Friday, March 21, 2008

All That Craters Is Not Gold

After a brief foray into historiography, normal service is resumed today, albeit in heavily abbreviated form. The market sure hasn't gotten any easier, has it?

We've seen a 30 point SPX round trip the last two days and enough rumour and innuendo to last a lifetime. The real interesting action has been in the commodity complex, however, which has been absolutely roasted since the "hawkish" outturn of the 6ed meeting.

Gold is the poster child for the decline, as its shed more than $100/oz. However, action in other contracts has been even more ferocious; silver, for example, was nearly 21 a few days ago, closed yesterday below 17. *y caramba!

So is this the start of the deflationary crunch feared by so many? Macro Man finds that difficult to credit. After all, the commodity carnage has come over a time period when stocks have rallied on aggregate. No, it looks like good old-fashioned profit-taking to Macro Man....though it does provide a hint of how hideous true asset deflation could be.


MP said...

It is no secret that commodity markets attracted huge amounts of hot money which lead to increased volatility and erratic price action (both on the up and downside). Even more important, as many of this money has been moving to the longer end of the futures curve in order to avoid roll over effects or execute more complicated strategies, it also distorted basic operations of these markets (hedging of future production, new projects evaluation etc).

It is astonishing how many people are involved in the game today which lack basic understanding of the peculiarities of this market and fail to make a correct assessment of the underlying forces of supply&demand (e.g. cross substitution among metals, geology, production costs, metallurgy, destocking strategies, differences between spot-future and long term contract market, exchange rates, treatment charges for refining and smelting, material flows across the supply chain, power shortages etc).

It seems like the majority is satisfied with the mantras of "commodities offer diversification" and "this is a super cycle". And it's exactly this herding behavior that cancels out any diversification in the first place (as diversification comes from the underlying market dynamics and the mindset of the involved players). Maybe that's enough in order to generate some agnostic driven beta, but in order to capture the alpha trades one needs to dig deeper and carefully overlay the global macro picture on top of the micro picture for each commodity separately.

But as Galbraith once said: "There is far more money out there, than intelligence for the task".

Anonymous said...

This was an accident waiting to happen it didn't take but one glance to see that this had run to far to fast. I might add that IMHOP there are certain governments who have a vested interest in seeing this unravel and when passing out free money in exchange for junk collateral a little arm twisting can not be ruled out. I acquired most of my silver in 2003 and dumped at 21 with a cost basis of less then 5 so there was also some profit taking by longer term investors, not speculators no doubt.

zanon said...

Not sure if gold should be lumped with other commodities. It is money, after all, and should provide a store of value in both high inflationary and deflationary environments.

Commodities with industrial use will fall in a contraction.

MP said...

A classical example of what I was referring to can be found in an article from the Economist:

"Fears of a shortage of hydroelectric power in Chile are helping to buoy the price of copper."

Well, there are power problems in Chile but due to the geography of the country, Chile has four independent electricity grids which are not connected. In the north of the country where copper mining takes place, the grid does not use any hydro power at all. The shortage in hydro is affecting the middle grid (Santiago area where most of the population lives). However, the north grid faces it's own problems due to reduced gas supplies from Argentina which might indeed cause power rationing and lead to reduced copper production.

All in all, the conclusion is right even if based on wrong facts.

Aren't bull markets wonderful?

Bruce said...

I agree with Zannon, after being beaten up by commodities deleveraging, I'm thinking about shorting something like aluminum and staying long gold.

Mencius Moldbug said...

All astute comments. The idea that wheat, oil and gold have something in common because they happen to be traded on the same exchanges with the same mechanisms is horrifying. By any reasonable economic definition, euros, yen and dollars are "commodities" as well - that is, they are fungible goods.

As zanon and bruce observe, gold is predominantly a monetary commodity - as with euros, yen and dollars, its cost is not explained by its physical utility, and there are large stockpiles of it which are not used for any practical purpose.

As with any asset, people who buy a commodity basket without understanding the fundamentals are asking to get burned.

The fundamental pricing principle of a nonmonetary commodity is that the price is right when production equals consumption, and stockpiles exist only to smooth out seasonal or other fluctuations.

