In today’s Money Morning…why gold is so difficult to analyse…gold standard myths…why gold will most likely fall from here…and more…
While iron ore is the commodity grabbing all the headlines, today I’m going to take a look at the gold price. It’s dropped off the radar a bit lately, despite the yellow metal having a pretty good run so far in 2017.
Before I do that though, make sure you check out my colleague Jason Stevenson’s special report on one of the ASX’s hottest sectors…one that also isn’t yet grabbing investors’ attention like iron ore.
The metals Jason is on about are crucial ingredients for the world’s new technology…and there simply aren’t enough of them. Not yet anyway. Which is why Jason thinks prices will soar this year.
Will gold enjoy a stellar year too?
I’ll try and answer that question in today’s Money Morning…
Gold is a tough metal to analyse. It comes with so much historical baggage and misunderstanding that people either love it or hate it before even thinking about the investment environment they’re in.
Because it’s a monetary metal, and not one driven by normal industrial demand, it defies conventional analysis.
That’s why gold is so appealing to those who think paper money and fractional reserve banking systems are fraudulent. They believe that gold should be the anchor of the financial system. If this were the case, they believe, we would not have the devastating booms and busts that characterise our modern monetary system.
Unfortunately, the thinking that gold brings about financial stability is a myth.
It’s true that under the classical gold standard (a period from roughly 1870–1914) prices were remarkably stable. Over that time frame there was virtually no inflation. That is, the value of money, backed as it was by gold, kept its value.
But there was still tremendous asset price and economic volatility. Those who sing the praises of the classical gold standard forget that the period contained a number of financial panics, and that the period from 1873–79 was referred to as the Long Depression.
There were financial panics in 1873, 1893, 1901 and 1907. While the gold standard didn’t cause these panics, it certainly made them worse.
That’s because when there is a panic, people rush into cash. And back then, cash was gold. As there was a limited amount of gold, and its price was fixed, asset prices had to fall significantly to satisfy the demand for gold.
That’s what makes a panic brutal under a gold standard. As currencies are fixed in price, there is no flexibility. Asset prices must take the whole adjustment. It can wipe people out in a matter of days.
Contrast that with today’s system. When there is a panic and investors rush to cash, central banks can create as much as they want. This additional supply eases the panic, and asset prices tend not to fall as much.
Under a gold standard, you get more frequent and more vicious panics, but under a floating currency credit-based monetary system — like the one we have now — you get fewer panics and more flexibility. But you also get more systemic risk building up in the system, because people tend to think it’s foolproof.
Which system is better? I’ll leave that for you to decide.
I will simply point out that we don’t live under a gold standard anymore, and it will never come back the way it was.
Gold fluctuates in price against every other asset. It is still a crucial part of the global monetary system, but it is not an ‘official’ part of it. That means the market sets the price.
So where will prices go in the short term?
To answer that question, we need to look at a chart.
Here’s a chart of the US dollar gold price:
Click to enlarge
It was looking good midway through 2016. Importantly, it peaked out around the time of the Brexit vote. Gold does well in times of financial system volatility or disorder. The market initially thought Brexit would be a debacle, but the financial system handled it nicely — in large part thanks to the system of floating exchange rates. The pound took the brunt of the Brexit vote, while the financial system was left unscathed.
That’s why gold sold off following the Brexit vote. It turned out to not be the systemic threat that many thought it would be.
From that point, gold drifted lower. Then sold off sharply on the prospect of higher US interest rates, and then again following the election of Trump.
The simple explanation for gold’s sharp fall in the back half of 2016 is that investors started to see an improving global economy. Meaning interest rates will move higher and there’s less need for holding gold as a financial insurance policy.
Has anything changed to alter that view?
I would argue that it hasn’t.
If you have a look at the chart above again, you’ll see that gold’s sharp sell-off last year pulled gold into a downtrend (note how the moving averages crossed to the downside in November 2016). Gold has since rallied strongly, but the moving averages still point to gold being in a downtrend.
The chart looks messy too. The price is right up against a minor area of resistance (green line) so there is a risk you could see the rally end here.
If it breaks through resistance, you need to see gold hold onto those gains for long enough to see the moving averages cross to the upside. That would indicate that upward momentum is returning.
From there, higher prices would need a catalyst. Perhaps something will go wrong with China’s credit expansion? Perhaps Donald Trump will offend one too many people and set of a crisis of confidence in the US administration?
Or — and I think this is more likely — gold will simply turn back down again. If that does happen, you’ll want to see gold form a higher low (meaning the next low should be above the US$1,224 low of December 2016). This will improve the odds that gold can then start moving higher.
After such a large sell-off, it would be unusual for gold to rally straight back to new highs. It makes more sense for gold to take some time to regain momentum.
This is why you should expect another correction in the yellow metal soon.
From the Port Phillip Publishing Library