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I’ve had this piece half-written sitting in my inbox for a week now. Although it is a long-term theme, in my heart, I’m still a trader, and I couldn’t bring myself to hit publish amid what I thought was a ridiculous commodity scramble.
But now that oil is $35 lower from that panicky Sunday night gap, and the Bloomberg Commodity Index has lumped off almost 20 points from the “aggressive” 140 print, I feel better talking about long positions.
Although I highlighted BCOM’s 15% and Crude’s 28% decline from last week’s highs, they weren’t really what I was waiting for. No, what I couldn’t bring myself to chase was gold.
But now that we have corrected more than $100 from the highs, I feel comfortable writing about it.
The immediate reasons are not always obvious
It’s safe to say that the West’s decision to sanction the Russian Central Bank caught most everyone off guard. It’s one thing to make life uncomfortable for some oligarchs, but the decision to freeze Central Bank assets is in another league all together.
With a stroke of a pen, the West took Russia’s FX Reserves, and made them useless.
Every single Central Bank now has to consider the possibility that this could happen to them.
Ultimately, this development is massively negative for the US dollar, but right now, we are in the midst of a rush into “safe” assets, so few are thinking that far ahead.
Yet, by using this power, the risk profile of Western financial obligations changed.
There is no need to judge whether this was justified; it’s been done, and there is no going back.
But forget about Russia. They are not the most important player.
This is all about China.
If you are the controller of the People’s Bank of China, you have to be asking; is it prudent to have such a large part of FX reserves in U.S. financial obligations? Of course Westerners would say; “just don’t do anything wrong, and your assets are perfectly safe.” However, to some nations, those assurances might ring a little hallow.
If the world has changed as much as I believe, then we could be on the verge of one of the largest moves in gold of the past half-century.
Just how much money are we talking about, anyway?
To get a sense of the scale of FX reserves, I made a table of the larger country holdings, along with their respective gold positions:
I’ll leave the political analysis to others, but the lesson Russia (and by extension China) just learned was that U.S. financial assets are obligations from a country. They might be obligations from the largest, most powerful nation in the world, but they are still obligations.
I remember seeing an interview with hedge fund manager Warren Mosler. When asked whether he worried about the amount of U.S. bonds owned by the Chinese, he responded something to the effect; “no, not at all - they are the ones who should be worried. China gives us real goods and we give them entries on a spreadsheet at the Federal Reserve.”
This whole episode reminds me of a J.P. Morgan quip; “gold is money, everything else is credit.”
Please don’t mistake me as some gold bug who thinks Fort Knox is empty, and it’s all a big conspiracy to keep the price of gold down for the benefit of the money-center banks. I don’t want a return to the gold standard, and my comments are not judgements on what should be done, but forecasts about what will be done.
Yet, when it comes to sovereign nations who can potentially go to war with one another, claims on financial assets are not the same thing as a physical metal stored in your own country. Russia just learned that the hard way.
There are few financial assets that are truly no one’s obligation, and gold is the easiest one to amass, transport, and store.
But wait! What about bitcoin and other crypto? Surely that’s a much better way for a Central Bank to store their reserves.
Some believe that bitcoin is also no one’s liability, yet it cannot exist without the internet. If instead of owning U.S. financial assets, the Russian Central Bank owned crypto, their government would still depend on the internet. It’s not out of the realm of possibility that Western nations unplug Russia from the network. Crypto is no individual entity or country’s liability, but it still requires acceptance in the global computing environment. Crypto is still an obligation - it’s an obligation issued by the internet. [For those interested in the ‘tourist’s views of crypto vs. gold, check out this post PLANETARY PAGANS].
Contrast bitcoin’s network reliance to gold. There is no method for foreign country authorities to encumber gold. Once gold is in your physical possession, no one else has any claim to it in any manner.
Gold is indistinguishable from other gold. It lasts forever. It might not be productive, but there is a reason it’s maintained its purchasing power for thousands of years.
