Lighthouse

Precious Metals Report - August 2014

Precious Metals

Why is
September


Lighthouse Investment Management
August 2014
Precious Metals Report
Why is Gold Price Declining?
ptember 2014
Page 1
Report

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Precious Metals Report - August 2014 Page 2

Contents
Why Is The Price of Gold Falling? .................................................................................................................. 3
Commodities: Bear-Market .......................................................................................................................... 4
Currencies: Strong Dollar .............................................................................................................................. 5
Reasons For Dollar Strength ......................................................................................................................... 6
Nominal Yields: Slight Increase ..................................................................................................................... 7
Real Yields: Notable Increase ........................................................................................................................ 8
Inflation Expectations: Falling ....................................................................................................................... 9
US Inflation: Slow-down.............................................................................................................................. 10
Central Bank Balance Sheets (combined) ................................................................................................... 13
Central Bank Balance Sheets (y/y change).................................................................................................. 14
Swiss Gold Exports by Region: What About China? .................................................................................... 15


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Precious Metals Report - August 2014 Page 3

Why Is The Price of Gold Falling?
Year-to-date, gold is up 1%, while silver has lost 9%:

While gold's performance this year is far from disaster, it certainly feels that way.
Why is gold performing so poorly when the stock market is making new all-time highs?
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Commodities: Bear-Market
Precious metals are not alone; some commodities have fared worse:

The CRB commodity index is unchanged for the year
Crude oil (WTI), Natural Gas (US) and Platinum are down 5%
Copper and Lumber are down 11%
Crude oil (Brent) is down 12%
Wheat is down 22%
Corn is down 23%
Soybeans are down 29%

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Precious Metals Report - August 2014 Page 5

Currencies: Strong Dollar

The Dollar has been strong against all major currencies, particularly since mid-July
While the weakness of the Japanese
Yen is significant, the Euro has been even
weaker over the past five months
Gold (black dotted line) can be
considered as a currency. A strong dollar
often implies a weaker gold price, and vice
versa.
The negative correlation between
dollar ($USD, chart on left) and gold is
currently very strong (-0.95)

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Precious Metals Report - August 2014 Page 6

Reasons For Dollar Strength
While the US economy grew 4.6% (real, quarter-on-quarter annualized) in Q2, Europe has slowed
down (some countries dropped back into recessionary territory). China (finally) seems to experience
a significant slow-down in growth.
The US Central Bank (Fed) has continued reducing monthly asset purchases, and is likely to end
them in Q4.
The European Central Bank (ECB) has done the opposite; after reducing its balance sheet by roughly
1 trillion Euro it recently pledged to reverse that decline:

As a result, the Fed is getting less expansive at the same time as the ECB is getting more so. Less
additional supply of dollars is meeting increased supply of Euros.

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Precious Metals Report - August 2014 Page 7

Nominal Yields: Slight Increase

While nominal US government bond yields have risen slightly over recent weeks...


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Precious Metals Report - August 2014 Page 8

Real Yields: Notable Increase

... real yields have seen a break in down-trend (10y, 30y) or broken above recent highs (5y)
REAL yield = NOMINAL yield minus INFLATION
You can turn this formula around in order to get implied inflation (or inflation expectations):
INFLATION EXPECTATIONS = NOMINAL yield minus REAL yield
You will find the resulting chart of inflation expectations on the following page

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Precious Metals Report - August 2014 Page 9

Inflation Expectations: Falling

Inflation expectations, especially in the medium (5y) horizon, have been falling significantly (from
2% to 1.6%) since July.
This might seem counter-intuitive given accelerating US growth. However, bond investors seem to
expect growth to slow down after the end of QE ('quantitative easing'), combined with a possible
interest rate hike in 2015.
Lower inflation expectations are negative for real assets such as commodities, including gold.

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Precious Metals Report - August 2014 Page 10

