Gold Price Strength Shouldn’t Be a Major Surprise to Anyone! (Part One)

ROADHOUSE REGULAR: Gavin Wendt says that the recent decision by the Federal Reserve to raise interest rates in the face of a rapidly weakening global economy has given a new lease of life to gold.

A year ago, oil and other commodities signalled that potential turmoil was coming to the global economy. Now the signal is starting to come from gold.

We’ve commented consistently that we expected gold to firm in the wake of the US rate rise – not fall – contrary to what so many other market-watchers had predicted.

In formulating our views we’d looked at the underlying health of the US economy, along with actual evidence from previous rate-rising cycles over the past 50 years.

At the end of the day it’s about negative real interest rates, where the rate of inflation is still well above the underlying rate of interest.

As we’ve previously written, “The Dow Jones at record levels does not necessarily reflect a robust economy – it’s in many respects a reflection of an equity market that’s been pumped full of Fed-administered hot air.”

The Federal Reserve made a big mistake when it raised interest rates in December.

It wasn’t the mixed economic data that caused the change in policy, it was a desire to ‘normalise’ monetary policy.

The data makes it seem like the US economy is on a roll, when it clearly is not.

Firstly, the US labour force participation rate is averaging four per cent less than it did a decade ago, prior to the Great Recession.

This means 10 million unemployed people are categorized as having given up looking for work and not in the labour force.

They are therefore unemployed – and if properly accounted for – the unemployment rate would be reported as being a little over 10 per cent.

Secondly, the unemployment rate is determined by a survey of 60,000 people each month.

It’s like a giant poll. If a person says they have started a business they are counted as employed. If they lost their job and can’t find one, but start up an E-bay business selling stuff from home, they are counted as fully employed – no matter how little their business makes.

Many people who can’t find work try to pick up what they can by starting some sort of small service business. This little known fact makes a mockery out of the headline numbers.

Other data also paints a less than glowing picture of the US economy, as recently released US 2015 fourth quarter GDP was just 0.7 per cent.

To demonstrate how worried the markets are, the Japanese 10-year government bond fell to negative interest rates recently.

The rate has never been negative before and this movement is not confined to Japan.

Rates on debt instruments perceived as safe are falling everywhere. It is possible the yield on the German 10-year bond may also fall below zero.

10-year Japanese Bonds, Source Bloomberg

Markets’ Loss of Fed Confidence

Markets are expressing a loss of confidence in the global economy and a loss of confidence in the Federal Reserve, as Chairman Yellen commented this week that the Fed may pause on expected additional rate rises this year based on outcomes in the economy.

What’s intriguing is that The Fed has consistently ‘talked tough’ with respect to interest rates, seemingly recognising the dangers of keeping rates too low for too long. It has also pointed to economic growth in the US as clear evidence that its ‘easy money’ policies have been working.

Yet it seems to now be admitting what we’ve been saying for some time – that all isn’t well.

Something the Fed hasn’t previously been prepared to directly acknowledge for fear of spooking markets.

One lesson here is that the Fed’s great monetary experiment since the recession ended in 2009 looks increasingly like a failure.

Recall the Fed’s theory that quantitative easing (bond buying) and near-zero interest rates would lift financial assets, which in turn would lift the real economy.

While stocks have soared, as have speculative assets like junk bonds and commercial real estate, the real economy hasn’t.

The Wall Street Journal recently commented that, “This remains the worst economic recovery by far since World War II, and we’ll be watching to see if financial assets now fall to match the slow real economy.”

The table above is courtesy of The Wall Street Journal and compares GDP growth projections by the Fed’s governors and regional bank presidents to actual results.

What it highlights is how optimistic the Fed has been with its growth forecasts, with actual growth rates falling well short.

Fed policy was also supposed to raise inflation to its target of 2 per cent a year, but it has failed even that test.

The same monetary also lesson applies to the rest of the world. Bond buying and near-zero rates have been implemented worldwide, but the global economy has to this point failed to respond with faster growth.

The European Central Bank’s bond has so far prevented a recession, but European growth remains sluggish.

Meanwhile, the emerging-market economies that benefited from capital inflows during the height of QE are now seeing those flows and economic growth recede.

China is trying to clean up its stimulus excesses without going into recession.

However the far bigger concern lies in the fact that financial markets have become so dependent on QE and artificially-suppressed interest rates that it will be very difficult for the Fed to reverse these policies without major repercussions.

Markets of course have typically been comfortable with the ‘easy money’ scenario continuing, as it will help maintain the value of already-inflated share and property investments.

For now the game of musical chairs continues, but the day of reckoning seems to be getting closer.

Gavin Wendt



www.minelife.com.au

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