If one casted one’s mind back to 2007 (before the global banking crisis erupted) and tried to envisage a scenario which would catapult gold to $3,000 an ounce, one would be hard pressed to imagine a sceanrio as conducive as the one that unfolded: a US banking system on the verge of systemic breakdown; spiralling public debt; a seismic crisis in the European Union and a potential unravelling of the Euro; doubt about the creditworthiness of the most sacrosanct institutions; a massive flight to safety…
The gold price did indeed respond to the threat of financial Armageddon, reaching a peak of $1900/ounce in September 2011. The crux of the bull argument for gold was as follows: we are in unchartered waters with central banks printing money with unprecedented zeal and governments bingeing on debt; the increase in money supply is bound to catalyse a massive surge in inflation; gold is the only hard, store in value that will remain uncontaminated by this profligate monetary experiment; QE (Quantitative Easing) along with its infinite permutations must lead to a surge in the dollar gold price to reflect its relative scarcity in the face of this monetary explosion.
In order to understand why gold did not race past $3,000 an ounce, a reminder of how banks create credit may be worthwhile. When an individual deposits $1,000 of new cash into a bank that operates under a reserve assets ratio of 5%, the bank is eligible to lend 95% of that deposit to a new borrower. The new borrower in turn deposits her $950 with her bank, and that bank in turn, may lend out $902 as a new loan (95% of $950). In this way an initial injection of a $1,000 can theoretically end up creating $20,000 (i.e. $1000/5%) of new deposits (and loans) in the banking system. This process of high-powered money (new $ bills) leading to a multi-fold increase in credit depends on both, the reserve assets ratio set by the regulators, and the willingness of banks to lend to new borrowers; the statistic that best illustrates the process is the Money Multiplier.
The chart below illustrates the US monetary base; since the inception of the Fed until 2008, the monetary base staged a gradual expansion to $800 bn. With the onset of the financial crisis, it more than tripled in the ensuing 5 years to a current value of $3,300 bn.
However, this did not lead to an explosion of credit, as the Money Multiplier collapsed. In simplistic terms, the Federal Reserve bought all the dodgy assets (think subprime debt in every garden variety) from banks to avoid a paralysis of the banking system. It paid for these ‘assets’ with new notes printed from its indefatigable printing press. Under normal conditions – as the gold bulls averred – the new notes in circulation would trigger a frenzy in new bank credit, leading to a surge in inflation (and the gold price).
However (see chart above), the credit mechanism was recalibrated by the global financial crisis and the Multiplier collapsed. Just how much of this deceleration is due to the host of new capital adequacy requirements introduced by stricter banking regulation, and how much is due to a heightened awareness of risk (post crisis) as a bank manager appraised a new loan, is a moot point. But the fact remains that virtually the entire increase in the monetary base found itself back as cash held in the Federal Reserve on behalf of the banking system, or as ‘Excess Reserves of Depositary Institutions’ in the graph below.
As we currently approach a moderation (and rationality prevailing, an eventual termination) in the grand QE experiment, it begs the question how this will affect asset prices, especially gold since it was lauded as the primary beneficiary. The much-anticipated spike to $3,000 did not materialise, just as inflation remained subdued despite the warranted fears. The chart below depicts how distorted the gold price currently is to a number of other variables including overall consumer prices (CPI), house prices, and the S&P 500 (all rebased to 100 in 2006, before the start of distortions by QE).
US house prices are particularly interesting; the leniency of credit prior to 2006 created the housing bubble, and despite the concerted efforts to resuscitate them thereafter, they stubbornly remain 20% below their peak. Markets have a tendency of eventually finding their equilibrium, even with the intervention of potent meddlers.
In the same vein, if the temporary rocket fuel that was to propel gold skywards (and didn’t) is about to wane, how long will it take for gold to find its equilibrium? And will that new equilibrium be below the marginal cost of production in order to dissuade supply in a post-QE world? Doubtless each of the indices below was profoundly influenced by QE, but the graph leaves no prizes for guessing which might be most adversely impacted by a return to normalcy.
* Sunil Shah, a former fund manager who is still passionate about markets, has just released his first novel, a financial thriller called White Man’s Numbers.
Credit to Source: The Federal Reserve Economic Data (FRED) of Saint Louis for graphs and publications.