Gold: Mercury for the Financial System

We take a look at gold and the US dollar, and what their price movements say about financial markets.

This year’s rally has been driven by six ‘puts’, in our view. All show how far policymakers could go to avoid disruption. None are a solution.

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While trade wars have been the story of the last few months, we believe that the tail risks – rather than either the US or China – lies in Europe, particularly within the banking sector.

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Will negative yields in Switzerland create M&A heaven; and has Value reached the end of its ebb tide?

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In commentaries earlier this year, we identified six puts which were supporting the market, and explored the vulnerability of the European banking system to the US-China trade war. The trade deal put has, so far, failed to materialise completely. Instead, a series of mini-deals might occur, leaving our put roughly intact: President Donald Trump has continued to increase some US tariffs against China, adding a further USD110 billion on 1 September 2019, while delaying the implementation of others.1,2 Protests in Hong Kong, the collapse of Italian governing coalition, the rising likelihood of a no-deal Brexit and the collapse of the Argentine stock market have all contributed to make the summer of 2019 febrile rather than restful.

Pressure Points

Markets have barely reacted to this ongoing pressure, with the S&P 500 Index down only 1.8% during the month of August 2019. This is largely due to support from the Federal Reserve, which cut its key rate for the first time in a decade, and the European Central Bank, which provided a comprehensive stimulus package. However, recession indicators are flashing: the US 10-year/2-year yield curve has inverted, and the Fed calculated the probability of a recession before July 2020 as 31.5% — a higher figure than the start of 2007 (Figure 1).3

Figure 1: Probability of Recession Predicted by US Treasury Spread

Source: New York Fed, as of 2 August 2019.

In Europe, the picture is equally bad, with the German economy heading for recession after contracting 0.1% in the second quarter of 2019. With the prospect and subsequent announcement of further quantitative easing from the ECB, European yields are turning negative across much of the curve. Some non-euro issuers, such as Denmark and Switzerland, have had their yield curves turn entirely negative. In these circumstances, it becomes unprofitable for banks to continue to lend. This relationship is already being priced in by equity markets: the Euro Stoxx Banks Index is trading at 80.7, below its 2009 level, and only slightly above its nadir during the Greek Crisis of 2012 (Figure 2).

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Source: Bloomberg, as of 2 September 2019.

What exacerbates the short-term risk for Europe, in our view, is that the region relies on its banking sector to provide corporate financing via direct loans to much greater extent than the US, where corporates traditionally turn to the bond market to provide financing. Some 70% of European corporate financing is delivered via bank loans, as opposed to 30% for the US.4


In the midst of this uncertainty, it is not surprising that the price of gold has increased (Figure 3).

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Source: Bloomberg, as of 2 September 2019.

Gold’s price is driven by three factors: industrial demand; its status as a financial asset (investment demand); and demand from consumers in the form of jewellery and bullion. It’s worth noting that consumer and industrial demand far outweigh investment demand: BCA Research estimates that the latter forms only 28% of total demand for the metal.

Still, we believe it is this investment demand that is the driver behind the recent gold spike. The two components of investment demand are as a haven asset and as a hedge against inflation.

With regards to the latter, eagle-eyed readers will comment that inflation expectations are the lowest they have ever been, as priced by the 5-year, 5-year inflation swap (Figure 4). Our answer to that is that we believe investors are looking beyond the inflation expectations and forecasting a scenario where worries about a fiat currency system would abound.

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Source: Bloomberg, as of 12 September 2019.

So, the bond market at least does not expect inflation, yet gold is spiking. A possible explanation for this anomaly is that gold buyers are expecting low inflation in the short term, but are looking one step further. Central banks have spent years trying to stimulate inflation, with both conventional and unconventional monetary policy tools. If this fails (and the swap rate implies that the market expects continued failure), it seems reasonable to expect further unconventional monetary policy such as Modern Monetary Theory, which could cause central banks to lose control of inflation.

With regards to haven demand, market volatility, trade uncertainty and geo-political concerns have provided the obvious catalyst for a risk-off move. What is unusual is gold’s relative attractiveness versus other haven assets. Ultra low and negative interest rates have reduced the opportunity cost of holding gold. For instance, Swiss franc deposit holders are now charged 75 basis points annually – holding gold, a non-paying asset, is no longer quite so painful in such a scenario. The paucity of return from currencies and government bonds is assisting gold’s strong performance.

Indeed, one way of interpreting the price of gold is as a rough barometer of systemic risk, with the rush to gold having a strong correlation with periods of financial stress. Long before the collapse of Lehman Brothers and Bear Stearns, gold was rising in response to the increasing risk, rising nearly 60% between January 2005 and July 2007. In a worrying trend, gold has risen 18% between 1 May and 31 August in 2019.

Partly in reaction to this perceived risk, central banks are busily buying up gold reserves. The central banks of both China and Russia have engaged in large-scale gold purchasing (Figure 5), which accounts for almost the entire global annual output, according to BCA Research. This is an interesting choice: previously, emerging market central banks have often chosen to build foreign exchange reserves, particularly their US dollar reserves. Why then, is gold benefitting so much, and the dollar so little?