US Inflation: Slow-down

The increase in core (excluding food & energy) US consumer prices as slowed down significantly in
August to less than 1% (last 3 months annualized).
The Fed will not like this picture; inflation remains below its target range of 2 to 2.5% (and might
drop further)
The Fed needs to fight deflationary pressures (resulting from an overbearing load of debt). Nominal
debt remains serviceable only in a growing economy. If real GDP growth is not sufficient, the
difference must be made up by inflation (Nominal GDP = real GDP plus inflation).
Therefore, I expect the Fed to react with renewed expansion of its balance sheet if economic growth
and/or inflation show persistent signs of weakening. This should be positive for gold.
A new 'twist' could be the purchase of foreign government bonds (as the Fed already owns almost
half of all Treasury securities maturing in more than 10 years). It would also stop recent strength in
the US Dollar (as the Fed would purchase foreign currency and sell USD). This might upset foreign
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Precious Metals Report - August 2014 Page 11

central banks (as it would disrupt their plans to cheapen their own currency) and could lead to a
"war of central banks".
The Swiss National Bank (SNB) is already faced with such a dilemma: Defending the Swiss Franc
(preventing it from becoming too strong) requires the SNB to sell CHF and buy Euros. Keeping Euros
at the ECB will, due to negative deposit rates, lose money. The SNB hence invests it in Euro-zone
government bonds. The SNB cannot afford to lose money on its investments (it lost CHF 18bn in the
18 months preceding the 1.20 cap) as it is politically sensitive (and cost former SNB-chief
Hildebrandt his job). Hence the SNB can only purchase AAA-rated Euro-zone government bonds. The
only market large enough to accommodate SNB buying is the German one. I suspect that this has
helped the recent collapse in German government bond yields (10yr below 0.9%, negative yields all
the way out to 3yr). It looks as if the SNB's resolve will be tested again:

Buying short-term government bonds at negative yields by a foreign central banks amounts to a
direct subsidy from the taxpayers of one country to another (German government actually makes
money by issuing debt at negative yields). This, too, will be difficult to explain to Swiss citizens.
As a final, desperate measure, the Fed could purchase gold in large amounts. In the end, it does not
matter what kind of assets central banks purchase; any purchase increases the amount of currency
in circulation (which should help stoking inflation).
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Precious Metals Report - August 2014 Page 12

A strong increase in the gold price might also steer inflation expectations into the 'right' direction.
'Gold bugs' are often ridiculed as $15 trillion of money printing has not created any inflation until
now. Jim Rickards describes the current equilibrium as a tug-of-war between strong deflationary and
inflationary pressures. The Fed's balance sheet expanded by roughly $3 trillion to 4.1 trillion.
However, commercial banks' excess reserves went from zero to $2.7 trillion. Hence 90% of the
money the Fed created returned 'unused' to the Fed. On the other hand, the shadow banking sector
experienced a serious deleveraging. Asset backed securities outstanding in the US declined from
$4.5 trillion to $1.6 trillion. That's 3 trillion of financing not available any more.
On the surface conditions might appear stable, but deep inside the system is cracking:

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Precious Metals Report - August 2014 Page 13

Central Bank Balance Sheets (combined)

Over the past decade, the combined balance sheets of the top-6 Central Banks have gone up
from $3 trillion to $15 trillion.
For comparison: the value of gold held by the world's central banks is a mere $1.25 trillion.

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Precious Metals Report - August 2014 Page 14

Central Bank Balance Sheets (y/y change)

Economic stimulus via 'Quantitative Easing' is constantly changing, as the above chart shows.
Central Bankers tried twice (2010, 2012) to taper off the monetary faucet, but failed each time.
Additionally, the ECB deviated from the crowd in 2013 (but reversed course this summer).




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Precious Metals Report - August 2014 Page 15

Swiss Gold Exports by Region: What About China?

Looking at Swiss gold exports by region clearly shows the overwhelming demand from China
However, exports to greater China have declined dramatically over the past months (from a
peak of 37t to 3t for China, and from 99t to 3t for Hong Kong).
It is hard to say whether the decline is caused by lack of supply or lack of demand.
The gold price has not moved much in H1 2014. The Chinese continue to have a huge amount of
USD denominated FX reserves, and too little gold reserves compared to their GDP. The most
likely interpretation is that, somewhat shockingly, the London gold vaults are nearly empty. The
Chinese are too smart to push the gold price up by continuous purchases. They need much
more, and want to avoid a buying panic.
Alternative explanation: the Chinese have reached the desired amount of gold.
The Shanghai Gold Exchange (SGE) launched Yuan-denominated gold futures contracts on
September 18. Those contracts will be settled by physical delivery.
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Precious Metals Report - August 2014 Page 16

Contracts with "Au9999"-specification (99.99 purity gold, 1kg bars) were the most frequently
traded ones.

"London Good Delivery" bars have only 99.5% purity (and hence are not eligible for delivery at
the SGE)
China strives to become the trading (and price) center for gold.
Therefore, London (and COMEX) will become less important in setting (and manipulating?) the
gold price.


Any questions or feedback highly welcome.
Alex dot Gloy at LighthouseInvestmentManagement dot com
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