Gold and the problem of fiat money

 

The US government has consistently tried to marginalize gold, and has all of the focus on the dollar, but that only works if we behave ourselves. If we add a lot of debt on top of a fiat currency, it doesn't work.” - Chris Walen

I have not been a gold bug, nor will I change, but there is a problem with fiat money. Money is a store of vlaue because people believe it is a store of value. It is a matter of trust. The safe asset is a safe asset becasue it is belived to be a place where value is maintained.

The literature on safe assets does note that the safety is a relative concept. If there is too much of the safe asset, there will be a decline in that asset's safety value. When that happens, investors will look for other safe assets. If those other safe assets have a problem of excess supply, there will be a demand for real assets that offer safety and limited supply. 

The increase in gold demand is a response to the excess supply of Treasuries based on the large US budget deficits. The safety of Treasuries is being eroded, so there is a search for alternatives.  

Commodities march differently than gold

Gold is going higher, so it must be the case that commodities are also going higher? The data tells us otherwise. Commodities, on average, have been rangebound, but the gold versus commodity ratio tells a different story. The gains in gold are the result of something different. It is driven by the demand for a safe asset, not for its use in some production process or for consumption.  

Does this mean that commodity prices should see a gain in the future? There could be a general commodity rise, but it is not in the card based on a ratio. Sometimes a charge is interesting but not informative.

 

Gold as a safe asset - an alternative to debt.

 

One of the topics that has received attention in microfinance research is the discussion of what constitutes a safe asset and whether it is in short supply. 

During a crisis, there is an increased demand for safe assets that are information-insensitive and serve as a means to protect wealth. A simple example of a safe asset is the US Treasury bill. When there is high uncertainty, investors tend to sell risky assets and shift to safer ones. However, if there is a shortage of these safe assets, the price will be bid up, placing downward pressure on interest rates. 

Nevertheless, there is the assumption that the supposed safe asset will really be safe. That is, the risk or market uncertainty cannot come from the producer of the safe asset. If there is an increase in risk from the safe asset, it will lose its convenience yield, and it will no longer be uncorrelated with risky assets. 

In this case, there will be a demand for alternative safe assets. One alternative is gold. Gold is often uncorrelated with risky assets during times of stress. It is negatively correlated with volatility and uncertainty, and it often protects against higher inflation that impacts the real value of debt-safe assets. It is information-insensitive, and it can be used as collateral. 

Many have suggested that gold is in a bubble, but that narrative shifts if you view gold as a safe asset substitute. If the US debt is less secure, then there will be a stronger demand for gold, which will push its value higher. If the relative safety shifts to gold and away from debt, then there will be stronger upward pressure on gold. The price increase has been significant, but it will be sustained if the safety feature continues to drive demand.

Gold and central banks - Do what we do not what we say

 

I thought at one time that central banks believed that gold was a "barbarous relic". Those times are long gone. The latest survey on central bank behavior and gold shows that 3/4ths will increase their gold portion of total reserves. It is higher simply because the price of gold is higher; yet, we are seeing more central banks increasing their gold exposure. Where is it coming from? Survey results suggest that dollar exposure is expected to decline. Reduce dollar exposure and hold more gold. 

43% of central banks expect to increase their gold exposure in the next 12 months. This is up from 8% in 2019. Gold, the hard asset, is back with central banks. No, this comes even as inflation has fallen, so central banks may be arriving late to the table, although central bank gold holdings have been on the rise for years. 

The explosive increase in gold prices is simply. There is a shortage of this "safe asset" relative to supply. There have been pockets of lower demand, but central banks are price-insensitive 800-lb gorillas in the gold marketplace. This is more than an inflation hedge, but for many EM central banks, a sanction hedge. 

It is hard to see a substantial price reversal in gold when central banks are key buyers. Gold is not at attractive prices for accumulation but central banks are telling the market you should hold this diversifier. 

Gold price increases tied to higher uncertainty

Gold is considered a safe asset because it has the safe asset statistical qualities of being negatively correlated with risk assets during a market downturn. While this is generally true, it is not always the case. We know that gold has some of the characteristics of a safe asset because it will do better when there is high uncertainty. A simple examination tested more formally in academic research finds a positive link between gold, volatility, and uncertainty. From volatility, there is a change in asset demand. More risk with risky assets will lead to higher demand for safe assets.

