Gold and the Punchbowl
Illustration: Phil Couzens

Gold and the Punchbowl

I have just been listening to Ben Davies' podcast. (see also FT Alphaville here) from Hinde Capital about the funding issues of the Japanese government and the points he makes are important. I have used the metaphor of Japan as a bumblebee before and while I believe that the story on Japanese savings may just be a little more complicated than many believe, I think Ben points his finger at two very important points. The first is how Japan has difficulty with both deflation and potential inflation (higher yields) which not only puts the economy in a very tight spot, but also locks Japan in towards a balance between veering too far in either direction, a balance which can be difficult to strike. The second is that while Ben believes that Japan will ultimately pop, the central bank (and indeed Japan itself) will try to do everything it can before that happens. The last point especially, is very important. Coupled with the need for Japan to attempt to maintain a structural external surplus it brings me back to a point I have made before (and will continue to make again and again).

Aging societies are not, in the main, characterized by aggregate dissaving, but rather by the fight against it.

So, Japan will fight and the central bank will do the government's dirty work and the most intriguing question here is how long will unsterilized hyper-QE take before an economy such as Japan stuck in both a fertility and liquidity trap [1] implodes in hyperinflation? Will it happen at all? And what can the country do to balance the trade-off between deflation and inflation?

Finally, on Ben, he is bullish on gold but then again, as he runs a gold fund, he would be wouldn't he? But there is a subtler point underneath the reaffirmation of the bull market in gold since Hinde is also following Ben's comments—long volatility, a bet which has not yet paid off (and one would assume the “position” has some carrying/opportunity costs even if volatility is flat). Or put differently, gold (precious metals) has performed strongly alongside risky assets as liquidity has been plentiful, but what has not yet happened is the ultimate shakeout in which volatility spikes and investors buy gold, not the dollar. I think that you need to fit two stories in your head. One is why gold might move alongside risky assets as fiat currencies are slowly debased, the other is how gold should also do well in a situation where volatility suddenly increases quickly and abruptly—although I suspect this last situation is the ultimate endgame with the interim mainly being one of dollar strength in times of sudden reversals in market fortune.

But even gold can’t be a free lunch, right? Perhaps, this is one way to rationalize the fact that investor performance currently seems to be demarcated by those who climbed on the gold train a year ago (or 2-3 years ago, if you will) and those who didn't. When times are tough and volatility spikes, the USD rallies, but such events almost inevitably carry an immediate response of more liquidity, so gold (and other non-printable assets) will do well. But then as liquidity manages to smooth over markets and the SP500 starts to tick back up, this should again be constructive for gold since after all, the whole precondition for low volatility at the moment is the promise of more QE from the Fed (well not quite, but still very close I think). This is then good for a long gold position but not a long volatility position—although I am intrigued by the ultimate punt on the final coup de grace in which gold and volatility becomes the only place to be. Still you got to have that acking feeling on gold. I mean, either it trades as a risky asset, or it becomes the safe haven of choice in times of volatility. So, which is it? I don't know, but perhaps we are going to find out very soon.

The Punchbowl
Indeed, I suspect that many readers would have counted on me pointing to gold as the ultimate punchbowl. While I can certainly envision a situation in which gold takes a 10-15 percent correction (or even more), the point is that this would not counter the trend—not even close. This brings me to the real punchbowl at the moment: equities, emerging markets and high beta EM currencies (Asia and Latam). I am largely indifferent to the first in the long run, long-term bullish on the second, and by consequence, pretty constructive on the third as well in the long run [2].

However, in the short run I think that while the punchbowl never left the table, talks about a new round of QE and how Japan's intervention might actually be a leading indicator of more to come from OECD central banks at the same time as the SP500 breaks 1160 is extraordinary.

(quote Bloomberg)
The Bank of Japan may have acted first in a new round of central bank action to prop up the global economy as recoveries in industrial nations falter.

