"We see upside surprise risks on gold and silver in the years ahead," is how UBS commodity strategy team begins a deep dive into a multi-factor valuation perspective of the precious metals. The key to their expectation, intriguingly, that new regulation will put substantial pressure on banks to deleverage – raising the onus on the Fed to reflate much harder in 2014 than markets are pricing in. In this view UBS commodity team is also more cautious on US macro...
Via UBS,
In testimony in front of the Senate banking committee in July, Ben Bernanke made an unusual comment; 'nobody really understands gold prices and I don’t pretend to understand them either'. That's a surprising admission, because, as head of the central bank that controls the word's reserve currency, we think Bernanke should understand gold. Because gold, in our view, is a critical barometer of the state of global credit.
Many clients have asked us whether gold is an inflation hedge. The chart below suggests not.
But we believe that gold is in fact an inflation hedge - but the inflation it is hedging is not inflation as most people commonly understand it.
Friedrich Hayek said that inflation is not a change in the consumer price index, it is an increase in money and credit. To this he added near money - any asset that could be quickly and easily swapped for traditional money or credit. (For ease of writing - I'll refer to money, near money and credit combined as 'credit'). For Hayek, neutral inflation was when credit expanded in line with the productive potential of the economy.
Whether Hayek's inflation leads to traditional CPI inflation depends on the nature of the economy. If it is sclerotic - bound up by unions, capital controls and excessive state spending as it was in the 1970s - then you get CPI inflation. In a globalised world characterised by industrial overcapacity in China, a large global under-utilised workforce, and exceptionally low rates, the impact is asset price inflation.
Hayek had a lot to say about an environment where 'inflation' or credit expanded too fast and asset prices rose. He argued that it accelerated growth, because there was a large incentive for companies that service or build assets (from estate agents and investment banks, to property developers) to expand, to build, and to transact more asset sales.
Hayek's problem; this causes a major misallocation of capital - because the returns from servicing and building assets are available only when credit is expanding.
When credit stops accelerating (not even declining) asset prices start to fall.
Returns in these areas decline precipitously, and value is destroyed. When credit grows in line with the productive potential of the economy, a very different incentive structure emerges. Assets as a group tend to rise in line with incomes. So the incentive is to boost income and wealth through building businesses that create sustainable returns above the cost of capital.
So how does gold fit into this? In commodity strategy, we see gold as a barometer of global credit inflation. The best way to understand this is to highlight the Bretton Woods II system of global capital flows that drove gold through a 12 year bull market up to 2011.
We highlighted this mechanism in the note 'Reverse Bretton Woods' (3 September 2013) and depicted in Figure 3 below. It starts in the central oval with the Fed running easy money, and with the commercial banks expanding their balance sheets. In the 2000s and under QE1 and QE2, a key feature of this was the use of repo and the purchase of credit with CDS insurance. This balance sheet expansion neatly avoided raising risk weighted capital ratios - which allowed the banks to progress towards their Basle III targets. (More on the regulator backlash later).
This immediately suggests the first two things to track to measure the expansion of global money and credit - measure the change in the size of the Fed's balance sheet and the change in banks domestic lending. Those two neatly add up to M2 - notes and coins in circulation and deposits with commercial banks.
But that misses out 'near money' - assets that can be swapped for cash and used to buy more assets.
The Treasury borrowing advisory committee have estimated this - at US$43trn at the start of the year. But the data is very slow coming out. One way to proxy developments is to follow the amount of liquid assets that the US banks hold that can be used for collateral in repo transactions. That's shown in the chart below.
That's not perfect, as it doesn't take account of rehypothecation - the reuse of capital (which is like the velocity of money in the repo market). We are not aware how we track this in a timely manner - but any suggestions, please get in touch. What we do know is that new regulations - notably central clearing rules, are sharply reducing the reuse of collateral for repo and other trades.
But then there is the global aspect - the right side oval in figure 3 shows that when capital flows into emerging markets, central banks print their own currency to buy the incoming dollars. This sets off a chain reaction of credit growth - first deposits rise, then banks lend to consumers and corporates. That raises growth and inflation, lowering real rates and inducing more savings into the system (from consumers who need to save more to build a nest egg) and more demand for loans from corporates, and consumers who want to gear up speculate on property or fixed capital formation. Which causes even more credit expansion.
So the initial capital flows into the rest of the world are multiplied up first by the emerging market central banks, and then by the commercial banks, and by the incentives that a combination of strong liquidity growth, rising inflation and sticky nominal rates then induce.
Again, the data on this is slow and partial (as a chunk of emerging market lending occurs off balance sheet). So, out of expediency we take the change in foreign central bank treasury holdings held at the Fed, as a timely proxy, and we multiply it up five times - as a proxy of the impact of the fractional and shadow banking multiplier in emerging markets.
This gives us four metrics.
Of these - we believe that a necessary condition for gold to rally is the expectation that 1) capital will flow into emerging markets, 2) the combination of the fed's balance sheet and the banks marketable securities holdings rises.
