One Chart Which has the Gold Bugs Jumping

• Why the Fed are not “printing money”
• US personal savings rate as high as they have ever been
• Gold likely to keep trending higher… 

At the beginning of this year – one prediction I had was keep an eye on gold. 

I said it could be in for a good year… 

Three primary reasons (but not limited to):

(1) the weekly trend was bullish – offering a target of $1,800
(2) the yield curve told me in mid-2019 a recession was likely within 18-24 months
(3) the yield on 5-year TIPS was plummeting…  which meant gold prices were likely to rally. 

And now we have a fourth reason – which I will get to shortly. 

But let’s start with gold… as it remains a buy. 

Gold’s Bullish

Whilst equities have staged a remarkable 37% comeback in less than 10 weeks… now within single digits of the S&P 500 all-time high… gold is not far behind.

Gold has continued to trend higher – despite the recent “risk on” environment – maintaining its weekly bullish trend: 

Gold – May 28 2020

The weekly trend shift (and initial buy signal) was around $1270 – in December of 2018. 

At the time I was wary of resistance of $1,400 – which we saw for a period. 

However, as soon as we broke that major 7-year resistance level – it was off to the races. 

In short, look to buy gold at or around the 35-week EMA – with a stop of the last major low of $1,450

Gold is almost certainly going higher – but it won’t be in a straight line. 

5-Year TIPS Yields Confirm

If you want to know where gold is headed – look no further than what we see with 5-year TIPS yields. 

If the economy is improving – these yields will rally.

On the other hand, if the bond market sees trouble ahead (which it does) – these yields sink like a stone. 

Today these yields are negative (which I will show below)

Now when you inverst these yields and plot them against gold – they generally track each other closely. 

Here’s what we see: 

Gold vs 5-Year TIPS Inverted – May 28 2020

Long-term readers will know this is one of my favourite charts in finance (and one rarely cited by mainstream). 

Put simply – if you want to know if the outlook for the economy is improving – then look for 5-Year TIPS to start rising.

For example, you can see from the chart from November 2018, the bond market started taking a negative view of the economy (well before the onset of COVID-19). 

Note – the blue line (TIPS Yields) are inverted. Therefore, if the line is rising, it means the yields are falling (axis on the left-hand side)

5-Year TIPS yields are our best real-time proxy for how bond market participants are thinking about forward economic growth. 

As I mentioned above, TIPS 5-year yields are negative 0.5% – as bad as we have seen in many years. 

And whilst equities think good time are ahead – the price action in both the gold and bond market do not agree. 

Remember: bond investors are generally right and early. 

But this is the Chart to Watch… 

And whilst both of these charts are justify a high probability position in gold… the chart below has gold bugs salivating like a kid in a candy store… 

US M2 Money Stocks Annualized Change YoY

In short, this is M2 Money Stock.

If there was ever such a thing as a “TIME Magazine” chart of the year for 2020 – this would be it. 

I doubt anyone – not even the perpetual crash callers – could have seen anything like this. 

In fact, we have never seen anything like this. 

And as I will explore below – we don’t know what the consequences will be.

As Warren Buffett said during his annual shareholder conference… “they could be extreme”.

In the past six months – M2 Money Supply is up 40% annualized rate, and in the past year (the chart above), M2 has increased by over 23%,

And guess what – these numbers have not stopped rising.

This is a big deal.

Because if this is mismanaged – then there’s a possibility the US dollar turns into confetti.

But to be clear – I don’t think that will happen. 

Why the Fed are not “Printing Money”

Google Search the term “Fed Money Printing” and this is what you will find…

Printing money from thin air”….”Fed’s back money printing again”… “more helicopter money”… is often the gist. 

And whilst the sentiment is right – the basic understanding of how the Fed creates money is typically inaccurate. 

First up, when the Fed conducts these “money printing” operations – they are supplying reserves to accommodate the banking sector’s demand for safe assets

Before I continue – I want to call out the excellent work of Scott Grannis here – who talked about the Fed operations here. 