The unexpected decision by the Japanese central bank yesterday to drop its interest rate to “virtually zero” and expand its balance sheet follows the U.S. Federal Reserve’s move toward more unconventional easing. Bank of England officials will consider further stimulus tomorrow, while the central banks of Australia, Canada and New Zealand are among those now holding fire on further interest-rate increases.

It reminds me of a point made recently [3] that the marginal returns of additional QE measures (Q1, Q2, Q3 ... QN) are declining rapidly. I mean, how much QE do we need before the SP500 hits 1200, or perhaps 1250? Certainly, I think this is a worthwhile consideration when talking about the effects of QE even if the ultimate policy rationale for additional measures has intensified with the macro environment definitely turning darker in the OECD.

Actually, if you will allow me a mathematical description of this.

The first derivative of QE with respect to the macroeconomy and risky assets is positive, but the second derivative appears to be negative for the macroeconomy. More and more is needed to have a smaller and smaller effect. But it is more complicated than that. Some asset classes clearly have a very positive second derivative (gold for instance), and look at those poor emerging markets as well. More and more liquidity chasing relatively few assets and high yield opportunities are relatively scarce. This is then a positive second derivative and a clear risk of a bubble.

Quote Bloomberg
Emerging-market borrowers are on course to sell more bonds than ever this year after yields hit record lows and developing economies rebounded faster from the credit crisis than advanced nations. Governments and companies in developing countries including Vale SA, the world’s biggest iron-ore exporter, and Korea Electric Power Corp., South Korea’s largest electricity producer, borrowed $196 billion from July to September, the most for any quarter, according to data compiled by Bloomberg. Bond sales surged from $157 billion in the second quarter of 2010 as yields in developing countries slid to an all-time low of 5.4 percent on Aug. 23 from as high as 6.8 percent in February, JPMorgan Chase & Co.’s EMBI+ index shows.

(...)

Brazil doubled the tax yesterday on foreign investment to 4 percent on fixed-income securities to stem the currency’s two-year rally and help shore up exports. The move coincided with the Bank of Japan’s reduction of the overnight call rate target to a range of zero to 0.1 percent, the lowest since 2006, and said it would set up a fund to buy bonds. Brazil’s benchmark interest rate, at 10.75 percent, is the second-highest among the Group of 20 nations after Argentina’s and is luring demand for local-currency debt. “The IOF tax isn’t enough to contain the flows coming from the liquidity injection by the Japanese central bank and global dollar weakening,” said Luis Otavio Souza Leal, chief economist with Banco ABC Brasil SA in Sao Paulo.

(...)

Governments from South Korea to Brazil are stepping up attempts to control their currencies as investors pour a record amount of money into emerging markets.

Regulators in Seoul will start an audit of lenders handling foreign-currency derivatives on Oct. 19 to curb volatility caused by capital flows, the finance ministry said today. Brazil doubled a tax it charges foreigners on investments in fixed- income securities to 4 percent yesterday. The yen fell the most in three weeks after the Bank of Japan cut benchmark interest rates and pledged 5 trillion yen ($60 billion) to buy bonds and other assets, having sold $25 billion worth of its own currency last month in the first intervention since 2004.

This is just a small smorgasbord then of the effects this is having in emerging markets where more and more creative policy measures are being tried to keep money out. This is then a strongly positive second derivative effect and a key mechanism to be aware of in the global economy.

The point here is of course that there is a lack of stability. It is fairly well established from Japan's experience that once caught in a liquidity trap with a rapidly aging society, the extra effect of more liquidity is almost zero with respect to the macroeconomy (until of course the balance tilts, but sufficient unto that day and all). Yet, there is always a bubble waiting to inflate elsewhere. As such, the Japans of the world create a huge externality in the global economic system by filling the proverbial punchbowl for risky assets.

Yet for now, as markets seem to want more and more QE to push forward, it appears that investors should be careful of diving too deep into the punchbowl even if it might appear currently as a golden opportunity.

[1] - For more on the fertility trap, look no further.
[2] - Although an AUD/USD at 0.97 is unbelievable to me. I think this is one of the brightest stars high their looking for a strong correction.
[3] - I can't for the life of me remember who it was.

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