The banks' vanilla lending at home in the US has little positive impact, and probably a negative impact on gold prices. Why? Because it doesn't deliver capital lows overseas, and it induces expectations of tightening monetary policy from the Fed.
So we have created a weighted indicator made up of foreign central bank treasury holdings with the Fed, Fed balance sheet expansion and the US banks liquid security holdings.
It is potentially more revealing to show the change in liquidity vs the gold price.
In commodity strategy, our view is that US combined central bank and commercial bank asset purchases are the key driver of yield compression - which makes gold a relatively more attractive asset to hold - and the global reach for yield, that induces flows into emerging markets. Those flows then start a very bullish gold dynamic;
- The falling dollar raises dollar denominated gold prices. Rising FX reserves induce central banks to buy gold to maintain the gold ratio in reserves.
- The liquidity boost in emerging markets raises income among consumers who tend to invest in gold. Rising commodity prices and commodity currencies raise dollar based gold costs, and reduce revenues in local currency terms – constraining supply.
But when the Fed started QE3 last October, the improving growth outlook and rising stock market had gold anticipating the threat of tapering (first mentioned by the Fed three months later on Jan 4th), anticipating capital outflows from emerging markets (which began in Jan/February and which accelerated in May). And anticipating commercial bank liquid asset sales - which also began in May. All considered negative for gold.
So while Bernanke may not understand gold, it would appear that gold certainly understands Bernanke.
Perhaps the most significant aspect of the tapering debate was that the Fed became increasingly hawkish on tapering in 1H13, despite the fact that growth was modest and inflation subdued. Our interpretation of this was that the Fed started to become highly concerned about credit market overheating.
Governer Jeremy Stein raised the issue in the December 2012 meeting, and his speech in February 2013 outlined research that showed not just tight spreads, but outsized low quality credit issuance - the classic signals of an overheated credit market, with the clear rider that this could lead to a bust. Soon after Stein presented his results, the tone from Bernanke et al became much more hawkish on QE.
The most revealing aspect of the market reaction to Bernanke in 2013 is that it was the diametric opposite to the market reaction to Greenspan in 2004, even though their communication appeared identical. Back in February 2004, Greenspan stated that, if growth continued along the lines the Fed anticipated, then it would start to remove accommodation gradually. Greenspan then started raising rates by 25bps a meeting from June. Capital flowed into emerging markets, banks bought liquid assets, and the Bretton woods 2 system of flows kicked in so powerfully that treasury yields actually fell while rates rose. Something Greenspan dubbed 'a conundrum'.
Then Bernanke repeated the same communication procedure in 2013, announcing in June that, providing growth met the Fed's expectations, it would, in due course, gradually remove accommodation. The market response; capital flowed out of emerging markets, banks sold their liquid assets, treasury yields blew out 100 points and mortgage yields blew out more.
In our view in commodity strategy, that is a clear expression of the fact that the global liquidity dynamic of the 2000s, and under QE1 & QE2 is now set to run in reverse.
It is worth noting that Fig 12 shows that foreign treasury holdings have bounced since the Fed announced a delay to its tapering programme in September. EM currencies & equities have also jumped. We expect these trends to reverse as bank deleveraging takes hold, and as bullish positioning in broader risk assets unwinds. Asset price developments indicate that the pool of available liquidity has narrowed dramatically. The majority of major asset classes are well off their tops. None are confirming the near high in the S&P.
Within the US market, banks have started to underperform.
And a narrowing group of stocks is driving the market - led by a group of growth/concept companies on largely triple digit multiples - Tesla, Netflix, Netsuite, 3D systems corp etc.. We have created a basket of these names in the chart below. We are using this index as an indicator for when a decline in liquidity reduces investors’ appetites for highly valued issues.
We've highlighted that regulation will now likely drive a new wave of deleveraging by the banks.
What we're worried about is the interaction of several simultaneous strands of legislation - all acting to reduce liquidity – on the amount of money or near money available to buy assets. And the ease with which financial players can trade those assets.
Before we go into the details, one of the main questions we get asked is why would the regulators continue with a process that seems to cause market dislocation?
In our view it is because they believe in the morality of their actions - that banks that are too big to fail should shed assets or raise equity to the point where it's much harder for them to fail, to prevent a repeat of the financial crisis and the heavy burden on taxpayers that ensued. Fed Governor Jeremy Stein’s speech last week (‘Lean or clean?), and Governor Tarullo’s speech from May (Evaluating Progress in Regulatory Reforms to Promote Financial Stability) highlight that desire.
That, in our view in commodity strategy, is a laudable aim. The difficulty, as the old joke has it, is that to get there, you don't want to start from here.
Second, to many regulators, the banks have raised their exposure levels, and raised counterparty risk in the system, in order to raise net interest margin and equity value. So while the systemic banks reduced risk weighted assets by a third from the financial crisis, total leverage has risen 10%. This is precisely the opposite of what the regulators intended when they negotiated the Basle III capital requirements with the banks. The regulators apparently believe that the banks acted in bad faith. The regulators are now fighting back. The clearest comments on this were from Thomas Hoenig, deputy Chairman of FDIC, the US regulator.