Figure 5: Central Bank Gold Purchasing

Source: BCA Research, IMF, as of July 2019.

Why Not the Dollar?

We don’t normally like to comment on currencies – it is not really the business of long/short equity specialists to weigh in on the FX markets. In this particular case, we will make an exception. The impact of the strength of the dollar as a driver of sector rotation between importers and exporters makes it difficult to invest in equities without keeping an eye on what the dollar is doing. At this moment, it feels as if the dollar is at a crossroads, with a variety of tailwinds and headwinds making a directional prediction fraught with risk. Nevertheless, fundamental analysts still have to account for the impact of dollar moves on exporters, so we will endeavour to grapple with the topic.

On the face of it, there are many reasons for the dollar to appreciate: the US is one of the few major economies to have positive yields across the curve; it is currently the strongest global economy; it is enforcing a tax amnesty which should encourage US corporations to repatriate capital; and the Trump administration is applying tariffs, a theoretical benefit to the dollar. Why, then, is the dollar not rampant?

In our view, six factors are holding back its appreciation: the relatively high US interest rate, President Trump’s attack on the Fed; the spiralling US budget deficit; the size of the global dollar short; the weaponisation of the dollar; and the ramifications from quantitative easing.

Wither regards to the first factor, the Fed has more room to cut rates than other developed central banks. After the rate cut at the July Federal Open Market Committee meeting, market participants are pricing in 100 basis points of rate cuts by 29 April, 2020, weighing on any appreciative dollar moves.

The political backdrop reinforces this behaviour. Despite a tight US job market and a healthy domestic economy, President Trump is currently baying for rate cuts and quantitative easing to further boost economic growth.5 A nadir was reached on 23 August, when Trump asked: “who is our bigger enemy [Fed Chairman Jerome Powell] or President Xi?”6 Such direct criticism of the Fed is unprecedented. Whilst Powell will continue to assert its independence, ultimately, Fed governors are appointed by the president, who has two vacancies to fill on the board. It is unlikely, in our view, that Trump will appoint hawks. The only reason this is not having more of an effect on the dollar, in our view, is that the rest of the world is loosening monetary policy even more.

President Trump’s tax cuts have also increased the size of the US budget deficit by 27% year over year in the first 10 months of the fiscal year 20197. Indeed, the deficit is projected to rise to more than USD1 trillion by 2022. As the size of the deficit increases, the temptation for the US to print away its debts will increase in lockstep, a factor which in our view will weigh on the dollar for years to come.

Also weighing on the dollar is the size of the global short position. Created by non-US banks lending in US dollars, the position stands at USD12.8 trillion as of the end of June 20188, according to the Bank of International Settlements. This is a sizeable, if unpredictable, factor preventing dollar depreciation. We would caveat this by saying in the event of a shock which caused the dollar to appreciate, this could cause a vicious unwind as shorts rush to cover their position. A trade this crowded is, in our view, highly unpredictable.

This brings us to another factor: the weaponisation of the dollar. Any transactions made in dollars, whether within or outside the US, ensures engagement with the US financial system – something that French bank BNP Paribas learnt the hard way, when in 2014, the US not only fined it a record USD9 billion for money laundering crimes, but also in an unprecedented move, restricted the bank from conducting certain dollar transactions for a year. With more than 40% of international payments being made in US dollars, these actions could discourage institutions and countries from transacting in dollars to avoid legal repercussions, and thus depress demand for the currency. Indeed, we have already started these instances starting to occur: Under a 25-year deal reportedly sealed in August 2019, China will buy – in renminbi – oil, gas and petrochemical products at discounted prices from Iran. This allows China to bypass the dollar-denominated international financial system. Should we see more instances of such fines and restrictions, the long-arm of Uncle Sam could be a drag on the dollar.

As the risks of a recession mount, central banks have very few monetary policy tools to play with after QE. Helicopter money, either by direct printing or the application of Modern Monetary Theory, could become the next policy in line. It is thus perfectly plausible that investors’ faith in fiat money is reduced. In this context, the PBOC and the Bank of Russia’s decision to buy gold makes a great deal of sense. This reasoning is somewhat speculative, but the short-term consequences of Russia and China’s gold purchasing are not: money that would have been used to build dollar reserves is now being used to buy gold.


Currency moves in 2019 have made FX analysis an important part of bottom-up analysis for sector specialists. Whilst the trajectory of the dollar is not certain, given the size of the global dollar short position, the assumption that the dollar will act as a haven in the next crisis may not be tenable given the possible trajectory of monetary policy.

It is now imperative that managers guard against systemic risks, in our view. With that in mind, managers should have more than one eye on the price of gold. As a leading indicator of tail risk in financial markets, the move higher in the price of gold is concerning.





4. Source: Man GLG