For me, no-one has done a better job of explaining how the Fed conducts monetary operations (and possible implications).

What follows is largely an extract of his work (but I encourage you to read it first hand)

Grannis first reminds us that this doesn’t immediately result in inflation.

He cites economist Milton Friedman – who once told us – inflation only happens when the supply of money exceeds the demand for it.

Now today – the demand (as I will show) has never been greater. 

With respect to inflation itself – it remains well below 2% (the Fed’s target level).

And it’s been that way since 2008… despite at the time the “gold bugs” pounding the table that these actions from the Fed would produce Argentine-style inflation.

But it never came. 

In effect, this demonstrates how the Fed was not really “printing money”

Here Grannis points us to the most important feature of the US monetary system – and this is the Fed can not create money directly.

This can only be done by the banks.

Now what the Fed can do is make it easier for banks to create money by increasing the supply of bank reserves.

And this is what they did with their latest operations. 

Grannis adds that banks need reserves in order to collateralize their deposits.

The Fed creates reserves by buying securities (e.g., Treasury bills, notes and bonds, and more recently, mortgage-backed securities and some corporate bonds).

In effect, the Fed buys securities and pays for them with bank reserves.

But what’s important is these reserves are not money that can be spent anywhere.

Grannis explains that what happens is the Fed simply swaps reserves for notes and bonds. And this is known as the transmogrification (word of the day) of longer-term securities into short-term, risk-free securities.

Money Demand is High

Grannis goes to lengths in his post to talk about money demand.

Obviously in times of great uncertainty (not unlike what we saw during 2008) – the demand for safe assets and cash equivalents is massive.

For example, personal savings rates are as high as they have ever been – surging to levels well beyond previous recessions (hitting 33% in April)

As a result of the insatiable demand (and as Grannis explains) – the Fed fills the market’s need for short-term safe securities by buying riskier securities and paying for them with risk-free reserves.

A couple of things happen from here….

First, if the banks don’t want to hold the reserves they can use them to support increased lending, which will see monetary expansion.

Now if that monetary expansion exceeds the market’s demand for money – then watch inflation jump. 

So far, that is not the case.

Today, US bank excess reserves total $3.2 trillion (May 2020)—have served to satisfy the banking system’s demand for risk-free, short-term assets

Excess Bank Reserves

But what’s more – with 40M+ people into forced into unemployment (thanks to the actions of government — not the private sector) – the Fed’s operations were also to immediately satisfy the public’s demand for a massive increase in bank savings deposits

So Will We See Hyper-Inflation?

Grannis says it’s possible. But unlikely.

And I agree…  

Now at some point (hopefully soon) – the sheer panic over COVID-19 eases – and the demand for money once again begins to decline. 

But that’s going to take time (especially given what we see with savings rates). 

At this point – the Fed will reverse course – by eliminating bank reserves. 

For example, they will start to sell treasury notes, mortgage backed securities and corporate debt (and you can be sure the market will be paying very close attention – especially with respect to corporate debt!) 

Who is going to buy it? And what’s a fair price?

Another question for another day.

But the big question is will we find the market “flooded with money” as a result of their actions? 

Let’s hope not. 

And perhaps as a bit of insurance (and the tape certainly supports the thesis) – maybe allocate up to 10% of your portfolio (not more than) to holding a few of those gold bars. 

Yes it’s insurance against the Fed losing control (and the mismanagement of government) –  but the yellow metal is likely to continue rising in this climate. 

I don’t see that changing… and do I see bond yields rising. 

If anything – I see the 10-year turning negative. 

As an FYI – from 1971 to 2020 – gold has appreciated ~8.1% per annum on average.

Not bad for an insurance contract.

And whilst risk assets (stocks) have outperformed gold (inclusive of dividends) over the long-run – the yellow metal is not too far behind. 

Regards
Adrian Tout