Cropland decline - A future concern

 

US cropland has declined over the last ten years. It was steady from 1998 to 2014, but the farmland acreage is decreasing. See the farmdoc daily blog for the details. What is especially scary is that the economists who have looked at the data do not have a good explanation for this fall. We should be especially concerned because if there are no increases in productivity, we will be in a food deficit. Of course, Latin America has been a large marginal producer, and there is no current problem, but the risk of a food shortfall will increase if there is less land for farming. This is an issue worth keeping on the radar screen.

Gold prices are now all about political uncertainty

"Buying gold is just purchasing a put against the idiocy of the political cycle. It's that simple." - Kyle Bass. 

Inflation is lower. Real rates for bonds are higher. Yet, gold is near all-time highs. It may not be the political cycle but the uncertainty cycle. The combination of trade wars and policy uncertainty, with talk of a new world order, drives gold buying. If you don't want to buy the dollar and you are wary of other currencies, gold is a good place to be as a safe asset. Can we place a valuation number on the price of gold? No, this is the difficult part of the process, yet uncertainty seems to be the key causal driver.

The ongoing mystery of the gold price move

 

Gold is now over $3000 an oz. and like any market that has a strong run-up in price there is talk of a bubble. The bubble talk becomes stronger when it is unclear what are the drivers for the increase in gold prices. The classic story is that gold rises as an inflation hedge, yet inflation has fall from its higher levels post-pandemic. We have seen the jump from $1250 pre-pandemic to the $2000 level at the end of 2023. Now we are seeing a move to $3000 which suggests that a new story is needed to explain the move. 

Erb and Harvey in their new paper "Is there still a golden dilemma?" offer a new view on gold which is both interesting and compelling. First, they show that inflation is not volatile enough to explain the variation in gold. Second, they find that there is a distinct change in the gold market based on the composition of buyers. The introduction of gold ETFs has made it easier to purchase a form of gold return which has increased the trend. Make it easier to purchase and demand will go up. Three, there has been an institutional change in gold demand based on de-dollarization. Given the dollar is being used as a form of financial statecraft to punish bad actors, there is a move by several countries to reduce their dollar holdings. 

Erb and Harvey offer an explanation for the rising prices but there is a problem. This explanation just suggests that there are new buyers that are pushing the real price higher based on economic or political expectations. There is no central driving force that will suggest prices should be higher. Expectations dominate bubble thinking, so it is hard to know whether a higher real price is sustainable or will be reversed as in the past.

Gold reserves increasing off lows

 

Gold prices are at all-time highs, yet inflation is lower. There is geopolitical risk, yet these risks may not seem to warrant new highs. Perhaps thinking about gold should not be focused on the immediate but on the new economic regime. The post-COVID environment can be characterized by the following:

• The threat of inflation. We lived in a sub 2% world to now a world where higher than 2% is the norm.
• The polycrisis world where geopolitical risks are higher. We have not seen true downside event, but the risks are all higher.
• The sanction world of have and have-not states that may be cut from dollar financing.
• A fiscal debt threat world where safe assets may not be so safe. 

No one of these should push gold to highs but the combination is pushing even central banks to hold more gold. The conservative central banks that control inflation and capital flows is saying that they need gold.

If you believe the economic regime is different than the demand for gold is different. This is especially true for those outside the US who may be hurt more from this new economic regime. 

The 21st century has been defined by the GFC, the global pandemic, a war in Ukraine, the eastern edge of EU, Middle East tensions and rising tensions between China and the West. This is not your post-Cold War period, and the threat from nuclear weapons is higher than 30 years ago. Welcome to a new world and a new gold regime.

Who grows our crops around the world by country?

This a very interesting chart on who is growing the major crops around the world. The US is still the breadbasket for the world, but it may surprise many what is happening around the rest of the world. Note, we are not incorporating rice production. First, the production in the US has been falling albeit slightly, yet the world still needs food. That food production is coming from one major supplier, Brazil. The explosion of soybeans from Brazil is truly amazing. It outstrips the US and every other country. When you add the rest of Latin America, the EM south is the bean capital for production. The amount of corn from this region is also quite large. It may surprise many how much corn and wheat production comes from China. This is for domestic production, but corn is king in China. The world trade in grains is mainly about the US, in the north, Brazil in the south, and extra needs from China.

Gold behavior - Not what you may expect

 

Gold has always been known as an inflation hedge. It has also been known as a good investment when the real rate of interest is negative. Now we are seeing inflation lower with current levels at approximately 2.5% and real rates are positive even if the Fed starts to lower nominal rates. Under this world, we are seeing gold reach new highs of $2500 per ounce. This is not what one would expect. 

