An Update on Gold
(August 14, 2008)
Dear Subscribers and Readers,
While many retail investors are still focused on the housing market, the latest CPI and PPI numbers (which are inherently lagging), and jobless claims, the more important development over the last few weeks has been the significant strength in the US Dollar Index and the ongoing correction in the price of gold. As a matter of fact, the latest rise of the US dollar has been very broad based. On a month-to-date basis, for example, the US Dollar is 4.6% against the Euro, 6% against the Pound Sterling, and 7.6% against the Australian Dollar. Even the Chinese Renminbi is down 0.4% against the US Dollar. In fact, the only major currency holding its own against the USD is the Japanese Yen.
Concurrently, we have also seen a major correction in gold and silver prices as the popular trades and positions over the last (arguably) six years continue to unwind. On a month-to-date basis, gold is down nearly 10% while silver is down nearly 16%. The strength in the USD and the accompanying decline in precious metals prices is not surprising, as the US trade balance has continued to improve (given higher exports and lower imports because of lower non-oil consumer spending and the latest decline in oil prices) – thus putting a damper on global USD liquidity as more countries scramble in search of US Dollars (or to cover their short positions in USD). As a matter of fact, major countries such as Australia and South Korea have had to sell off portions of their USD reserves in order to defend their currencies and to service their USD debts.
At the same time, there is no doubt that gold is now severely oversold – at least on a short-term basis. As discussed in a recent Bank Credit Analyst commentary, the gold-to-WTI crude oil ratio was near a record low (lowest in three years) as recently as a few weeks ago. Given the ongoing correction in oil prices, BCA argues that central bankers around the world would be more open to easing interest rates going forward, which in turn would create more fiat money, hence putting a cushion underneath gold prices. Quoting the BCA:
Historically, precious metals are highly correlated with the dollar (negatively) and oil prices (positively). As the oil strength and dollar weakness of the past year unwind, gold has faced downward pressure. However, several factors suggest that gold should soon find support and begin to edge higher in both absolute terms and relative to oil. Specifically, the setback in crude prices will help to alleviate inflation angst at the major central banks. This, coupled with rising economic pressure on the ECB and BoE to abandon their hawkish stance may bring lower European real interest rates, which is bullish for gold by increasing the supply of fiat money. In addition, gold ETF demand is recovering after a brief pullback and our model indicates that the "fair value" of gold is in the low $900/ounce zone and rising. Finally, gold tends to be less sensitive to a global economic slowdown than industrial metals or energy. Bottom line: Gold is likely to find support around $850/ounce and then edge higher. The gold/oil ratio should continue its oversold bounce over the next few months.
In the short-run, I agree with BCA that the price of gold is now very oversold. In fact, the price of gold (in US$ terms) is now right at the 325-day simple moving average – a price which has provided immense support for the price of gold ever since the current bull market in gold began in late 2001/early 2002, as shown in the following chart:
My sense is that the price of gold will at least mount some kind of “come-back” from the 325-day moving average over the next couple of weeks, given the fact that the 325-day moving average has provided such tremendous support over the last six to seven years. Moreover, while the bull market and the bullish momentum is now getting very extended (after all, the bull market in gold has gone on for over six years with hardly an interrupted run), I should point out the fact that using 12-month momentum as a factor in determining future price trends in the precious metals and commodities arena has worked wonderfully over the last decade, while buying value (buying losers over the last five years) in general has been a losing strategy (although it worked from 1990 to 1999). The run in gold is no doubt extended but the momentum is still in place. In fact, assuming that crude oil or industrials commodities break their uptrend over the last six years, then gold may be the remaining major "commodity" left that is still in an uptrend. This means investment dollars will shift into the long side of gold (FWIW, hedge funds are now net short crude oil). That being said, the elephant is the ECB and they are still quite hawkish, and I don't see them adopting an easing bias until the Euro Zone starts to flirt with recessionary numbers and until crude oil declines back to $100 a barrel or below. Of course, there is no doubt the ECB is keeping an eye on the price of gold as well, but even at $800 an ounce, I doubt the ECB would regard the price of gold and other global inflation indicators as low enough to justify a preemptive easing in its overnight rates, especially since the price of gold in Euros is still very high. In the intermediate and longer-term, I would still hold off on buying gold in a major way until I see some signs that the ECB and the Bank of England will ease – hopefully later this year. At the same time – should the US Treasury comes in and orchestrate a bailout of the GSEs – then it may be a good time to buy gold as well, as the Treasury and GSEs will no doubt subsequently flood the mortgage and general financial markets with liquidity.
