Claims continue to decline

Weekly claims for unemployment continue to slowly decline. No sign of anything unusual going on in the labor market. That's good, because avoiding recession is all that matters from an investment perspective these days.

When yields on risk-free assets are close to zero, it only makes sense to hold those assets if you need liquidity and/or are highly concerned about the potential for losses in other assets, most of which are yielding substantially more, as shown in the chart above. From a macro perspective, the fact that significant assets are being held with virtually a zero yield (e.g., bank savings deposits are now $6.8 trillion, up from $4 trillion in late 2008) can be interpreted as a sign that the market is very worried about a recession, since that is the one event most likely to create widespread losses in risky assets.

Argentine peso blues update

The chart above is an updated version of the one I posted last month. This is like watching a slow-motion train wreck. Argentina is headed for another big devaluation, and the economy—already suffering from restrictions on imports and capital flight—is going to take a big hit. The so-called "blue" rate shows that the market is expecting a devaluation of the official rate of more than 40%. It's starting to get ugly.

As I mentioned in my prior post, visitors to Argentina will want to take lots of $100 bills with them, rather than relying on ATMs and credit cards to pay their expenses. Dollar cash is in huge demand in Argentina, because the central bank is growing the supply of Argentine currency at the rate of 40% per year, effectively debasing the currency in a major way.

Stocks surge relative to gold

In a previous post on the subject of gold re-linking to commodities, I mentioned in passing something that Larry Kudlow reminded me of recently: the last time gold suffered such a huge drop (January 1980) was 2 1/2 years before the economic and stock market boom of the 1980s got underway. Lots of things are different this time around, of course, but it's an idea worth fleshing out.

The first chart above shows the ratio of monthly spot gold prices to the S&P 500 (just the index, not including reinvested dividends) over the past 85 years, while the second chart shows the ratio of daily prices over the past five years. As should be obvious, we have just seen a significant change in the relative strength of stocks and gold. Stocks appear to be on the cusp of a new trend, rising in terms of gold, and this could portend optimistic tidings.

Over the time period of the first chart, there have been only two episodes in which stocks strongly outperformed gold over a sustained period: the first, from around 1950 to around 1965, and the second, from late 1982 through 2000. In the first period, real GDP grew at an annualized rate of 4.5%, which is substantially more than the the 3.1% long-term average growth rate of the U.S. economy. In the second period, real GDP grew at an annualized rate of 3.7%, well above average. Real GDP growth was below average in the periods during which stocks fell relative to gold, the worst being from 2000 through 2012, when real GDP growth was an annualized 1.6%.

Of course, changes in the ratio of stocks to gold aren't what drives economic growth. Rather, it is strong economic growth that drives stocks higher relative to gold. During periods of healthy growth investors naturally gravitate to equities at the expense of gold, because profits are rising, stocks pay dividends, and gold yields nothing. When growth is weak, uncertainties typically abound, profits are squeezed, and gold gets the nod in favor of equities because speculation tends to supplant investment.

The upturn in stocks is thus a preliminary indicator that the economic fundamentals may be shifting in favor of equities, and that, in turn, would suggest that the long-term outlook for the economy is improving. Probably not immediately, but some time in the next few years we could see some genuine improvement in the economic fundamentals. Markets are always forward looking, and this indicator (the ratio of stocks to gold) could be one of the most forward-looking of all. Let's hope so.

Mortgage applications on the rise

Applications for new mortgages, an index of which is shown in the chart above, plunged in the first 5 months of 2010 and hit a 15-year low in 2011. Since then, they have risen 37%. This provides yet more confirmation of the resurgence in the residential housing market. New buyers are coming back into the market. The most recent data available from Radar Logic shows that housing prices are up about 10% from year-ago levels:

Unmistakable signs of growth and recovery

March data released today for industrial production and housing starts show unmistakable signs of growth and recovery. Economic growth in the first quarter of this year is almost certain to be much stronger than the anemic growth of the fourth quarter.

Here's a great example of how a sector of the U.S. economy that suffered a devastating blow during the Great Recession has staged a "V-shaped recovery." Industrial production has expanded by 19% since its low of mid-2009, and is only 1.4% shy of an all-time high. Production is up 3.5% in the past year, and it rose at an impressive 5.7% annualized rate in the first quarter of this year.  

The chart above is a reminder of just how much better the U.S. economy is performing than the Eurozone economy. The Eurozone has been in a recession for almost two years, burdened by the struggling PIIGS economies and the threat of sovereign debt defaults, but the U.S. has shrugged off the problems across the pond and continued to forge ahead.

Pessimists focus on the fact that housing starts today are at levels that marked recessions in the past, but optimists focus (correctly) on the huge improvement on the margin. Residential construction has only recovered about half of what it lost in the Great Recession, but gains in the past two years have been nothing short of spectacular. Starts are up 92% since the end of 2010, they have jumped 49% since the end of 2011, and in the year ended March, they are up 48%. These are rather extraordinary statistics. The most beaten-up sector of the economy is coming back to life by leaps and bounds. Why are there still so many long faces out there?