If you go long wheat, you are betting that at the present price, consumption would exceed production and stockpiles would drop. As mp says, if you do not believe in this theory, why in the name of great Cthulhu are you making the bet?

But this is not what CRB index buyers are thinking. They are treating wheat as if it was gold. This is just as dumb as treating gold (which, except for minor industrial applications, is not "consumed" in any meaningful way, and whose stockpile can grow without bound) as if it was wheat. Clearly there's a learning process that will have to go on.

When the "free money" finds its way into precious metals, though, look out. Arm-twisting happens, but it's also easy to work around. The Fed has committed to lending unlimited amounts of money at derisory rates to unregulated institutions. Not an easy decision to back out of.

Anonymous said...

Insightful comments abound here at MM. As usual. We are having a lot of commodity-price related discussion on my department. Do you guys have any suggestions of blogs or articles touching the matter?

Mr. Prop said...

Comments are largely on track. I would add that Gold is also a perceived hedge against financial risk, deflation, and inflation. These tail risks have higher than normal deltas when markets simultaneously worry about the costs of the current Fed policy in terms of sewing the seeds for a 2009 inflation problem as well as the other possibility of a Japan-style deflationary outcome. While I reject the latter on the aggressiveness of the Fed response, the US cultural proclivity towards risk taking rather than conservative bunker mentality and different demographics, it is also acquiring some delta. The runup in gold is partly explained by this. The FX link is real but is understood as a confidence issue. The collapse of the gold price and the recovery of the dollar are an early barometer that the Fed and other members of the Illuminati are finally winning the war against the dark forces of the credit crunch. I am a raging bull on financial assets from these clearly misvalued levels

Mr. Prop said...
This comment has been removed by the author.
Macro Man said...

Interesting comments all. Moldbug, I wondered if you could resist the lure of a gold post ;). You are right that there is little (though not zero) correlatiopn between the prices of wheat and gold. But that is the very reason that people like to bundle them up-to create and index of uncorrelated constituents.

The problem arises when this index generates so much demand that the flow of funds becomes the new fundamental determinant of price. And this time, the driver (and thus the price) IS correlated. So much for diversification!

Over the fullness of time, the correlation should recede...thpugh perhaps not before other correlations of unrelated prices- say, the DAX and NZD/JPY.

Mr Prop, good to see you commenting here. I wish I could share ypur level of conviction- during my time off, all my best views have played out, so I am not sure how to play things now.

MP said...

I pretty much agree with Mr. Prop's view on the function of gold.

However I am not sure whether the crisis is indeed over. For sure the radical measures by the FED gave the market some reassurance and that is probably the most important thing right now.

Regarding optimism, I am struggling to understand what could the business model of financial institutions look like in the coming years and how the transition from the defaulted securitization model to the next one will happen.

I suppose we will need again some kind of credit expansion cycle, the question is against what type of collateral? Where will the good credit come from in order to improve balance sheets? (Back to basics might offer a way out.)

And if we indeed avoid the deflation scenario, wouldn't the threat of inflation force towards a tighter monetary policy? And given the double deficit, I assume that fiscal policy might find itself quite restricted as well.

It looks as if the US are currently not facing only a single instability, but rather a bunch of them and it will be hard to stabilize it. There seems to be something fundamentally wrong in the business model of the country as a whole.

BTW: the situation in the UK (especially in terms of household debt vs GDP) doesn't look too good either.

I admit that my knowledge about all these issues is rather limited and my logic might be pointing to the wrong direction. Hence, any feedback would be highly appreciated.

Gregor said...

So is this the start of the deflationary crunch feared by so many?

Nope. As I have written elsewhere, let's make a helpful distinction between deflationary pressures, and paradigmatic deflation. We've had deflationary pressures for over a decade, coming at us in waves from Asia. The 1990's in the USA was accurately described as a Deflationary Boom.

Recently, deflationary pressures have ramped up, for sure. Liquidation in the global banking and credit system is absolutely creating new deflationary pressure. However, the pathway now charted by monetary authorities is clear. So, that pathway combined with an independent cycle of food and energy inflation keeps that balance tipped, for me, towards inflation.

