Gold Sell-Off: There Is Only One Question That Matters

Guest post by Detlev Schlicter

Last Friday, I participated in a short debate on BBC Radio 4's Today program on the future direction of gold. Tom Kendall, global head of precious metals research at Credit Suisse, argued that gold was in trouble. I argued that it wasn't. So yours truly is on record on national radio the morning of gold's two worst trading days in 30 years arguing that it was still a good investment.

Is it?

I still think what I said on radio is correct. Even after two days of brutal bloodletting in the gold market and two days of soul-searching for the explanations, I believe the only questions that ultimately matter for the direction of gold are these:

Has the direction of global monetary policy changed fundamentally, or is it about to change fundamentally? Is the period of "quantitative easing" and super-low interest rates about to come to an end?

If the answer to these questions is yes, then gold will continue to be in trouble. If no, then it will come back.

Reasons to own gold
The reason I own gold and why I recommended it as an essential self-defence asset is not based on the chart pattern of the gold price, the opinion of Goldman Sachs, or the Indian wedding season. Rather, it's the diagnosis that the global fiat money economy has checkmated itself.

After 40 years of relentless paper money expansion, and in particular after 25 years of Fed-led global bubble finance, the dislocations in the global financial system are so massive that nobody in power dares turn off the monetary spigot.

Nor do they allow market forces to do their work. In other words, price credit and risk according to the available pool of real savings and the potential for real income generation, rather than according to the wishes of our master monetary central planners.

The reason why, for almost half a decade now, all the major central banks around the world have kept rates at zero and printed vast amounts of bank reserves is that the system is massively dislocated. Nobody wants the market to have a go at correcting this.

There are two potential outcomes (as I explain in my book):

1. This policy is maintained and even intensified, which will ultimately lead to higher inflation and paper money collapse.
2. This policy is abandoned and the liquidation of imbalances through market forces is allowed to unfold.

Gold is mainly a hedge against the first scenario, but it won't go to zero in the second scenario either. So far, I see little indication that central bankers are about to switch from the first scenario to the second, but we always have to consider the fact that the market is smarter than us and has its ears closer to the ground. What is the evidence?

Cyprus and Economic Monetary Union (EMU) of the European Union
Taken on their own, the events in Cyprus were not supportive of gold. Not because the island nation could potentially sell a smidgen of gold into the market, but rather because the EU masters decided to go for liquidation and deflation, rather than full-scale bailout and reflation. Cyprus' major bank is being liquidated. Not rescued and "recapitalized" as in the bad examples of RBS, Northern Rock, and Commerzbank. Or, in a more indirect and shameless way, reliquification in the case of Goldman Sachs, Morgan Stanley, Citibank, and numerous others.

The ECB's balance sheet has been shrinking over the past three months, not expanding. Depositors in EMU banks are being told that in future they shouldn't rely on unlimited money printing. Nor should they expect unlimited transfers from taxpayers in other countries to see the nominal value of their deposits protected. This is a strike for monetary sanity and a negative for gold. It should reduce the risk premium on paper money on the margin.

If this sets an example of how the global monetary bureaucracy is moving, then gold is indeed in trouble.

However, I don't see it.

As I argued before, it seems more likely to me that Japan is the role model for where other central banks will be heading: aggressive fiat money debasement, a last-gasp attempt at throwing the monetary kitchen sink at the economy.

Additionally, the EU bureaucracy may not be as principled on the question of hard or soft money when the patient brought in on a stretcher is not a European lightweight like Cyprus or even Greece. Imagine if one of the big boys, i.e., Spain, Italy, or France (the latter having been the EMU's big accident waiting to happen for some time), were in the same situation. Mr. Draghi's phone would immediately ring off the hook.

My sense is that even in Europe, the days of "quantitative easing" are not numbered by any stretch of the imagination.

Bernanke, the anti-Volcker
But the central bank that really matters is the Fed. Will we one day look back on the days of April 2013 as the moment an incredibly prescient gold market told us that Bernanke was getting isolated at the Fed? That people had begun to seriously tire of his academic stubbornness about the U.S government having the technology (a printing press) that allows it to print as many dollars as it wishes.

Of course, I don't know, but I somehow doubt it.

Yesterday was the worst day in the gold market since February 1983. Back then, gold was in a gigantic bear market. Not because of what Goldman thought or said, but because Paul Volcker was Fed chairman and had just applied a monetary root canal treatment to the U.S. economy, simply by stopping the printing presses. This allowed short rates to go up and restored faith in the paper dollar. Twenty percent return on T-bills? How's that for a signal that paper money won't be printed into oblivion!

The important thing was that Volcker (and some of his political masters) had the backbone to inflict this short-term pain to achieve long-term (although, sadly, not lasting) stability and to live with the consequences of the tightening.
Today, the consequences would be much more severe, and there is also much less central banker backbone on display. Over the past two decades, the central banker has, instead, become the leveraged trader's best friend. Volcker was made of sterner stuff.

If the gold market knows that easy money is about to end, how come the other markets haven't gotten the news yet?

Do we really believe that stocks would be trading at or near all-time highs, the bonds of fiscally challenged nations and of small-fry corporations trading at record-low yields, if the end of easy money were around the corner?

To justify the lofty valuations of these markets on fundamentals, one would have to assume that they no longer benefit from cheap money. Instead, they'll again have to become the efficient-market hypothesis' disinterested, objective, reliable, and forward-looking barometers of our economic future. A bright future, indeed. One in which, apparently, all our problems -- cyclical, structural, fiscal, and demographic -- have now been solved so that the central bankers can pack up the emergency tool kit and gold can be sent to the museum.

Well, good luck with that.

The sucker trade
In the debate last Friday, my "opponent," Tom Kendall, made a very good point. Tom said that what causes problems for gold is the "direction of travel" of the economy and other asset markets. It is a bit of a strange phrase, but the way I understood it, it is quite fitting: Equities are trading higher (in my view mainly because of easy money and the correct expectation that easy money will stay with us), while bonds are stable, and inflation (so far) is not a problem.
In this environment, the gold allocation in a portfolio feels like a dead weight. For most investors, it is difficult to stand on the sidelines of a rallying equity market. They need to be part of it.

I think that what is happening here is that Bernanke & Co. are enjoying, for the moment, a monetary policy sweet spot at which their monetary machinations boost equities sufficiently to suck in more and more players from the sidelines. Yet they do not affect the major inflation readings, nor do they upset the bond market. This policy is not bringing the financial system back into balance. It does not reduce imbalances nor dissolve economic dislocations. To the contrary, this policy is marginally adding to long-term problems. But it feels good for now.

Bernanke is blowing new bubbles, and as we have seen in the past, it is in the early inflation phases of new bubbles that gold struggles. Equity investors are getting sucked in again, and the gold bugs may have to wait until they get spat out and the Fed's cavalry again rides to their rescue before gold comes back.

In any case, I remain certain of one thing:
This will end badly.

Sincerely,
Detlev Schlichter

Detlev Schlichter is a writer and Austrian School economist who has spent nearly twenty years working in international finance, including for Merrill Lynch, J.P. Morgan, and Wester Asset Management.
His book Paper Money Collapse argues the present crisis is the unavoidable result of elastic money; and that the continuous money production to stimulate the economy could lead to a complete collapse of the monetary system.

A version of this article appeared at the Laissez Faire Book Club.