The Latest Move in Bullion: Something's Gotta Give

Man, you would have done all right in the last couple of years if you had been only in bonds and gold. As much as you hate USTs, the numbers don't lie. Recently, we have had a rally in the bond market, a rally in the stock market, and a rally in gold bullion with tame currency moves. What gives?


The move in bullion last week is not driven by the currency markets, as it typically—not always— happens with the Midas metal. At $1000/oz., there is only $1trillion in gold bullion in total above ground inventory (where is Project Mayhem to call me on that one?). A lot of it is not for sale, save for Gordon Brown's brilliancy in 2000, which called the bottom (conspiracy theorists chime in).


True, if you count the trillions that have been printed here, in Europe, and in Japan (the inventors of QE, oh, how well it worked there), bullion should be flying. But, what the gold bugs miss is the trillions that have been wiped out in the house of cards called “structured finance”, and they miss the trillions that will be wiped out in a similar scheme of unfortunate larger proportions called “derivatives”.


From the CLSA 1Q preview that was available earlier in the year on their website (note to CLSA compliance, I will never post anything of yours that was not previously in the public domain, I like you guys too much to do that). This was their thinking at the beginning of the the year, but, some of the points are still very much valid:


What’s been happening with the dollar?

...Currency and commodity price moves are presently dominated by the destruction of liquidity synthetically created within the financial markets between 2002 and 2007. Before turning to currency moves we therefore need to provide the framework of what we mean by “liquidity” and its destruction.

Figure 9 shows a chart that we first used in Triple-A on 28 February 2007: Exuberance glut. It is taken from David Roche, founder of Independent Strategy, and shows liquidity as an inverted pyramid. At the bottom is “power” or reserve money – liquidity created on the balance sheet of central banks. Above this is liquidity (or claims on goods, services and assets) created through the conventional credit multiplier mechanism of commercial banks. Above this is liquidity created by securitisation. This (supposedly) enabled risk to be pooled and averaged, allowing claims on illiquid assets to grow further relative to the reserve money in the system. Finally above all are credit and interest rate derivatives, a system in which each institution, by “insuring” against losses, was able further to increase its claims on physical and financial assets without increasing precautionary reserves either of capital or reserve money.


...For the purposes of understanding currency and price movements it is sufficient to observe that the securitisation of debt and creation of credit and financial derivatives amounted to a huge virtual printing press, fuelled by the pro-cyclical increase in risk appetite which, outside of the conventional system of monetary policy and control, allowed a massive expansion of the value of claims on financial assets and goods and services.

...The risk pooling and credit insurance processes that were central to money creation at the top of the pyramid have proven vulnerable to a breakdown of confidence (and as the systems have started to break down this risk aversion has been justified in a classic self fulfilling prophecy). 2008 was characterised by a massive destruction of money and we expect this to dominate in 2009 also. [AD: so far it has been contained]


...The reversal of this process has been key to understanding currency movements which, since July, have been too large and too rapid to be easily explained by shifts in economic expectations or short rate expectations. Instead the dollar has been caught in a short squeeze as the liquidity pyramid has started to shrink.




Now, Bernanke knows this very well, and so does Trichet. This is what has been dictating the magnitude of the printing, and this is why printing so far has been rather benign in inflationary outcomes. They have managed to reverse the rise in the dollar since March, but will they ultimately succeed? Europe is in worse shape than the US, and, the CEE CRE time bomb—more like a rolling series of explosions given how infested the region is—has yet to fully detonate. And don't get me started on China; that will hurt badly when it happens (both dollar and maybe bullion bullish, why not?)


I am not saying printing will be benign ad infinitum, but pay close attention to the missive from Societe Generale. Before the long-awaited inflationary outcome, we way very well get a nasty round of deflation.


I don't believe in the naïve notion (I was about to say idea, but that is too strong of a word) that you can solve a debt problem with more debt, or a problem created by ultra easy monetary policy by even easier monetary policy. That is like giving an obese man drugs to improve his appetite; it's not going to end well. But before it ends, interesting things will happen.


I am not sure we have seen the ultimate high in bond prices/lows in yields. It is not a good sign though that Bloomberg TV is running commercials for Monex almost as often as it was running commercials for Sun Microsystems in 1998 that it is “the dot in dot com”. That was a great rally in Sun shares over the next two years, before it got Prechterized. And Sun does look like the chart of silver back from 1980, courtesy of the Hunt brothers (how is the squid different from them, it escapes me).


Given who is running the Fed for anther term, this is an unlikely outcome for gold bullion, but just a reminder to keep things in perspective. Yes, I expect a big run in gold, but did the monster rally start last week, I don't know... yet. What I do know: when the time comes for the gold bugs to sell at $2K, $3K of $4K, they won't.


EDIT: BTW, I find it funny that no one is clicking or commenting on Vitaly's bearish rant on gold above me in the contributor section---which I don't agree with---but I will give him the plug (without a link!)