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The end of the second great gold rally

The recent 12-year bull market in gold has come to an end. Gold today is 22% below its 2011 high, but it is still 480% above its 2001 low. This could be a wild ride.


The first great gold rally occurred in the 1970s, sparked by Nixon's decision to abandon the dollar's link to gold. The Fed had been failing to tighten policy since the mid-1960s, despite continual outflows of gold which were symptomatic of declining dollar demand and rising dollar supply—in short, dollars were in excess supply. Set free, gold rose from $35/oz. to a peak of $850 in January 1980, for a spectacular gain of over 2,330%, and the excess of dollars combined with loss of confidence in the dollar fueled a surge of inflation. That incredible gold rally was brought to an end by Fed chairman Paul Volcker, who in 1979 decided to slam on the monetary brakes in order to bring inflation under control. From its peak in early 1980, gold proceeded to fall for the next 21 years. 


The chart above converts the nominal price of gold, shown in the first chart, into an inflation-adjusted or constant dollar price. This also highlights how significant the big moves in gold were, and how well they corresponded to sea-changes in monetary policy. The big decline in gold from 1980 through 2000 coincided with generally tight monetary policy that brought inflation down from double digits to only 2%.

The second great gold rally began in 2001, around the time the Fed realized that it had been too tight for too long and began reducing the Fed funds rate target from 6.5% to 1.75% over the course of that year. The PCE deflator fell at a -0.4% annual pace in the second half of 2001, which was the first time it had ever visited deflationary levels—proof that the Fed had been too tight. As the Fed embraced easy money, gold rose from a low of $256 in early April 2001 to a high of $1900 in September 2011, for a gain of 642%. In real terms, gold reached almost the same levels it had in early 1980.

The latest gold rally is now over, having fallen more than 20% from its all-time nominal high. Many will speculate about its origins and its recent demise, but for me it is fairly straightforward. Gold rose because it had been suppressed by 21 years of tight monetary policy which ended in 2002. Gold rose because the market began to sense that the Fed was too easy—that lowering the funds rate target to 1% and keeping it there from mid-2003 to mid-2004 was excessive ease—and that it was an inflationary mistake. And indeed it was: housing prices soared from 2002 through 2006; commodity prices soared from late 2001 through 2008; and the CPI registered a 5.5% increase in the 12 months ended July 2008. After a brief decline in 2008, when the financial crisis caused a surge in dollar demand that the Fed was slow to respond to, gold resumed its upward climb. Commodities also suffered in 2008, but even more so than gold because a the global recession destroyed demand. Like gold, commodities then resumed their rally from 2009 through early 2011. Commodities peaked in April 2011, and gold peaked shortly thereafter, in August 2011.


As the chart above suggests, gold overshot commodities prices by a significant amount over the past five years. Speculative fever, as expressed by numerous analysts and pundits who called for gold to rise to $15,000, $20,000, and even $46,000, could be one reason. The Fed's quantitative easing programs plumbed uncharted depths and caused any number of people, myself included, to worry that the result could be a lot of inflation and perhaps even a collapse of the dollar. Indeed, there was no shortage of reasons for why gold rose as much as it did. Most of the world's major central banks (with the notable exception of the Bank of Japan) became ultra-accomodative in the wake of the global financial crisis and recession. The Eurozone sovereign debt crisis that erupted in 2010 and 2011 threatened the dissolution of the euro, which by then had become one of the world's most important currencies. But one after one, the fears—of hyperinflation, a dollar collapse, or a euro collapse—fell by the wayside, and now the Fed is talking seriously about ending QE3 within a matter of months. 


In a bizarre twist, the Japanese central bank, which had been doggedly pursuing a mildly deflationary monetary policy for decades, is now committed to a reflationary policy. With the recent sharp weakening of the yen, gold in yen terms has finally reached the same level as it did in early 1980 in nominal terms, though it is still about 30% below the inflation-adjusted levels of early 1980.  

Looking ahead, as a first approximation I think gold could fall to $1000 or even less, as it realigns with other commodity prices (see second chart above). Gold bugs: look out below! There are undoubtedly a lot of speculative purchases that may need to be unwound in coming years.


Claims back on track

As I noted last week, the jump in claims was bogus, the result of flawed seasonal adjustment assumptions. This week claims fell by more than they rose last week, so claims are back on their declining trend.