A higher gold price only makes sense if the market believes that inflation is not tamed, the dollar will move lower, and there will be significant financial risk. The gold market is an expectational market and the view from gold buyers is that the future will not be as good as what we currently see. 

Commodity return prediction and intertemporal pricing

 

The paper "Commodity Futures Return Predictability and Intertemporal Asset Pricing" is another study that connects macroeconomic behavior to commodity returns. If you track key variables that proxy for the business cycle, you will be able to generate significant out-of-sample returns. These predictions are structured in a Merton-type inter temporal asset pricing model which is consistent with theory.

The authors form combination forecast of 28 potential predictors that add to Sharpe ratios across a broad set of commodity markets. Several combination methodologies are used with the predictors to form a forecast for future economic activity which is then combined in a regression with the market risk factor. The combination approach allows for a better representation for what future economic activity will be than single predictor or a regression with multiple predictors. This makes for a complex set results, but the overall conclusions are consistent with other work on this topic. 

Tell me something about the real economic and I can tell you something about commodity excess returns. The study focuses on two-factor models which combines the market factors with innovations from the real economic combination forecasts. The work is consistent with the expectations from an inter-temporal asset pricing model (ICAPM). Given the focus on ICAPM, the models include factors that would also be associated with other asset classes. As with other studies conducted on predictions of commodity excess returns, macroeconomics variables and risks are key determinant for commodity returns forecasting.  Of course, the R-squared for these forecasts are very low, under 5 percent, but the values are still economically meaningful. 

What this work suggests is that even some simple macro adjustments to a commodity return model will provide value-added that is greater than just using past excess returns.

More on commodity returns and macro drivers - Use the forward curve

 

The paper "Commodity Return Predictability" combines the basis and forward curve with macro variables to make effective predictions on commodity returns.  We know that when commodity markets are in strong backwardation or contango the future prices have important information that can be exploited. If the commodity curve is inverted, in backwardation, current prices are higher than future prices and the curve suggests there is strong commodity demand. On the other hand, if the market is in contango, current prices are lower than future prices and there is likely less current demand. This current demand is also related to the business cycle and suggests that commodity price moves are pro-cyclical. 

The author of this paper shows that combining the shape of the forward curve along with macro information can be effectively used to explain commodity returns both in-sample and out-of-sample. It is not enough to just look at the basis over one month, rather it is more valuable to look at the whole futures curve and account for the level, slope and curvature of this forward curve just like the yield curve. A close look at the data will find that the curvature of the forward curve provides strong added information. Forward factor regressions have been used to show that the shape of the yield curve can be used to predict bond returns, so the same methodology can be applied to commodity forward curves, and it also is effective. The key is looking at the longer-dated basis and not just the nearby futures. 

Additionally, the shape of the curve and the basis is related to the business cycle, so factors that account for the business cycle like, industrial production, the composite leading indicators, business confidence, and trade will also have an impact on commodity returns. What is very interesting is that the out-of-sample forecasts with macro variables alone are not very effective. 

Finally, the author tests some other variables known to have some predictive power from past tests and finds the growth in open interest is also a useful predictor. If the futures are being used to hold position exposure, it is a sign that returns are moving higher. 

The combination of endogenous information embedded in the yield curve along with exogenous macro information, especially in the case of composite leading indicators, will be a useful for making commodity return forecasts. Nevertheless, there is a concern that the majority of the forecasting gains are associated with the super-cycle extremes of 2008. The gains during other periods are more modest. 

Commodity returns and macro drivers - business cycle and inflation

 

What drives commodity prices? This is an age-old question addressed in a paper which has looked 140 years of history across a wide set of commodity markets in the energy, agricultural, and metals markets. Their results are consistent with what you think if you applied business and monetary policy thinking. Industrial production and inflation are the two most important variables for predicting commodity returns. Track the business cycle and inflation and you will have some predictions for commodity returns. See, "Predictability in Commodity Markets: Evidence from More Than a Century".

Different commodities have variable sensitivities to macro data. Agriculture and metals are sensitive to industrial production, yet the energy complex is not sensitive to the business cycle. Commodities in general are sensitive to inflation.  Many of the factors tested are significant for in-sample tests but lose their significance out of sample. Commodities are more predictive during the business cycle expansion relative to a contraction.

Volatility can also be predicted, but not for agriculture out of sample. The general high volatility and seasonality for agriculture may be the reason for this poor predictability.

The overall number suggest that some macro variables can be linked with trend to improve commodity trading.