Gold is re-linking to commodities

This is a followup to my post last Friday, in which I explained why gold's second great rally had ended, and gold's downside risk loomed large. Gold today is down over 11%, to $1350/oz. as I write this. At 11%, that's the biggest one-day decline in over 30 years. The chart above is a good guide to how much downside is left. In short, it looks like gold is on its way to re-linking to commodity prices, with a likely price target of $900-1000/oz.

To summarize my argument of last week, in late 2008 gold began to overshoot commodity prices. Call it an "end of the world as we know it" trade. Gold was reacting to fears that the world's central banks were engaged in a massive money printing scheme that would result in hyperinflation, and/or a global currency collapse. Gold was also propelled higher by the Eurozone sovereign debt crisis, which many thought would lead to the demise of the Euro, and by fears of exploding sovereign deficits that might inevitably be resolved by a big increase of inflation.

Back in January I had a post that offered yet another explanation for why gold rose so much and was headed for a fall: "Developments in China explain the end of gold's rise." It's worth reviewing and updating, because I think the argument has at least some validity, and because we have fresh data today on China's GDP growth and foreign reserves. What follows is a revised and updated version of my January post.

Arguably, there have been only a handful of major developments in the global economy in the past 10-12 years: 1) the Chinese economy enjoyed an unprecedented 10% annual economic growth rate, on average, for most of the past decade, but growth has now slowed to 7-8%; 2) beginning in 2000, China's foreign exchange reserves soared from $170 billion to now $3.4 trillion, and the growth of reserves has now slowed to a crawl; and 3) the price of gold soared 642% from 2001 to 2011, but it has since retreated by almost 30%. It's likely that all three of these developments are related, and that they help explain the recent decline in gold.

China's decision in early 1994 to peg the yuan to the dollar was a key factor driving China's growth, since it brought Chinese inflation rapidly down to the level of the U.S., where it has remained ever since. The prospect of a strong and relatively stable currency not only reduced inflation and its multiple distortions, it also increased the market's confidence in China and that in turn helped boost investment in the country. Indeed, since the yuan has only appreciated against the dollar since 1994, foreign investors benefited from strong Chinese growth and yuan gains. China was the boomtown of the century.

As the first of the two charts above shows, the huge capital inflows that helped China grow needed to be sterilized or accommodated by the Bank of China, otherwise they would have caused the yuan to soar, and that could have short-circuited China's ability to grow. Massive inflows of foreign capital seeking to benefit from rapid Chinese development essentially forced the Bank of China to buy over $3 trillion of foreign exchange, with a commensurate increase in the Chinese money supply. Converting capital inflows into yuan is the only way foreign capital could actually enter the economy, because you can't build a factory or hire workers with dollars—the dollars need to be converted to yuan, and it is the proper role of the BoC to buy those dollars and issue new yuan in the process. Yet despite massive forex purchases, which relieved pressure on the yuan to appreciate, the BoC still had to allow the yuan to float irregularly upwards, in recognition of China's declining relative cost advantage that in turn was a function of huge increases in worker productivity. At the same time, a stronger yuan helped to keep the inflationary pressures of rapid growth under control.

As I explained in this post, it now appears that this process of huge forex purchases and continual yuan appreciation is at or nearing an end. This is a big deal. China's foreign exchange reserves have not increased materially for the last two years, and the yuan has risen less than 1% against the dollar over past five months. Capital flows and trade flows appear to be reaching some kind of equilibrium, just as Chinese and U.S. inflation have converged. Moreover, China's growth rate has slowed significantly in recent years, as shown in the chart above. China is now growing at rates similar to what we saw prior to golds' surge.

The above chart compares the rise in China's forex reserves with the rise in the dollar price of gold, both of which have been impressive over most of the past 10-12 years. China's central bank started buying up capital inflows in earnest in early 2001, right about the time that gold was hitting a multi-year low. This came to an end in early 2011, as net capital inflows to China approached zero, and shortly thereafter gold peaked. Both forex purchases and the price of gold increased by many orders of magnitude over roughly the same period. Now, about 18 months after China's reserves have been relatively stable and 20 months after gold hit its peak of $1900, gold has dropped sharply.

Is there a plausible explanation for the strong correlation between these disparate variables? I think there is, but I can't say so with authority.

Gold bugs like to argue that gold rose because both the Fed and the BoC were "printing money" with abandon. The global monetary base exploded during this period, so naturally gold rose, so the theory goes, because the world was being flooded with fiat currency. Gold was the only port in an eventual inflationary storm.

Yet Chinese and U.S. inflation rates are still relatively low. There has been over a decade of impressive expansion of bank reserves and yuan, but inflation has so far failed to show up. As I explained here, the truth is that the Fed has NOT been "printing money" as is widely believed—the Fed has simply been accommodating a huge increase in the demand for safe securities. The BoC hasn't been "printing money" either, because it has simply been purchasing the net inflow of dollars to China and converting those dollars to yuan so they can accommodate the impressive growth of the Chinese economy.

