Diary of a Financier

Signs of Net Deflation: Introducing Gold’s 2006 Analogue

In Capital Markets on Thu 5 Jul 2012 at 21:49

I wanted to add some observations about the Gold (GC/) market to followup on my recent comments about metals and my ongoing series about GLD. In stark contrast to the rally in American risk-assets, precious metals have remained tepid, and an analogue to Gold’s 2006 chart has emerged.

I had some hesitance approaching Silver (SI/) last week. SI was the only piece in the US multi-asset puzzle that just didn’t fit with my thesis regarding a new cyclical bull:

Silver (SI/) is the precious metal that provides a good gauge of risk-appetite. Truth be told, SI has formed a bearish descending triangle, upon which $26.50 support it now rests. Its technical indicators (specifically stochastics) have all bottomed on all fractals, which votes for its support holding and risk rallying, despite the bearish classical pattern.

I had been willing to put SI on a back-burner and watch it develop. It has rallied, as expected, but its rally has merely matched the 4% performance of SPX since 6/27. I expect higher Beta out of an asset like Silver. SI has straddled the $28 level since Tuesday, and its lethargy is unnerving me, given the resonance to risk.

I could continue to fade Silver’s warning, but Gold sounds a similar alarm. I’ve sat long the Gold ETF (GLD) since March, and the chart has developed slowly & poorly, despite my high hopes:

Gold traded along a bull trendline support for almost three years (since 2009) then shot skyward (July 2011) only to return back to its original trendline. Since that 2011 high, Gold has traded into the vertex of a symmetrical triangle that I’d argue is a bull pennant. The next move–invariably a breakout or breakdown–is crucial. While indicators don’t suggest anything too optimistic, I defer to the classical patterns (bull pennant here) in trending markets like Gold.

That next move was a breakdown. So, here we are. GC closed today at $1605, and I’m now working on selling my GLD position (-4%+) before this weekend.

Over the last two weeks, Gold held support of both a long-term trendline & a shorter-term bear descending triangle. It’s wandered up to that triangle’s trendline resistance as of tonight:

GC (daily)- at resistance of bear descending triangle, having held recent brushes of LT support trendline.

This construction reminded me of 2006, which bears a striking resemblance to today on all accounts. 2006 was the same story: a bear descending triangle was the capstone atop a long-term trendline, and the classical pattern’s support eventually broke. Daily & weekly indicators are well aligned with that analogue too:

GC 2006:2012 analogue (daily/weekly/monthly)- 2012’s bear descending triangle looks a lot like 2006’s, both at the end of LT trendlines.

I fully expect the modern $1536 support to break, fulfilling the bear triangle’s pattern. Per the analogue, the pattern should morph into a symmetrical triangle after the downside breach. That will offer traders a reentry point around the $1525 trendline support (red-dotted line):

GC 2006:2012 analogue (daily)- after breaching support of bear triangle, the chart morphs into symmetrical triangle, then rallies; focus on 2nd support ~1525 (red-dotted line)

Hence, I’m offloading the remainder of my GLD with the expectation that I’ll reenter ~$1525.

~~~~

Fundamentally, I can’t disagree with what Gold’s saying in protest of this risk-rally. I don’t want to underestimate the reflationary potential of the ECB’s rate easing/growth pledges, the Fed’s OT2-lite, the BOEs renewed QE, the BOJ, PBOC, SNB, et al. These things take time to work their way through the system. Yet, the half-life of every subsequent measure seems to get halved. At best, 2012’s global central bank interventions have not amounted to much more than offsetting the system’s inherent deflation. At worst, they’ve failed to outpace the rate of decline. We’re experiencing net deflation again, a term I used to describe the 4q11 environment too:

ECB’s balance sheet ($3.2T) is not only far greater than the Fed ($2.9T), but at 30x leverage it has the same risk as Lehman. A major distinction is that the Fed has been forced transparent, while the ECB is fully opaque about asset quality. The ballooning has happened and continues to happen. There was a period of net deflation triggered by mark-to-market events, whence asset liquidation (MTM losses) outran printing on a net basis. That occurred from early October up until XMas–full stride in December (around LTRO).

The balance sheet needs to expand even more though, and I don’t think such earnest inflation is sustainable in the long term. I’ve continually referenced the Gold market as evidence of the shift from net deflation to monetization, and that hasn’t changed.

The “bailouts” we’ve seen in Europe–and elsewhere show policymakers continually pursuing the remedy of emergency loans, which buries insolvent institutions beneath more debt:

As with the shortcomings exhibited by LTROs, the sterilized measures merely reshuffle the deck. They create liquidity, but that liquidity is also a liability. It’s an emergency loan or a credit line. That’s part of why deferral redoubles the infliction. (Recall my suggestion to the US in 2009 that bailouts–if they must–should not bury banks beneath more liabilities; distressed banks need Tier 1 Capital, not debt. TARP, et al followed that advice by employing equity injections.) There’s an increase in gross debt with the promise of [at very least] proportionally increasing income (GDP) in the future. There’s no creation of a net new asset to displace the spiraling deflation of impaired & defaulted assets.

Programs like Europe’s LTROs were launched to promote liquidity with the byproduct of reflation. While illiquidity is a concern from most EU banks, insolvency is the lingering threat. The SMP, EFSF, LTROs & ESM are term facilities that both add to debtloads and withdraw liquidity from the system upon maturity. LTRO loans mature 3 years after issuance, which does nothing to sustainably reflate or stimulate longer-term investment.

In contrast, US programs like TALF and TARP’s Public-Private Investment Program (PPIP) injected net new assets into the system. For example, PPIP investors were allowed to buy swaths of ABS from banks by leveraging their equity as much as 6-to-1. Their leveraged loans were backed by a guarantee from the FDIC. While PPIP funds have a longer-term life (8-year term with a Treasury option to extend them another 2 years), the cost of capital is virtually nil and the leveraged gains add incremental liquidity that remains in the private sector.

An understanding of all these pseudo-Modern Monetary Theory fundamentals will become increasingly relevant in the coming months. Europe will have to restart a hunt for another fix soon enough. They absolutely will not be able to renew an LTRO-esque, collateralized mechanism again. The ECB just reported another surge in Margin Calls last week. The sequence of increasing ECB “deposits related to margin calls” means asset values are still eroding. It also means we’ve reached limit of what the ECB can do via collateralized lending. The same-old Keynesian hammer will not work for the delicate surgery that Europe needs now.

~~~~

Gold has wallowed in reaction to all of this. The globe continues to struggle with deflation, and Europe seems to lack a plan for reflation in the near future. This all coordinates well with my read on equities, which should pullback here as well.

–Romeo

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