At this rate, it won't be long before we see claims fall to 300K per week or a bit less, and that is about as good as it gets for the labor market. The most important thing that claims tell us is that there is no sign of any deterioration in the labor market, and therefore a recession or even a signficant slowdown in growth is very unlikely.



One of the most significant trends in today's labor market is the decline in the number of people receiving unemployment insurance. That is down by over 19% in the past year, or 1.24 million people. This is a powerful trend, since it creates incentives for large numbers of people to seek out and accept employment. Many have no doubt been discouraged in this effort, however, as witnessed by the very weak growth of the labor force—millions have simply "dropped out" and decided to stop looking for a job. But many of those are likely still on standby, ready to re-enter the labor force should job opportunities and other incentives to work improve.

Come and get it


This isn't the first time I've called the low in mortgage rates, but it could be the last. The chart below shows the nationwide averages according to BanxQuote: currently 3.49% for conforming, and 3.68% for jumbo loans. Jumbo rates briefly dipped to as low as 3.55% last December. That could well prove to the be lowest level in my lifetime. All it takes for rates to move higher is continued economic growth, even if it's relatively sluggish. That would bring the Fed closer and closer to the end of its QE3 program, and the Fed is already hinting that they might well discontinue it before the end of this year, or as early as mid-year.


The Fed now owns about 11% of the nation's $9.5 trillion of home mortgages (data in the chart only goes up to the end of last year, but the Fed is still buying $40 billion of MBS per month). This is not likely to increase much before QE3 ends. I don't think that Fed purchases of MBS have resulted in any meaningful reduction in mortgage rates, but I could be wrong. In any event, the end of QE3 means that the Fed thinks the outlook for the economy is improving, and that should help dissuade the market from continuing to pile into and/or hold long-term, fixed-income securities that are trading very near all-time lows.

For investors it's a warning shot across the bow. For home buyers, it's "come and get it!"

And if I'm wrong and mortgage rates continue to decline, it's relatively easy and cheap to refinance.

UPDATE: I should add that with the deductibility of mortgage interest and inflation, a 30-yr fixed-rate mortgage is essentially free money. The CPI has averaged about 2.5% for the past 15 years, and most folks with a jumbo loan should be able to deduct about 35% of the interest. The after-tax interest cost would be about 2.5%, and subtracting inflation of 2.5% gives you zero.

There are of course downside risks. You would be exposed to a further decline in housing prices, another recession, and/or a bout of deflation. But if any or all of those happen, interest rates are likely to decline further, leaving open the possibility of refinancing.

Impressive progress in the federal budget

Thanks to a gridlocked Congress and a recovering economy, the federal budget has registered some impressive improvements in the past three years. Spending has not increased at all, while tax revenues have surged by over $550 billion, with the result that the burden of the federal budget deficit has dropped almost in half, from 10.5% of GDP to 5.75%. As the federal government absorbs less and less of the economy's output, this opens the door for a stronger private sector. This is a very encouraging development that is not widely appreciated or understood.


For the 12 months ended March, 2013, federal spending was $3.49 trillion. As the chart above shows, spending has not increased at all since the end of the 2008-09 recession. Revenues, in contrast, have risen from a post-recession low of $2.02 trillion to $2.58 trillion in 12 months ended March, 2013. The federal budget deficit has fallen from a high of $1.47 trillion in late 2009 to $910 billion in March of this year. Revenues are now only about $20 billion shy of an all-time high. This is real progress: the best way to grow revenues is to grow the economy without raising tax rates, and the easiest way to "cut" spending is to just not let it grow.


Despite no effective increase in tax rates in recent years (and in fact a 2-yr reduction in payroll taxes), revenues have grown much faster than GDP—as is typical during a recovery.


With spending flat but nominal GDP now up over 15% since the recovery started, federal spending as a percent of GDP has fallen from a high of 25.2% to about 22%. It is now within the post-war historical range.


The chart above combines the previous two charts for a better historical picture of what's happening. Both revenues and spending are slowly but surely coming back into line with their historical averages.


The reduction in the burden of the federal deficit has been impressive, although it is still a bit larger than it was at its Reagan-era peak.


One important source of the reduction in spending has been automatic stabilizers like unemployment insurance. As the economy has grown, the number of people receiving unemployment insurance has declined by 3.3 million from its peak in mid-2010.

Unfortunately, the impressive progress to date in the budget is threatened by the looming onset of Obamacare, which will almost certainly increase government spending significantly as it also raises healthcare costs. Moreover, the financial health of social security worsens with each passing year, due to the very low level of labor force participation and increasing life expectancies. But at least for now we are making excellent progress.