Third, the regulators believe that the fact that the markets have rallied for five years gives them scope to act without causing too much damage.
And finally, regulators don't follow an Austrian view of the world. They may not perceive the degree to which credit markets have become overheated. And they are unlikely to recognise that the credit boom of the past five years has induced a massive misallocation of capital globally, and has created the potential for Hayek's 'recessionary symptoms' to show up as liquidity is drained from the system.
So what are the key regulatory actions?
- Central clearing house trading to replace OTC - the key issue is that this raises collateral requirements, making the trades more expensive, and it makes it impossible to rehypothecate the collateral - which reduces system liquidity. The Treasury Borrowing Advisory Committee estimated that there was around us$4.5trn of rehypothecated in the US assets at the start of 2013.
- US requirements for foreign owned banks to hold separate ring-fenced collateral to their parents. Oliver Wyman, the consultants, estimate that this will force foreign owned banks to reduce repo by US$300bn in the US.
- Leverage ratios which do not allow the netting of repo, or credit against CDS - proposed at a minimum of 3% by the BIS, the US Comptroller of the currency has proposed 5-6%. European and UK regulators yet to decide
- Capital requirements behind trading - including market risk capital changes, stressed value at risk, and incremental risk charges. Stephane Deo, UBS head of asset allocation, believes that these will reduce liquidity and raise volatility across several asset classes
- Multiple additional measures under Dodd-Frank, etc
The problems with the regulation are fourfold.
- First, they make it much more expensive for banks to hold assets and carry out repo, or buy credit with a CDs insurance wrapper
- They tie up collateral, reducing the velocity of collateral.
- They make it less attractive for banks to originate credit, and to offer securities inventory holding/trade facilitation.
- They reduce liquidity and raise volatility across multiple asset classes.
And the problem with repo is that it is highly pro-cyclical. Rising values for high quality collateral used in repo reduce the amount of collateral you need to post to secure funding, and allow you to buy more assets. It can also reduce the haircuts for some lower quality collateral.
And a point Jeremy Stein highlighted in his speech on 'credit overheating' was that the more the cost of capital falls as a result of banks expanding their repo operations, the more financial institutions are induced to reach for yield - further accelerating the Bretton Woods II liquidity cycle.
But falling collateral values do the opposite. They reduce the capacity of firms to carry out repo and use the funds for credit transactions and for funding credit warehousing etc. and it reduces the tendency of financial companies to reach for yield. All this, in our view in commodity strategy, causes Bretton Woods II to go in reverse.
A key observation of the Bretton Woods II process of capital flows is that the risk free rate – the yield on 10-year treasuries – is no longer risk free. It is subject to a pro-cyclical and speculative expansion of leverage on the upside. The implication is that, when risk aversion rises, the normal safe haven bid for treasuries may be offset by selling from domestic commercial banks and foreign central banks. So yields may rise, or not fall as much as would be typical. This removes a natural stabilisation mechanism in markets. The higher cost of capital (than usual) may make the impact of risk aversion on markets and macro more severe than we are used to.
And just as the Bretton Woods process was highly reflationary and bullish for all assets, reverse Bretton Woods is considered bearish for everything, except gold and silver. And that's because of the capital misallocation generated during the credit inflation will unwind, destroying value and precipitating what Hayek called 'recessionary symptoms'. Hayek said all it took to start the unwind was a deceleration in credit expansion. Our description of the impact of QE on growth is shown in the following two charts
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A rising cost of capital and shrinking liquidity, for any given rate of growth, does not only de-rate asset prices. It hurts growth in all the asset related businesses from financial services through to construction. And then it hurts growth via the reduced supply and higher cost of credit - which included from 2009-13 consumer spending (via mortgage refinancing, or cheap and plentiful car loans), or small companies (via tighter high yield spreads).
So far, this set up appears very similar to 1937. Back then the US was into a fourth year of recovery from the depression. The Roosevelt administration scaled back deficit spending and the Fed raised reserve requirements (not thought of as a problem at the time, due to bank’s excess reserves) and started sterilising gold inflows. Manufacturing declined 37% & the Dow halved. The difference, though, is that this time the Fed is likely to move earlier.
In our view in commodity strategy, as the private sector takes away leverage and reduces liquid asset holdings, the Fed will be forced into providing the heavy lifting to keep total asset purchases up. On that basis, the Fed will be doing much more QE in 2014 than the market anticipates.
And with gold and silver acting as a barometer of whether the Fed will be reflationary or deflating the global economy in 6-12 months time, we anticipate hem to rally as soon as the deflationary process becomes visible in a breakdown in the S&P or a breakdown in US macro surprises.
And in particular, with Yellen now all but certain to take Chair, the market will immediately assume that the Fed will reflate in response to any deterioration in broader markets or macro conditions. Something that we believe would be much more debatable had Summers taken the post.