Speaking of the mortgage markets, there has been a lot of ink spilled on the issue of the upcoming Alt-A resets recently. As shown in this chart, the wave of Alt-A resets will start hitting in the April to June 2009 timeframe, and will peak during the October 2009 and January 2010 timeframe. My “bottom line” feeling on this is: It is a non-issue. Financials accidents – in general – only occur if bankers or regulators fail to see and heed all the warning signs, such as during the beginning of the subprime crisis in early 2007. The wave of Alt-A resets is a totally different story, as this has been covered by folks such as PIMCO, Goldman Sachs, and Credit Suisse ever since late last year. Moreover, there is no doubt that the Federal Reserve, Treasury, and Congress now acknowledge the “problem” and are actively seeking solutions to cushion in the continuing liquidity problems in housing, including a potential equity injection into Fannie Mae and Freddie Mac to prop up their balance sheets. According to a long-term and most trustworthy friend/subscriber – who has worked in the industry for the last two decades and has several contacts in Washington – it is not a matter of if but when Treasury will come in and rescue the GSEs. Not only are investors rapidly losing faith in the GSEs, but as shown by the actions of the GSEs in the last 12 to 18 months, there has been a dearth of leadership in these two GSEs, as neither GSE saw the “handwriting on the wall” and only started to raise capital at the urging of Paulson and Bernanke. My current position on this issue is that Paulson will come in and inject (at a minimum) a total of $30 billion into both GSEs before the Presidential election on November 4th.
The bigger reason why Alt-A resets will be a non-issue is simply because of the mathematics behind it. As discussed by our same subscriber friend, Alt-A ARMS – unlike subprime where the loan margins are high due to increased borrower risk factors – most Alt-A loans carry a fairly low margin, generally in the 2.25% to 3.5% range over 6-month LIBOR once the Alt-ARMS reset. Note that 6-month LIBOR (that plus a spread is a good proxy for reset rates) is at 3.1% today - still somewhat elevated but nowhere near as high as it was in December of last year, when 6-month LIBOR was at 4.5%. According to our subscriber friend, the weighted average starts rate on the 2005 and 2006 Alt-A ARMS funded by his company were:
3 Year - 6.26%
5 Year - 6.60%
7 Year - 6.65%
With 6-month LIBOR currently at 3.1%, Alt-A resets will only hit 6.6% even should borrowers need to pay the high end of reset margins (3.1% + 3.5%). In other words, many Alt-A mortgage holders will not even see any increase in their mortgage payments once they reset. In fact, with 6-month LIBOR at 3.1%, my sense is that many Alt-A mortgage payments may even decrease, given start rates in the 6.25% and 6.65% range and the relatively low loan margins of 2.25% to 3.5% in Alt-A ARMS resets. In addition, at the time of the Bear Stearns rescue in mid March, 6-month LIBOR actually bottomed at 2.4%. If/When Treasury comes in and rescue the GSEs, then 6-month LIBOR would surely decline dramatically. Should we hit 2.4% again, then it is safe to infer that the majority of Alt-A resets will actually reset at lower rates relative to their start rates. In such a scenario (which is actually my base scenario), the wave of Alt-A resets – assuming the Fed will keep the Fed Funds rate at 2.0% – will actually add liquidity to both the financial markets and economy, as opposed to the current bearish consensus view. Bottom line: The upcoming wave of Alt-A resets merely means that the Fed will keep rates low indefinitely. There is nothing else you can infer from it, and it is certainly nowhere close to an “Armageddon scenario.”
Henry To, CFA