inflation than from price inflation. Because all goods are denominated in currency, monetary inflation affects the values of all goods, especially of real assets. Real assets include raw materials, land, and other items that can be found in nature.
Assuming the aforementioned is true, gold price appreciation roughly should mimic growth in the monetary base. Since the second half of 1999, when the current secular gold bull market began, the U.S. monetary base has multiplied more than 4.5 times. Over the same timeframe, the price of an ounce of gold has more than quintupled from $300* to today’s price of about $1,600. So though not exactly correlated, the size of the monetary base and the price of gold have a close relationship.
In summary, Treasuries and gold have been top performing assets this year, because the disinflationary effects of debt deleveraging have been fought by the monetary inflationary effects of central bank stimulus. The former is bullish for U.S. government bonds, and the latter for gold. I am bullish on Treasuries in the near term, because disinflation is taking hold, and I expect inflation to decline for some time. I will discuss my views on Treasuries more in depth in the New Year.
As for my OUTLOOK on gold, I am bearish in the near term, because I do not expect central banks to respond to economic problems with QE and other monetary inflationary policies. Gold already has fallen more than 15% from its all-time high in August, as central banks have refrained from pursuing bold stimulus measures. You can see on the featured chart that the U.S. monetary base has not increased for several months. The Fed has indicated U.S. policymakers are unlikely to ease policy further for the time being. I suspect Fed officials will not launch QE III until spring of next year, unless a shock from the European debt crisis causes inflation to plummet. Similarly, the European Central Bank (ECB) appears unlikely to ‘print’ money, or create currency, to buy the bonds of overly indebted euro area governments for the time being. In theory, the ECB could cap the borrowing costs of indebted sovereigns by ‘printing’ unlimited amounts of money. But I am skeptical such a policy would succeed in saving the EUR in practice. In my view, gold is likely to fall further, as central bankers surprise markets with their will to maintain stable monetary bases, despite faltering economic growth.
In the long run, I am bullish on gold, because I believe the disinflationary forces of debt deleveraging eventually will present circumstances, under which central bankers feel comfortable increasing monetary inflation again. As I mentioned earlier, the growth of the monetary base roughly should mimic that of gold’s price. $300 times a little more than 4.5 would put a target entry range the yellow metal between $1,350 and $1,425 per ounce. Many technical strategists I have seen are eyeing $1,400, which likely means buyers will step in in mass in the low 1400s. The price at which I buy always is determined by the development of fundamental events. But I imagine if gold falls below $1,500, I will prepare to buy. If gold falls below $1,450, I probably will buy. And if gold falls below $1,400, I may buy aggressively.
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