miércoles, 5 de noviembre de 2014

miércoles, noviembre 05, 2014
Gold And QE: Setting The Record Straight
             

 
Summary
  • There is a causal link between QE and higher gold prices, but not a catalytic one.
  • This misconception has led investors to the conclusion that: "If gold can't rise during QE imagine how much i will fall after it stops!"
  • This misunderstanding is keeping investors out of the generational opportunity that is developing in gold.

I've received several comments regarding my writings on gold, silver or related equities that basically read like this:
During quantitative easing we saw an enormous amount of money printing and a substantial increase in the money supply, and yet the prices of gold and silver fell. How can you expect the prices of gold and silver to rise substantially assuming the end of quantitative easing and rising interest rates?
Having seen the comment twice today I decided to respond more formally with an article addressing the subject.

QE is good for gold, but that doesn't mean that QE is an immediate catalyst for gold. In fact it is fairly easy to see why QE is an immediate bearish catalyst for gold even if it is extremely bullish in the long run.

QE: The Blunt Explanation

QE means that the Fed buys bonds from banks who in turn either store that money or use it to buy more bonds. QE, in this way, creates a ripple effect of bond buying; and even though the money supply is increasing this increase is restricted at first to the bond market. As bonds go up interest rates go down, and that makes other interest bearing assets appear to be more attractive by comparison. It leads to a rise in the stock market and the creation of new bonds. After all, if you are a bank and you can borrow at 5% from the Fed it makes sense to buy an asset yielding 6% on leverage, but not one yielding 4%. But if the Fed lowers interest rates through bond purchases to, say, 3% all of a sudden it makes sense for a bank to borrow money in order to buy this asset.

QE spawns bond buying then stock buying--especially companies with a lot of growth, high profit margins and the ability to tap the capital markets. After all we've seen several companies borrow money in order to buy back stock, and it makes sense for a company who can borrow at 5% to borrow money in order to buy back its stock with a P/E ratio of <20. And we've seen several companies generate a lot of value for shareholders in this way.
  • AutoZone (NYSE:AZO)
  • Direct TV before it was bought out
  • Lorillard (NYSE:LO)
  • IBM (NYSE:IBM) until recently
The list can go on but the point is made.

What About Gold?

Gold doesn't have a coupon or an earnings yield and so it misses out on the party. This is the case even though gold is supposed to be a reflection of the value of the Dollar, and more Dollars should mean that each one is worth less.

Frustrated gold bulls need to realize that inflation manifests in different ways depending on how it comes about. If the government were to simply print a bunch of money and give everybody $1 million we'd see a rapid rise in the gold price and in the cost of goods. But considering the way in which money is created it finds its way into the hands of banks, bondholders, and well, Wall St.

When Is QE Good For Gold?

The notion that QE is good for gold and for other commodities is pretty straightforward and intuitive, but people often mistake causal relationships for catalytic ones. QE causes the gold price to rise, but the way in which it manifests it creates a kinetic energy or loaded-spring effect. QE is fuel for a rising gold price, but it is not the catalyst.

So if QE is good for gold when will we see this, and what will the catalyst be?

These are difficult questions to answer and frankly I simply don't know. But I do know that when we start to see a lack of interest in bonds this should create selling throughout the interest-bearing/dividend paying asset complex because just as lower interest rates in make other interest bearing assets more attractive by comparison to the Fed Funds rate (or whatever your benchmark is) higher interest rates make these assets far less attractive, and as interest rates rise this will precipitate bear markets in stocks and bonds more generally. This money which was created during QE in order to inflate the bond market, once it leaves the bond market, will very likely find a home in gold and related assets whose value is intrinsic rather than a function of its yield.

So to answer the question we should see a correlation between the gold price and interest rates, and in fact we have in the post-gold standard era (prior to the end of the gold standard bonds were effectively gold bonds and so the asset correlations were different than they are today).

This seems highly counterintuitive for those who believed that low/negative real rates are good for gold who bought in only to see the gold price fall, but it works insofar as low/negative real rates create the buying opportunity in gold. We can see this in the uncanny correlation between the Fed Funds rate and the gold price, which you can see on the following chart.


(click to enlarge)
(Source: Yours Truly for Goldstockbull.com)


The Bottom Line: What to Expect from Gold

The Fed's ZIRP has been an incredible catalyst for stocks and bonds, which trade at lofty valuations. It has further generated extremely positive sentiment in both markets and an unfettered belief that the Fed can really keep interest rates low and use more QE if necessary (that is, if the stock market starts to correct). But it has also been loading the most powerful powder keg that has ever sat under the gold market, and at some point the price is going to rocket higher in response to all of this quantitative easing. But this money has to come from somewhere, and that is going to be from bonds and stocks.

I don't know whether we've seen the bottom yet for gold, and I suspect we haven't. But we are closer to the end of the decline than we are to the beginning, and given the chaos we've been seeing in several of the mining stocks--especially the more leveraged plays--capitulation seems imminent, and I suspect that the start of the next bull run in gold will commence in the first half of next year as interest rates begin to rise.

Contrary to popular belief I would view more QE is an intermediate term neutral to bearish event for gold, although at that point other factors may begin to come into play such as the cost of production--about $1,150-$1,200/oz. for many miners--or stealth buying from the Russians, the Chinese, the Indians, or the Arabs. But this would only mean that the next upleg in the bull market would be that much more powerful.

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