Welcome to the Room - October 13, 2006
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Last Updated October 06, 2006
David Galland is in South America investigating real estate and investments this week so I planned to step in to give a commentary on international support for the U.S. economy. But with the $40 drop in gold we’ve seen over the last few days, a few comments on the short-term action in that market are in order.
I have not cut back my personal high-percentage commitment to gold, as the long term fundamentals are still as supportive as ever. What follows is a compilation of explanations for the short-term drop:
There are now obvious signs of economic slow-down in the U.S.: the 4% increase in Federal Funds means that things bought on credit now have a head-wind of higher effective price or lower affordability. The housing and auto industries have slowed. This week’s job report was less than half the expected level, and not enough to keep up with normal population growth. Revising previous reports upward by 52,000 mitigates the headline number, but the reading is still lackluster.
U.S. manufacturing is slowing as seen in measures from the Philadelphia Fed and the ISM dropping from 54.5 to 52.9. When the ISM gets below 50 the manufacturing sector is contracting. A slowing economy means less demand for all kinds of products, and that means moderating demand for the raw materials that drive the economy. The expectation of recession depresses gold.
Last week David showed the overlap of presidential popularity and the price of gasoline. The two track almost exactly. As gasoline rises, people facing $50 tank fill-ups become more frustrated with government policies. Gasoline on the west coast dropped almost a dollar a gallon. That seems overdone. Some analysts think either oil companies wanting to support a Texas oil president, or maybe behind-the-scenes derivatives operators could have added a bid to the price to keep the situation more palatable until November 7. A similar argument is made about the Fed no longer raising rates. Some say it is because of the slowing economy, which looks sensible, but it is also consistent with providing a more comfortable environment in time of election. Remember that Bernanke spent time at the White House before his appointment as Chair of the Fed.
You can’t mention hedge funds without reviewing the Amaranth debacle, where one trader lost $6.5B in a month trading natural gas derivatives. This is huge, but the reaction was not. There were no calls for government intervention, and the positions were readily absorbed by big banks. But with the convulsive situation, in the face of a surprising drop in many commodity prices, one wonders if there may be other hedge funds, maybe in gold, that had to make a hasty exit under margin call pressure. This week China is on holiday—and India was on holiday on Monday—so with two important buyers not playing, this would be a time for the market to sag, or for opportunists to exert downward pressure. There’s no way to be certain, but the pattern of extreme price moves without fundamental change in economic forces fits the pattern.
The central banks only divulge tidbits of their actions, as they like to maintain secrecy. We do have the report that they sold off only 397 tonnes under the Washington Agreement, a deal which allowed them to sell up to 500 tonnes in the year ending September 26.
There may have been some pressure to sell before that deadline, as the counting for the next year starts new after that date. It was most prominently Germany that stopped its sales, saying that it could not agree on the application of proceeds. Just good investment sense would seem to me to be reason enough not to sell, but I’m not a central banker.
Barclays Bank pointed out that the pattern of trading appeared to indicate that central banks, led by France, had effectively sold off 100 tonnes of gold just recently, but had done so through forward deliveries that would not show in the books as part of the Washington Agreement. I haven’t seen the data, but the pattern fits. Central banks relish lower gold prices, as that indicates that inflation is not so serious a problem, making their job of maintaining their currency easier, so sales could fit the pattern of keeping their currencies propped up.
Of these, only the fear of recession is a longer-term input to the equation of gold price. The others could come and go. The implications of recession may be that government provides further bail outs, further rate cutting, and obtains lower tax revenue. These could indicate a longer-term potential negative for the value of the dollar, which would be a longer-term positive for gold.
Last week we discussed the $1 trillion of foreign currency held by the Chinese, and their interest in rebalancing as much as $300B of their holdings into gold and oil. They are accumulating an additional $20B of reserves each month. To put this in perspective, annual production of gold mines is 2,500 tonnes which is worth only $48B. There isn’t enough gold for the Chinese to rebalance their portfolio. They could buy a reserve of oil, but $300B of $60/bbl would be 5B bbl of oil. China uses 2B bbl per year. They don’t need a Strategic Petroleum Reserve (SPR) with 2 years supply. The U.S. has about a month’s supply in its SPR. The numbers don’t add up.
The U.S. Treasury International Capital data shows some overall slowing of investment in the U.S. (the green line). This just could be short-term volatility, but it bears watching. This data is comprehensive but only through July.
Custody data from the Fed is weekly with the latest data from October 5 shown below. Treasury purchases are slowing. The chart below shows the amount of Treasuries purchased on behalf of foreign central banks by our Federal Reserve in the last quarter converted to an annual rate inverted so that the blue line goes down when there are large purchases by foreigners. The amount hit a peak rate of $400B at the beginning of 2004, and has dropped below $100B now. The interest rate on the 10 year Treasury has risen along with the decrease in foreign investment, as indicated in the red line.
The attitude toward the U.S. is becoming more negative, and may lead foreigners to invest in things other than the dollar. Obviously, this hurts the dollar and helps gold.
In balance, I believe the short term reasons for gold’s sharp pullback will fade as the big picture forces return to overtake the situation, especially after the election. This battle of confidence in positions is hard, especially in leveraged actions like futures, but the lower price should not scare us out of this market. Maintain positions in gold with the expectation that we have much more upside in the year ahead.
Your concerned analyst,