I thought you said there will be a copper shortage? short versus long-term investing

The big commodity buzz has been about shortages especially for key metals that are associated with the EV car and renewable energy revolution. Many analysts have argued that the long-run move in copper is higher. There is a shortage of supply form under-investment, and a strong demand from a shift to energy renewals and infrastructure. The tide is pulling copper prices higher.

So, what have we seen now that the copper story is at fever pitch? There has been a significant decline based on a China slowdown in the last month. Prices are still higher from the beginning of the yea, but the cost of buying copper fever has been high.  Chinese copper stocks in the warehouse for delivery on the SFE are now at the highest levels since 2020. Copper in China is now selling at a discount. 

If you want to be a copper trader, don't worry about the long-term, just follow the trends. This is the difference between investing and speculation, the former is long-term and the latter is short-term.  One is not better than the other, but each has a different timeframe and return objective. 

We can be headed into a new super-cycle, but that does not mean that the trend will always be pointed upwards. 

 

Commodities and the business cycle

 

The commodity cycle is not the same as the business cycle which is not the same as the credit cycle. Get these three right and you will be ahead of the competition. The problem, of course, is that there is too much time spent on forecasting the future and not enough time spent on determining where we are in the current cycle. You cannot talk about where you are going unless you know where you are.

It feels like this is or should be late stage in business cycle, but it is less clear where we are in the credit cycle. We are, by all accounts in the tightening phase, but the real economy and credit spreads do not reflect that in the data. 

Associated with the business cycle is the output gap. If we are late stage, then output should be above capacity and the gap should be falling, yet the world seems to have significant excess capacity. Following the simple chart, we might still argue that there is expansion.

Nevertheless, if we focus on specific capacity for industries, the story is different. Total capacity is not at extremes, but if we focus on commodity specific capacity, the story is different.  For mining and oil, we are at capacity. Fabrication may have excess capacity, but the raw production may be constrained which will lead to a drawdown on inventories; however, the capacity measure we may have a commodity issue.

This is a complex process, which is one of the reasons so many traders will just say show me the trend. 

Copper market potential - Not enough supply relative growing demand

Copper prices have been rising albeit there has been a decline since mid-May. There has been an increase in the spread between the first- and second-month copper futures prices which are telling us there is a tight supply situation. Despite less building in China, the world demand for copper is increasing and mining production has not kept pace with this demand. Unfortunately, it is not easy to just increase mine production. 

Can you trade on the potential copper shortage? If you are trading with a holding period inside a month, the answer is not likely, but if you are willing to hold copper for an extended period, it is more likely to be a good trade.  Trading long-term fundamentals is less profitable, but the long-term environment can support tilts in positions. 

 

The coming bull market in commodity markets

 

We know that commodities will often see super cycles which are different from the business cycle. A super-cycle in commodities can be related to weather, but more likely the big cycle will be associated with stronger than expected demand matched by supply constraints from under-investment. The under-investment is often the result of low commodity prices which caused investors to believe that the return on capital is not worth the effort to drill, dig, or plant. This is the story that Goldman Sachs is telling, and it seems reasonable. 

The GS story is based on what they call the 5-D's, disinvestment, decarbonization, de-risking, data centers, and defense spending. The simple story is that demand is increasing from unexpected places and supply will not be able to meet this demand because capital has not been sufficiently deployed in commodities.  

No positive feelings in the farm community

 

I don't use this as a trading signal, but the AG economy barometer index from Purdue University and CME provides some context on what farmers are thinking. It is not good. Current conditions are falling, and future expectations are rangebound. The overall barometer is not at lows but heading in that direction. The index has a month lag and does not reflect the current rebound in price, so it will be interesting to see the response to price; nevertheless, farm income will still be constrained.

What do central banks think about inflation - look at gold

 

Global inflation debases currencies. Higher inflation in the US debases the reserve currency. If the inflation is transitory, central banks should not change their exposures to different currencies; however, if you believe that inflation will last for a longer time, it is time to buy hard assets. Even though we are off the gold standard, and it was described by Keynes as a "barbarous relic", central banks are buying a lot of gold - tonnes of it. 

2022 and 2023 were banner years for gold buying. We believe that this is also sanction related. There is less reason to hold dollars if there is chance of sanctions reducing your ability to use those dollars. Look at the world official reserve assets in gold. It has moved from about 950m oz to above 1150m which is close to the levels seen when the world went off the gold standard. Despite high real rates and falling inflation, central banks want gold.  Central banks are voting with their gold and they do not want to hold currencies that may lose their purchasing power.