Note: in calculating revenues, spending, and the deficit as a % of GDP, I have assumed that nominal GDP grew at a 4.4% annual rate in the first quarter.

Stocks and bonds are not at odds with each other

I'm seeing more and more observers commenting on the apparent disconnect between the stock and bond markets. Reader "Rob" recently linked to a post by Thomas Kee at Smart Money that is typical. Kee argues that bond buyers these days are likely smarter than equity investors, because "they are educated and intelligent, and they make decisions for longer-term purposes." Whereas equity investors are more short-term focused ("fast money") and currently have been lulled into believing the recovery is real, when in fact it is "fabricated."

I think it's very difficult to defend the belief that one class of investors (bond buyers) see the world differently than another class (equity buyers), when both operate in the same capital market and both have access to the same information. To assert this, however, I need to show how it is that bond and equity investors today share similar beliefs about the economic fundamentals. If I'm right, then the "disconnect" is not really a disconnect, it's simply the result of how two very different asset classes react to the same information.


The chart above is a good illustration of the alleged "disconnect" between the stock and bond markets. Over the past three years, stock prices have been in a rising trend, while bond yields have been in a falling trend. That doesn't make sense, so the thinking goes, because falling bond yields are symptomatic of a market that is increasingly risk-averse, whereas rising equity prices are symptomatic of a market that is increasingly risk-loving. I think both interpretations are wrong.



As the first chart above shows, there is a decent correlation between the level of real yields and the strength of the economy. Real yields and real economic growth were both quite high in the late 1990s and early 2000s. The economy had been booming for several years, and the market expected this to continue. The real yield on TIPS had to compete with the very strong real yields on equities. This makes perfect sense. Now, over a decade later, real yields on TIPS are negative and the economy is in the midst of its weakest recovery ever, with a so-called "output gap" that could be as much as 13%. As the second chart shows, consumer confidence is extremely low; although it has risen in recent years, it is still at levels that in the past have coincided with recessions. The first chart suggests that the level of real yields is consistent with market expectations of almost zero growth for the next several years.


As the chart above shows, the equity risk premium—defined here as the difference between the earnings yield on equities minus the yield on 10-yr Treasuries—is extremely high. Why would the market be indifferent between an almost 5% earnings yield on equities and a paltry 1.7% yield on 10-yr Treasuries? The only explanation that makes sense is that the market has almost no confidence that corporate profits will maintain their current levels; instead, the market fully expects profits to decline significantly.


As the chart above shows, the earnings yield on equities tends to track inversely the real yield on TIPS. In other words, when real yields fall, as they have over the past decade, the earnings yield on equities has risen. The more gloomy the market becomes over the prospects for economic growth, the higher the equity yield that the market demands in compensation for what is expected to be a big decline in profits.  The two lines have diverged of late, and perhaps that is significant, but such divergences have happened before.


As the chart above shows, it is very unusual for the earnings yield on equities to be higher than the yield on BAA corporate bonds. Would you pass up the opportunity to buy stocks with a higher earnings yield than available on corporate bonds if you thought the economy was going to be healthy? No, because that would mean giving up the opportunity for price appreciation. Investors today are willing to accept a lower yield on corporate bonds because bonds are higher in the capital structure and have first claim to earnings, which the market suspects may be in for trouble.


But what about the fact that stock prices are at all-time highs? Doesn't that conflict with the fact that Treasury yields are close to all-time lows? Not necessarily. As the chart above shows, in inflation-adjusted terms the S&P 500 is still almost 25% below its 2000 all-time high. From a long-term perspective, the chart suggests that current equity prices are about "average," having followed a 3% trend growth rate, which happens to be the average real growth rate of the U.S. economy. Moreover, corporate profits today are almost 200% above the levels of late 2000. By these metrics, stocks are not optimistically priced at all. Today's S&P 500 PE ratio is just above 15, which is below its long-term average of 16. Shouldn't PE ratios be much higher than average considering that risk-free discount rates are at all-time lows?

Bonds and stocks are both priced to pessimistic assumptions about the future health of the U.S. economy, no matter how you look at it. And as for the assertion that the recovery has been "fabricated," I refer the reader back to many of my posts which show abundant evidence that many sectors of the economy are posting solid, undeniable growth, beginning with this recent post. This recovery may be the weakest ever, but it is no less real because of it.