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Thursday, January 13, 2011

Food Riots, Increased Fear of Inflation , Sovereign Debt Crisis and Continued Currency Crisis...But Why Isn't Gold Going Up ?

Looking on a global basis it would seem that the world is far closer to the gloom and doom scenario of the gold bugs that at any time in the last 2 years (or more)

  • Surging prices in the commodities that fuel actual inflation: oil, food, and base metals.
  • As a consequence food related riots and demonstrations in the thrid world: so far India, Bangladesh,Algeria and Tunisia(top photo)
  • High inflation in Brazil (8%) and elsewhere in Latin America due to strong currency and high commodity prices.go
  • Sovereign debt crisis in Europe currently focused on Portugal .
  • As a consequence of that debt crisis a weakening trend for the Euro.

Yet just as these crises are identifying gold has barely budged while other commodities have surged. Below th is a chart for the last three months (click to enlarge for gld (gold in green) +1%, FXE (euro etf red)-5.9%,USO (oil etf black) +7.8%,DBA(agriculture blue)+11%.,DBB(base metals yellow)

Why is this happening ?

The Gold rally hasn't really been based on economic analysis. Those with an economics bent can't see a rationale for owning gold: it neither has any actual use (other than jewelry) and doesnt pay interest. The only rationale for holding it is the prospect of being able to sell it to someone else at a higher price.

On the other hand the commodites that actually have something to do with real economic activity (food, base metals and energy) are responding to real economic forces be they growth in the developing world or short term events that cause shortages such as weather. Doubtless once these get moving based on fundamentals a momentum factor kicks in here as well, But unlike gold there is an economic rationale.

The "analysis" that spurred the price rise were more a mantra than an analysis. Gold has historically been a poor inflation hedge. The rest of the rationale for gold rested on a provincial analysis of the conditions only in the United States but looked at globally they seem pretty thin. A readoned analysis would show they argue far more for holding other commodities as well as that paper money  hated by gold bugs...the US dollar than for holding gold.

  • Basic commodities are a far small part of US consumers outlays and thus inflation than in the rest of the world, labor costand housing s are a far bigger components of inflation and they are not going up any time soon.
  • If one is looking for apocalyptic  political instability with riors in the streets  it is  already happening in Europe and the third world if such instability leads to a flight to gold why wouldnt riots in Greece, France and Britain cause that to happen.
  • The US certainly faces a long term crisis because of tis debt but that criisis is at a far more advanced stage in Europe. Shouldn't such a debt crisis lead to european purchases of gold ?
  • Because of the European debt crisis the Euro is undergoing weakness. If the rationale response to a crisis with a major currency is to sell the paper currency and buy gold why is the money flowing from the dollar and other paper currencies instead.
  • With the prospect of the US economy strengthening US interest rates have moved up a bit making the marginal cost of holding gold a bit higher. Looking around the world that cost is even higher. Money has been flowing into Brazil where 7% interest rates and an appreciating currency make holding gold not such an attractive proposition. In a global economy all of these are alternatives.
Looking at the above developments and the lack of movement in gold it's hard not to conclude that in the final analysis the gold rally has been a pure momentum play. In other words once things got going Gold kept going up because it was going up and more and more people bought for that reason far more than any "analysis" of gold's fundamentals.

There definitely is a momentum factor in markets particularly commodity markets (there certainly is some of that, along with fundamentals driving the other commodities) we also know that such momentum plays are pretty ugly especially for those not nimble enough to get in and out early. One would expect that will be the case for retail investors.

Once the momentum slows even without sharp declines the "fast money" of professional commodity players will move out and into the commodities that seem to have momemntum. After all why hold gold if sugar,copper,oil and even stocks have upward momentum all of these are traded in the futures markets by professional commodities traders. The retail investor looking at gold as a binary buy/sell decision will likely hang on longer suffering more pain on the way down.

The FT reports

But investors are stoking the commodities bull run with some big bets. Money flows into commodities have been huge. Barclays Capital estimates $60bn was injected into commodities in 2010. Some observers believe speculative trading has sent prices to excessively high levels, making a sharp recoil likely should the fragile economic optimism fade.
Figures from the Commodity Futures Trading Commission, the US regulator, reveal very bullish bets among money managers such as hedge funds.
In late December they owned a record net “long”, or buying, position in crude oil futures and options on the New York Mercantile Exchange. In September the same types of traders held record net longs in corn.
As well as hedge funds analysing global economic trends, money managers include trend followers who use computer programs to ride market momentum and “high-frequency” traders who move in and out of positions in microseconds. Electronic traders helped send volumes last year in energy, metals and agricultural commodities at the CME, the largest US futures exchange, to a record.

Could we be on the verge of that dreaded point in the gold market when the music stops and everyone runs for the door at the same time ? It could well be.

(I can't wait to see the comments on this one)

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