Gold is getting Trumped

Whenever I get a spidey sense that there is something wrong in a particular market, alarm bells go off for me. The more I look into the Gold market, the louder the bells are sounding. As a follow up to my previous post on Bitcoin as a Commodity, Store of Value or Digital Currency — I felt it was now appropriate to compare Digital Gold to Physical Gold.

I’ve often argued that Bitcoin was more of a commodity like platinum, but if it’s ever going to become a store of value then gold becomes the analog comparison, for sure.

As a disclaimer, I currently hold no positions in gold (long or short), nor do I intend to for the foreseeable future. I was shorting gold last year briefly, but I no longer have a position — so these are my unbiased thoughts on gold. This is not investment advice. Draw your own conclusions — there are merely observations as to how I think things may play out.

I’m obviously pro bitcoin, but I don’t believe that that necessarily means that I should be pro gold too, which happens to be the case most of the time with people who are holding Bitcoins. In fact, Bitcoin is being seen more and more as an uncorrelated asset class.

I am also not a gold analyst and I don’t follow the gold market closely. In fact, no-one in the gold industry has probably even heard of me unless they were researching Bitcoin! At best, I’m an armchair economist that has a solid understanding of crypto-economics (and the similarity to gold) and I think I have developed a relative unique market sense, having lived through periods of high inflation & interest rates in South Africa and low inflation & interest rates living in the USA.

I tweeted out earlier this week that I believe gold will dip or even end the year below $1,000 (which implies that I also believe the price of 1 Bitcoin will exceed the price of an ounce of Gold this year, given that I’ve forecasted Bitcoin reaching $2-$3k this year).

After doing some research for this post, I think gold is likely to fall even further — probably to around $700-$800 range before the end of 2018.

This is probably the most bearish prediction for gold that I have found in doing the research for this post.

I published this tweet six months ago, when gold was around $1,300/ounce — and it’s now hovering around $1,200 having already briefly dipped into the $1,100's.

Some of the Bitcoiners out there are diehard gold bugs. Their argument is that governments are going to screw everything up and print lots of money, cause inflation to run roughshod across the US economy and the world — and all we will have left to trade with one another is gold and magic internet money (Bitcoin). I felt it appropriate to highlight this sentiment, because this will probably be my most controversial Medium post yet — and I know I’m going out on a limb here, but I’m in good company given that Credit Suisse analysts also previously predicted the end of the gold era in 2013 —but their timing and reasons may have been a bit off. There is also new data emerging to suggest that Bitcoin and Gold are in fact negatively correlated.

Taking a macro view on an industry as large as gold is something which is extremely difficult to do. There are countless variables at play here and so my goal of this post isn’t to forecast how things play out in detail but to highlight some of the various macro factors that I believe may come into play to depress the gold price.

Bull vs Bear

The gold bulls would argue the following, pointing to an imminent breakout in the gold price:

• Global uncertainty — Trump, Brexit, Frexits, Grexits and *xits
• Failed monetary policies on a global scale by central bankers
• Quantitative easing hasn’t worked
• Inflation is inevitable
• Gold as a global safe haven in times of crisis
• $20 trillion global government bond market which has been on the “verge of collapse” for decades now.

2016 was a watershed year in many respects for Gold. Technical traders looking at gold charts are having a tough time adjusting for the changes in macro conditions and using decades of gold trading data will not help predict the future. Given the introduction of these new variables, especially the pending Brexit and Trump, I think we need to re-examine the globally accepted conventional views on gold.

Clearly, I’m not here to argue the bull case for physical gold, but I’d like to present some alternative views on how I believe things will play out. I may not hit the mark on every point, and time will tell, but I think directionally I’m not going to be too far off unless a black swan event occurs and the direction the world is taking changes course dramatically.

With a short blog post like this, I cannot expand on all the details, so apologies for any brevity — I’ve included links where possible for background reading.

The Trump Effect:

• When US dollar Real Interest Rates rise, gold falls as investors look to capitalize on the better yield. There are some caveats here —but I think it’s very evident that Real Interest Rates are going to rise precipitously under Trump, so I think it’s safe to say that this vector will play out. We can debate this at length, but the bottom line if he is going to be bringing more jobs into the domestic US economy at the expense of foreign jobs, rate rises will most likely be accompanied by growth and mild inflation in the short to medium term. This has proven to be negatively correlated to gold, historically.
• Equally, when oil rises, gold rises in line with inflation fears but clearly, Trump wants more oil supply from the US (Dakota Pipeline , offshore drilling, etc)— so why would prices rise if oil supply increases? I think oil may even drop back into the $20’s if the US starts producing more oil and OPEC increases supply again. Only a war would get the price back up if this happened… The only counter to this is that if the dollar strengthens, then foreign markets will see local inflation if they are reliant on foreign oil.
• Trump’s new isolationist approach to global trade is certainly going to contribute to decline in imports from a US perspective due to tariffs, which will exacerbate the dollar shortage worldwide.
• If the dollar strengthens, developed countries that have high levels of productivity and low unemployment are going to struggle to export their products to foreign markets, as their currencies would typically track the dollar given their forex reserves (usually dollar denominated or gold — unless they sell their reserves) and their accompanying dollar income. They will need to weaken their currency by selling gold in order to still be relevant to emerging markets. Trump’s philosophy is that the USA doesn’t need emerging markets — even if you believe that to be true, the problem with that is our trading partners and allies still do.

