Myriad questions

To predict the gold price always involves a lot of factors, but the situation today is about as complicated as it gets.

How long can the US dollar continue to climb? Is the US equities run ending? Will the Fed raise rates? What do those jobs numbers really mean? How much downside is left for the Euro and the Yen? How long can gold keep gaining against other currencies but sliding against the greenback? Will gold repeat its reliable strong season from July to December? How will oil’s slide impact the US economy?

In the longer term, other questions arise. What impact will the Shanghai gold fix have on the gold market? If we are truly at Peak Gold, when will supply shortages become significant? Will generalist investors return to the gold market? Can the gold market somehow sidestep the outsize influence of paper trading and return to a basis in supply and demand? Why does the World Gold Council continue to drastically underreport Chinese gold demand? When and how will the fundamental shift of gold holding and trading from West to East really start to have an impact?

To answer them all would require (1) several hundred pages of text and (2) a crystal ball. I have neither. Instead, comments on the first set of questions, based on my research and the many interesting conversations I had whilst attending PDAC last week.

And a conclusion: that the answers that matter continue to support this being gold’s broad bottom.

Greenback strength and the endless ‘rate’ debate

Half the economists I read see no reason for the dollar to stop climbing. The other half see a greenback with little to no momentum left.

Similarly, about half the pundits I talk to expect the Fed to raise rates in June, while the other half don’t expect to see higher rates this year.

The strong dollar is helping and hurting America. Exporters are in a world of pain, as international customers struggle to afford prices in the world’s strongest currency. For US multinationals the strong dollar can be a benefit but is more often a curse, depending how and where costs and revenues are pinned. Basically, the strong dollar squeezes earnings while slumping foreign economies diminish business opportunities.

The government is more than happy to continue servicing its mountain of debt with a strong currency…but only for a time, because a strong dollar erodes US competitiveness globally. In time US firms will be unable to compete with international peers riding positive exchange differentials. And the dollar is at 12-year peak against the Euro, an 8-year high against the Yen, a 26-year high versus the Mexican peso, and an 11-year high against the Brazilian real.

Those highs came after non-farm payroll numbers on Friday were notably better than expected, increasing by 295,000 in February and edging the unemployment rate down to 5.5% from 5.7%. What those numbers truly mean, in the context of a labor market where many have stopped looking and where oil-related layoffs are looming, is another question.

What does all this mean for rates? That’s the million-dollar question.

The main arguments for raising rates:

• Encourage safe-haven investors to buy US bonds. Many government bonds these days shockingly offer negative interest rates, so a positive rate would draw global money into US bonds and give the government more breathing room around its crazy debt load.
• Encourage the idea that the US economy is truly doing well. The rate debate has been going so long now that to not raise rates would send a negative message.
• Temper US equities madness by encouraging saving.
• Create breathing room – should the US economy need stimulus down the road, a higher rate gives room for a cut.

The main arguments against:

• The strong greenback plus the low interest rate has the US in a negative real interest rate situation. Raising rates would be a double whammy for multinational businesses: higher debt costs and currency losses.
• US equities have been on a tear that many believe is unsustainable. A rate increase could be the straw that breaks the camel’s back, sparking a stock market stutter that threatens America’s economic recovery.
• Oil’s price slide poses a real threat to the US economy. A disproportionate number of the new jobs created in recent years came from the shale oil fields of North Dakota and Montana. Similarly, surging US oil firms were an important driver of the US stock market boom. Now oil firms are laying off employees and reporting massive losses (Apache lost a whopping $4.8 billion in the last 90 days of 2014 and has slashed its 2015 capital budget in half). This instability is a real overhang on a rates raise.

This is an overly simplified version of events, but the point is to get the lay of the land. We’ll get a clearer idea on March 18th, at the press conference following the next two-day Federal Reserve meeting.

It’s also important to note that real borrowing costs are priced in the bond market, where a rate raise has already been priced in: 10-year yields are up 50 basis points since the start of February. And US markets are even or slightly down on the year mostly because investors are already pricing in a rate raise. In these senses, it doesn’t really matter.

I will admit that I had been poo-pooing the idea of a rates raise…until this week’s greenback strength and market weakness. Now I think it likely Yellen will raise rates – but only a smidge.

What Does It All Mean For Gold?

Theoretically, higher interest rates work against gold because being paid to hold cash or government debt is a disincentive to holding gold. However, we’re talking about a little tiny rate raise – 50 basis points perhaps – nothing that gold can’t handle.

Really, then, rates aren’t the question. The question is the strength of the US dollar, which will not weaken until the Euro has bottomed. However, that moment may be close.

From some chartists: the Euro’s pattern and depth of decline suggest it is nearing a bottom, similar to late 2000.

From other analysts: Europe has actually provided the lion’s share of positive economic surprises of late, beating economic expectations reliably over the past three months (compared to a United States that has missed on most marks).

The EU’s trade balance has improved dramatically over a few months, thanks to cheap oil and its devalued currency. Once Draghi’s stimulus program really gets underway the EU could provide some real positivity and the oversold Euro could rebound, paving the way for a weaker dollar.

And that is really what gold needs.

Gold is doing well in every important currency other than the dollar. And gold’s rise is simply a continuation of last year’s pattern: outside of the US dollar, gold was the best-performing currency in 2014.

And here’s an interesting pattern to watch: gold priced in foreign currencies is often a leading indicator for gold. When the price of gold dropped in 2001 and 2008, the rebound started with a rising foreign currency price. Both times the US dollar price continued downward for more than a year before bottoming and then climbing to new highs.

Another interesting and pertinent pattern: the last two times oil dropped more than 50% in one year – 1986 and 2008 – gold gained 25% the following year.

The strong dollar has absolutely impeded gold’s gain, but with the greenback at record highs and gold having repeatedly bottomed out near $1,150 per oz. in the last half year only to bounce back, consensus is building that this truly is the bottom.

I’ve said that before (many times!), but what is exciting today is that generalist investors are starting to agree.

At PDAC, at Roundup, at the Cambridge conference in Vancouver, I spoke with many investors looking for bottom fishing picks confident in their assessment that this is indeed the bottom.

Chuck Jeannes, CEO of Goldcorp, has been getting the same sense. At PDAC he mentioned that large institutional and individual investors are interested in Goldcorp, many returning after years away. Why? Because they can’t find another sector that looks cheaper.

Compared to an S&P that has rocketed skywards in the last three years, gold equities have slid into the basement. There has been so much discussion around how long US markets can continue to run that if – indeed, when – US equities start to turn, savvy investors will cash out and look to redeploy their capital in an undervalued space. Gold is an obvious candidate.

The broad bottom argument is increasingly important. Whether gold falls back below its November bottom or not, the majority of mining investors and actors believe we are at the broad bottom – which is why mergers and acquisitions are on the rise, trading volumes are up, gold equities are providing leverage when gold rises but showing support when gold falls, and even the gloomiest of gold bears talk about a bottom not far from current levels.

So the idea remains the same: play the cards on the table. Take advantage of opportunities, in specific stocks and around particular seasons. Have expectations appropriate to today’s sideways market and lock in gains. Watch for changes in the big picture: rates, US markets, and currencies. And be ready, because a big change in any of those could happen any time and would kick start the real gold and metals rebound that is coming.