Don Luskin, a good friend, got me started down the path to an explanation for how China's forex reserves are connected to the rise in the price of gold. He argues that the outstanding stock of gold is relatively fixed—growing only about 3% per year—but that the demand for gold has jumped by orders of magnitude since China, India, and other emerging markets have enjoyed explosive growth and prosperity gains. In other words, the number of potential buyers of gold has risen much faster than the supply of gold, so naturally gold's price has increased. This is not a story about massive money printing and hyper-inflationary consequences, it is a story about a one-time surge in the demand for the limited supply of gold.

That surge in Chinese demand for gold stopped almost two years ago as China's capital inflows have settled down to more manageable levels, and it has exposed the price of gold for what it was all along—a bubble that was inflating and would sooner or later deflate. Gold now is coming back down to more reasonable levels, both relative to other commodities and relative to its long-term average inflation-adjusted price, as seen in the chart above.

I don't see anything wrong here. This is not a reason to panic, unless you are long a lot of gold. And as Larry Kudlow reminds us, the last time we saw a large and sustained decline in the price of gold—in the early 1980s—it was setting the stage for a multi-year economic and equity boom. 

The end of the second great gold rally

The recent 12-year bull market in gold has come to an end. Gold today is 22% below its 2011 high, but it is still 480% above its 2001 low. This could be a wild ride.

The first great gold rally occurred in the 1970s, sparked by Nixon's decision to abandon the dollar's link to gold. The Fed had been failing to tighten policy since the mid-1960s, despite continual outflows of gold which were symptomatic of declining dollar demand and rising dollar supply—in short, dollars were in excess supply. Set free, gold rose from $35/oz. to a peak of $850 in January 1980, for a spectacular gain of over 2,330%, and the excess of dollars combined with loss of confidence in the dollar fueled a surge of inflation. That incredible gold rally was brought to an end by Fed chairman Paul Volcker, who in 1979 decided to slam on the monetary brakes in order to bring inflation under control. From its peak in early 1980, gold proceeded to fall for the next 21 years. 

The chart above converts the nominal price of gold, shown in the first chart, into an inflation-adjusted or constant dollar price. This also highlights how significant the big moves in gold were, and how well they corresponded to sea-changes in monetary policy. The big decline in gold from 1980 through 2000 coincided with generally tight monetary policy that brought inflation down from double digits to only 2%.

The second great gold rally began in 2001, around the time the Fed realized that it had been too tight for too long and began reducing the Fed funds rate target from 6.5% to 1.75% over the course of that year. The PCE deflator fell at a -0.4% annual pace in the second half of 2001, which was the first time it had ever visited deflationary levels—proof that the Fed had been too tight. As the Fed embraced easy money, gold rose from a low of $256 in early April 2001 to a high of $1900 in September 2011, for a gain of 642%. In real terms, gold reached almost the same levels it had in early 1980.

The latest gold rally is now over, having fallen more than 20% from its all-time nominal high. Many will speculate about its origins and its recent demise, but for me it is fairly straightforward. Gold rose because it had been suppressed by 21 years of tight monetary policy which ended in 2002. Gold rose because the market began to sense that the Fed was too easy—that lowering the funds rate target to 1% and keeping it there from mid-2003 to mid-2004 was excessive ease—and that it was an inflationary mistake. And indeed it was: housing prices soared from 2002 through 2006; commodity prices soared from late 2001 through 2008; and the CPI registered a 5.5% increase in the 12 months ended July 2008. After a brief decline in 2008, when the financial crisis caused a surge in dollar demand that the Fed was slow to respond to, gold resumed its upward climb. Commodities also suffered in 2008, but even more so than gold because a the global recession destroyed demand. Like gold, commodities then resumed their rally from 2009 through early 2011. Commodities peaked in April 2011, and gold peaked shortly thereafter, in August 2011.

As the chart above suggests, gold overshot commodities prices by a significant amount over the past five years. Speculative fever, as expressed by numerous analysts and pundits who called for gold to rise to $15,000, $20,000, and even $46,000, could be one reason. The Fed's quantitative easing programs plumbed uncharted depths and caused any number of people, myself included, to worry that the result could be a lot of inflation and perhaps even a collapse of the dollar. Indeed, there was no shortage of reasons for why gold rose as much as it did. Most of the world's major central banks (with the notable exception of the Bank of Japan) became ultra-accomodative in the wake of the global financial crisis and recession. The Eurozone sovereign debt crisis that erupted in 2010 and 2011 threatened the dissolution of the euro, which by then had become one of the world's most important currencies. But one after one, the fears—of hyperinflation, a dollar collapse, or a euro collapse—fell by the wayside, and now the Fed is talking seriously about ending QE3 within a matter of months. 

In a bizarre twist, the Japanese central bank, which had been doggedly pursuing a mildly deflationary monetary policy for decades, is now committed to a reflationary policy. With the recent sharp weakening of the yen, gold in yen terms has finally reached the same level as it did in early 1980 in nominal terms, though it is still about 30% below the inflation-adjusted levels of early 1980.  

Looking ahead, as a first approximation I think gold could fall to $1000 or even less, as it realigns with other commodity prices (see second chart above). Gold bugs: look out below! There are undoubtedly a lot of speculative purchases that may need to be unwound in coming years.