Gold Supply & Demand

• Most gold mining happens outside the US. As the dollar gets significantly stronger in places like South Africa, where the Rand has already been hit, marginal mines (mines that are not cost efficient below a certain local currency price) start opening and supply increases. This doesn’t happen immediately but there are a large number of marginal mines not in operation but could be.
• You can also have a situation where local owners of gold in foreign markets are going to see big local currency gains in the values of their gold holdings even if gold is flat or down as the dollar strengthens, which will encourage more selling than buying — similar to what happened when gold spiked to $1,800 and infomercials were driving people to dispose of their gold at record high prices.
• The IMF also accepts payments from nations in gold. This means that countries can pay their debts to the IMF, in an OTC (over the counter) trade effectively, and not affect the price of gold in the markets — this ultimately removes demand from the trading desk and moves it into the back rooms but has the invisible hand impact of removing demand from the market.

Inflation & Monetary Policy

• One argument from gold bugs (especially the ones hocking gold as an investment and make a living out of it), is that the governments are suppressing gold prices and everything is about to pop, and because inflation will run rampant and they won’t be able to control the price. Why would the biggest holders of gold (governments) in the world try to keep the price down? I’m still not sure I understand this — and I’ve looked at a lot of conspiracy theories about how over-leveraged gold is and that the physical gold doesn’t actually exist. All this remains to be seen, and it’s possible that there is some truth to this — but notwithstanding my other arguments in this post — if no one wants the gold, over leveraged long positions won’t matter…
• Quantitative easing has led to record amounts of dollar denominated debt being created outside the US. These debts are held by individuals, companies and countries that do not have sufficient dollar income to cover the interest rates, especially if rates rise and exports to the US decline. This has been widely spoken about and will contribute greatly to US dollar strength as these entities need to sell local currency to buy dollars to pay dollar based interest payments.
• If the debt is sovereign debt like Japan or the US, then they can just print enough to pay the bills and have minimal inflationary impact, which for me negates the argument that the entire bond market will collapse.

Euro Crisis

• The Eurozone is looking more and more likely to breakup over time, especially once the Brexit takes effect. This will force countries to abandon the Euro and forgo support from the European Central Bank and possibly even the IMF. Selling gold reserves will be the only option in some cases to balance the books, and weaken their currencies in order to be able to still export to the US.
• In 1999–2001, the Bank of England announced large amounts of gold sales. The price bottomed in the mid $250's. After that, the Euro central bankers all got together and signed a number of accords that continue until today, that they will cap gold sales at 400,000 tonnes per year — in other words, they can’t really use their large gold reserves to fund economic deficits or invest in their countries.
• This prompted the price to spike over time to over $1,800 at peak. By choking the supply point (central banks), the price of gold has been artificially inflated in my opinion, while the Euro was in effect. The real question is, if a country leaves the Euro, would they honor the agreement (which, as I understand, is a gentlemen’s agreement and not legally enforceable) and not embark on gold sales, especially if they are “out in the cold”. I’m not so sure…

Emerging Markets & Bitcoin

• Renewed dollar strength worldwide will place even more strain on emerging market currencies to pay for oil and other commodities that are priced in USD — but the upside is that the locally quoted currency price of gold will continue to climb, as will Bitcoin as per my prior post.
• The Bitcoin supply is fixed and predictable, a higher Bitcoin price will not unlock latent supply. By contrast, a higher gold price (in local currency that supplies the labor) will unlock latent gold supply. Bitcoin and gold are incomparable in this respect in terms of supply elasticity.
• A very important point that I want to make, is actually a generational one. I’m 38 years old and I’ve never really had any interest in owning gold, other than maybe World of Warcraft gold. My generation (Gen X) and the Millennials (Gen Y) couldn’t care less. We think it’s a pretty poor store of value, relative to other assets, no yield and we couldn’t care less who has it.
• My mom loves gold and so does her mom and sisters, etc. There is a massive generational divide here — the world has changed. Gold represents the old world wealth and economies and not the new world.
• If you ask anyone under the age of 40 who is tech savvy, would they prefer to hold 1 Bitcoin or 1 ounce of gold for 10 years, I’m almost certain that the majority would choose Bitcoin. If you asked people over the age of 40 — that number might be reversed. This generational shift and attitude toward gold is a fundamental one.

Global Instability

• Interestingly enough, China holds only around 2% of its foreign exchange reserves in Gold (although it could be higher, as some speculate), vs US, Germany, Italy & France where it’s around 70% each. The lower the gold reserves, the more susceptible the local currency is to devaluation against the US Dollar — in some cases, that’s exactly what that country wants or needs.
• Global trade can continue, but with the US becoming less favorable as a market opportunity due to tariffs being imposed by the Trump administration, holding gold reserves serve only to strengthen currencies which negatively impact export driven markets.
• Demonetization in India is weakening gold demand significantly and may only bounce back in 2018.
• US exports will falter under a stronger dollar. Yes, we will be producing more domestically but now our goods are services will not be competitive on the world markets, leaving the door open to competitors to dominate those markets.

The list goes on, (and this is already my longest blog post ever), but let’s just say that if gold breaks the psychological price of $1,000, many countries and other entities holding gold will quickly have second thoughts about it as a “store of value” and I suspect that supply will increase in the market, especially if fear sets in that gold cannot be relied upon to maintain its dollar denominated price.

The biggest risk that a strong dollar poses to the world economy is simply that if every other country is being negatively affected by this and other policies from the new administration, it’s not outside the realm of imagination to expect a retaliation from the rest of the world.

If we turn our back on the World, we shouldn’t be surprised when the World begins to turn its back on us…

What would happen if gold & other commodities begin to be priced in other currencies? Possibly even Bitcoin? Will the dollar remain the reserve currency if some or even all of my observations play out??

Sounds crazy — but then again so was the idea of Trump becoming president…

Special thanks to Zach Herbert and Brent Johnson of Santiago Capital for reviewing drafts of this post.