Gold trend says US Fed made policy mistake

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Published: February 14, 2016 9:32:08 PM

Gold and US Dollar are the two different kinds of global currency. Former, being a hard currency whose supply is found in nature and latter being a paper currency, produced by a central bank.

GoldThe very recent period of inverse move occurred during 2013-2015, as speculative flows moved away from hard assets towards financial assets, US Dollar became the currency of choice, and gold became an untouchable. (Reuters)

Today, before I delve into past week’s macro-economic trends let me take you through an important concept in global money, Gold. Gold and US Dollar are the two different kinds of global currency. Former, being a hard currency whose supply is found in nature and latter being a paper currency, produced by a central bank. They both have a disproportionately large credit market which sits on top of their physical supply. Therefore, the total supply of both currencies is determined by their physical supply as well as total credit which is denominated or backing them. In case of gold, that massive credit based supply or derivative supply, which we can refer as synthetic supply, is product of financial institutions, for eg. the derivatives on gold outstanding in CME in US or LBMA, London. In case of the dollar, the synthetic supply of dollar is controlled by banks, banks create dollar money. US Government is also producer of credit based dollar supply. Remember, supply of money is both the physical supply from Mint or Nature as well as the far bigger credit/synthetic supply which comes from the financial institutions and Government. There is a massive amount of US Dollar created outside America, through the EuroDollar market. It is estimated that over USD 10 trillion of USD denominated debt could be there outside US jurisdiction.

Like US Dollar, Gold’s price projection should be done taking into the consideration that overall demand and supply, that is both physical as well as synthetic supply. Gold is not a commodity. Commodity prices, for eg. Copper or oil, are driven by above ground inventory to demand ratio, higher that ratio, more the downward pressure on prices. If Gold were to be priced like commodities, then measuring above ground supply and physical demand, would be such a massively higher number, because all that has been mined is more or less still present above ground and not consumed, that it will value gold at near zero. Gold is more like a currency, which value is driven relative money supply growth and not already existing total supply (physical + synthetic ).

Gold does not have any interest rates on it. However, paper currencies are supposed to have some kind of interest rates. Therefore, when the interest rates on the US Dollar are high enough to offset the higher relative money supply between US Dollar and Gold, Gold tends to lose value against US Dollar. In real world prices are also affected by speculative interest in asset prices denominated in the fiat currencies and also the speculators in Gold trying to front run such shifts in relative money supply and cost of money.

Plotting the US Dollar Index against the US Gold prices, they exhibit an inverse relationship. The very recent period of inverse move occurred during 2013-2015, as speculative flows moved away from hard assets towards financial assets, US Dollar became the currency of choice, and gold became an untouchable. However, that has reversed since December of last year. Since mid-December, Gold prices have recovered 20% from the depths of USD 1047 per ounce and US Dollar Index has lost around 5%. Mid-December was when the US Fed hiked interest rates by 25 bps. The very fact that the inverse move occurred between Gold and US Dollar since then is a clear sign that Gold is saying that US Fed has made a policy mistake. Market is pricing the increased likelihood that US Fed would not be able to resist the debilitating impact of world economic slowdown on the US economy, and will eventually be forced to ease monetary policy. The easing may happen in any combination of: 1) Rates down to zero 2) Rate down to negative zone 3) Higher infusion of US Dollar money through physical supply like QE 4) Higher infusion of synthetic US Dollar through lax fiscal policy.

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