FRIDAY, APRIL 5, 2013
David Franklin and David Baker
Société Générale (“SocGen”) recently published a special report entitled “The end of the gold era” that garnered far more attention than we think it deserved. The majority of the report focused on SocGen’s “crash scenario” for gold wherein they suggest that gold could fall well below their 2013 target of US$1,375/oz. It also included a classic criticism that we’ve heard so many times before: that the gold price is in “bubble territory”. We have problems with both suggestions.
To begin, the report’s authors appear to view gold as a commodity, rather than as a currency. This is a common misconception that continues to plague most gold market analysis. Gold doesn’t really work as a commodity because it doesn’t get consumed like one. The vast majority of gold mined throughout history remains in existence today, and the total global gold stockpile grows in small increments every year through additional mine supply. This is also precisely why gold works so well as a currency. Total gold supply can only grow marginally, while fiat money supply can grow exponentially through printing programs. This is why gold’s monetary value is so important – it’s the only “currency” in play that is immune to government devaluation.
Chart A illustrates the relationship between the growth of central bank balance sheets in the US, EU, UK and Japan and the price of gold. This relationship has an extremely high correlation with an R2of about 95%. As central banks increase the size of their balance sheets through ‘open market operations’ to buy bonds, mortgage-backed securities (“MBS”) and the like, they inject more fiat dollars into their respective banking systems. As gold has a relatively stable supply, if there are more dollars available, the price of gold should rise in dollar terms. It’s really a very simple and intuitive relationship – as it should be.
Source: Bloomberg and Sprott Asset Management LP
This relationship between central bank printing and gold has existed since the beginning of the gold bull market in 2000. In fact, this relationship shows that for every US$1 trillion increase in the collective central banks’ balance sheets, the price of gold has generally appreciated by an average of US$210/oz.
Somewhat surprisingly, it turns out that the collective central bank balance sheets have actually shrunk over the past three months – by approximately US$415 billion. The biggest drop was seen in the ECB’s balance sheet, which shrunk by the equivalent of US$370 billion, while other central banks also experienced small declines. Based on our simple model above, a decrease of US$415 billion should produce a gold price decline of roughly US$87/oz. And as it turns out, gold fell by US$76/oz over the first quarter of 2013. Does this sound like a bubble to you? It certainly doesn’t appear to be. Gold is performing almost exactly as it should – by acting as a currency barometer for the amount of money being injected into or withdrawn from the economy... which leads us to Japan.
Japan’s recent QE announcement is a thing of wonder. It represents an absolutely massive injection of yen relative to the size of the Japanese economy. The Bank of Japan’s US$75 billion equivalent per month of yen printing, coupled with the US Federal Reserve’s $85 billion per month (through its current QE program) will addUS$1.97 trillionto the collective central bank balance sheets over the next 12 months. Given Japan’s considerable contribution, we seriously question how SocGen believes gold can drop to US$1,375/oz by the end of the year. For that to happen, we would need to see a collective balance sheet decline of roughly 15%. Does SocGen seriously believe the US Fed (or any other central bank for that matter) is going to reverse its QE accumulation and then start aggressively selling balance sheet assets over the next year?
The only gold ‘crash scenario’ that makes sense to us at Sprott is if governments begin to balance their budgets and return to sound money practices. There is no question that gold could lose its utility if western governments made a concerted effort to fix their fiscal imbalances, but who honestly believes that’s going to happen any time soon? We certainly don’t – especially in the US. While US deficit spending may diminish in scale, it will remain well above $1 trillion per year after factoring in unfunded obligations. We don’t know of any creditable forecaster who believes otherwise.
We also don’t see a chance of the US Federal Reserve ending its QE programs, despite the continual jaw-boning by various Fed officials of a planned QE exit strategy. There is simply too much risk to the US bond market for the Fed to cut the US$85 billion in monthly Treasury and MBS purchases that the current program employs. After all – remember that those purchases are what keep interest rates close to zero today. If the Fed were to remove that flow of capital, the free market would once again dictate US bond yields and stock prices. There’s not a chance the Fed will take the risk of finding out what US bonds or stocks are worth to the market without a perpetual government-induced backstop. Why take the risk? Especially since the cumulative QE programs to date have not caused a drastic increase in inflation expectations.
While we expect the Fed to continue to threaten to lower its monthly QE purchases, we believe the chances of even a mild decrease to its current US$85 billion per month rate are negligible. Four years into it this grand QE experiment, money printing has become the backbone of the US bond market, and the unsung driver of the US equity market. In our view, gold cannot become irrelevant for the precise reason that QE is here to stay… and the collective central bank balance sheets will continue to increase over time. We would question any pundit who believes otherwise – unless they can clearly articulate how the Fed can exit QE without causing irreparable harm to the very financial markets the QE programs were designed to assuage.
We believe gold is nowhere close to ‘bubble territory’ today. It is acting exactly as a currency should. Under its current stewardship, we expect the Federal Reserve’s balance sheet to continue to expand along with Japan’s. SocGen’s “crash” scenario would require a complete reversal of this trend, which we do not believe is even remotely possible at this point.
Gold is the base currency with which to compare the value of all government-sponsored money. Investors can incorporate it into their portfolios as ‘central bank insurance’, or ignore it entirely. Either way, we believe gold will continue to track the total aggregate of the central bank balance sheets of the US, UK, Eurozone and Japan. If SocGen believes the aggregate central bank balance sheet will continue to shrink as it did in Q1, then gold should continue its decline. We strongly suspect that shrinkage is over, however. Given Japan’s recent QE decision, we would expect the aggregate to grow a lot bigger, and fast. If there was ever a time for gold to be a relevant currency alternative – it’s now.
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