Macro Man said...

In my comment above, I meant, of course, that there is little correlation between the drivers of wheat and gold prices, not the prices themselves....

Mencius Moldbug said...

MM, I'm just glad I wasn't checking the mold price while my wife was in labor! I'll have to give the markets a little more warning next time she's about to pop one out.

Many dollar assets are surely "raging buys" indeed, if you compare their real risk of default to the implied risk as shown by the spread. However, a raging buy in dollar terms (US or Zimbabwean) may not be a raging buy in gold terms.

It's easy to rerun dollar numbers in gold - for future prices, a reasonable guess can be obtained by picking some measure of dollar dilution - M3 or whatever - and assuming a constant ratio. To suck savings back out of gold and into the dollar, for good fundamental reasons and not momentum, panic, false correlation, etc, holding dollar securities should produce a higher expected return in gold than just holding gold.

With the dollar area diluting at 10-20% a year, this is far from being the case. And note that in 1980, it was the case - ie, we have an excellent historical case study in what it takes to rescue a paper currency.

USD has two fundamental problems for which there is no conceivable political solution. One is that its issuer's policies are driven by a number - GNP - which has become quite dependent on continuing asset price inflation. Two is that it has issued large numbers of future commitments ($50T in SS/Medicare) which it cannot renege on, and which it can only pay by debasing the currency.

This is monetary addiction, and it's what kills ya. The whole model of the independent central bank is beginning to fail. The Fed has the power to inflict austerity in much the same sense that the Queen has the power to veto legislation. In theory she does, in practice she doesn't, and if she tried she would fail.

Much the same is true for fiscal austerity measures. I admire Cassandra for her principled and persistent invocation of the A-word - from the left side of the fence, no less. Certainly there are many who realize it is necessary. But the grand old days when mandarins could just mandate, irrespective of the news cycle, are gone. A figure like Volcker is simply unimaginable today.

The root cause of the problem is that the American people have become addicted to inflation, and in America the people are sovereign. Indeed they are more and more sovereign every day - at least, unpopular policies are harder and harder to pursue.

In short: USG is not a failed state. It is nowhere near. But it is a weak state, and weak states inflate. The Fed will find it difficult to get US asset prices - housing or stocks - rising again. Last week's efforts will not do the trick. But it has no alternative, and its only weapon is cheap money.

Anonymous said...

Mr. Prop

You may be right over the intermediate term say until the election this is a prop job but the building is going to fall over anyway.


I agree completely on the printing presses kicking into high gear to pay for entitlements and also see a sharp left turn coming on the political landscape in the US were the illusion of free money for all will will be the chosen way out.
The last Greenspan bubble in US treasuries is nearing it's peak.

Anonymous said...

Moldbug -

I'm traveling with family and have had dastardly time trying to get dedicated time online. I do have some points and an additional thought experiment related to to your post(s) and will follow-up - if not here - then offline (re: both yours in CDT and similar post here). Congrats to you and Mrs Moldy on addition - please send me details off-line..

-Cassie -

Anonymous said...

Mr. Prop if you follow your advice your portfolio will POP UP like corn. Gold was due to correction as many funds in commodities follow indices where gold weighs 20%, so as agriculturals commodities went down , these funds sold gold positions in order to adjust to those indices.
FED is gaining? This is the last bubble to be created , as noboby takes o lends money, FEd must take on that role. Besides,an undervalued dollar is the only thing that can avoid a full recession, it is against the us economy to foster a strong dollar. Too much debt accumulated in the last 15 years amounting to 44trillions , besides 50 billions in future social liabilities, tells me that the party is over.

Anonymous said...

enough of this doom and gloom.

yes, in the long run well all be dead, but dont worry about that, itll take care of itself.

sufficient amounts of snakeoil will drench any and all ills. think outside of that small box. use ur godgiven fantasy. dream. imagine. envision. experiment. create. lead...

Macro Man said...

Freshly arrived back off the plane from Dublin, let me also extend my congrat to Mr. and Mrs. Moldbug on their new arrival....

MP said...

Some thoughts from Peter Bernstein (The shape of the future):