The ultimate asset for the new era
You might not like gold. You might even believe it is a complete waste of human effort. I won’t argue. Not even a little.
However, ignore it at your peril because, as my buddy David Bezic recently told me in what I think is the best summation of the monumental change we are experiencing, “we are moving from the ledger world to the real world.”
What does he mean by that?
Over the past couple of decades, ledger entries representing claims on debt or equity were desired. Heck, look at the Swiss National Bank - previously one of the most conservative Central Banks in the world - what have they done with their assets? They bought the S&P 500! Think about how crazy that is; a Central Bank that not only owns foreign corporate assets, but those assets aren’t even debt! They are equity! And no bats an eye. Like this is the most normal thing in the world.
Even with more responsible investment decisions - like US Treasuries - there’s seldom been even the slightest whiff of concern from Central Banks about either inflation or impairment.
Over the past couple of decades, “electronic ledger assets” were sought after and never given a second thought.
Well, that’s changing.
We have entered the era of “real assets” over “ledger assets.”
It started with the COVID-crisis, but the Russian invasion of Ukraine (and more importantly, the West’s reaction to that aggression) has shredded any nagging last bits of doubt.
Although commodities are currently wildly overextended, in the coming years, they will likely be significantly higher.
If you are China and have $3.3 trillion in FX reserves invested in Western countries’ debt, and you are watching 7%-10% inflation ravage your holdings along with the possibility that your reserves can be impaired based on political decisions from your adversaries, what do you do?
You switch it from “ledger assets” to “real assets”; you sell bonds and buy commodities.
It’s that simple. And this is not something that will happen overnight. This will take years, and maybe even more than a decade, but it will mean an unrelenting bid for commodities at the expense of financial assets.
Timing this trade
The trouble with this observation is that we are already two years into a monster commodity bull run.
However, there is one asset that has lagged because it is sometimes viewed as more financial than commodity. Although gold had a big rally off the COVID-crisis lows, for the past two years, it’s gone sideways as it’s had to compete with rising yields of paper assets.
But, an increased yield in front-end fixed-income is proving inadequate compensation for raging inflation, and with the newly added political risk; gold has finally begun to get the joke.
The gold market has a size problem
Over the past couple of years, some of the crypto folks have made fun of gold’s poor performance. It was often called the “boomer” asset that was supposedly destined for the dustbin. I was not fussed by the fact that the public was buying bitcoin instead of gold, as their desire to hedge against fiat currency debasement was never the main reason I was bullish on gold. I have always said the gold bet pays off when the Peoples Bank of China comes for the gold by the bucket-full.
I am not interested in front-running the public, but would rather figure out where the entities with the truly monster balance sheets are going to shoot the puck.
A couple of years back, I highlighted a terrific Grant William’s presentation in my post, COULD GOLD BE A WIN-WIN? Grant questioned what would happen if money managers increased their miniscule allocation to gold. Although that bullish argument is just as valid today, I’d like to update Grant’s analysis by contemplating what would happen if China changed their FX reserve portfolio composition.
China has $3.3 trillion in FX reserves, and approximately $113 billion in gold. That’s only 3.3% of their holdings. Let’s imagine a shift to a 25% gold position in three years’ time - not an unrealistic assumption given how much the world has changed recently. That would mean swapping 7% of their holdings into gold each year - amounting to $220 billion of gold buying each year.
To get a sense of how much gold that is, here is a chart of the gold mined each year expressed as a US dollar value.
This year is projected to have $246 billion of new gold mined.
Yet, China can’t simply buy every ounce of new supply without driving the price to the moon.
But what about existing supply? Maybe the existing stock is big enough for China to pry it out of other holders’ hands. Gold is somewhat unique in that almost all the ounces pulled out of the ground still exist.
Let’s have a look at the largest publicly traded gold holding; the GLD ETF. It is the 15th largest ETF by market cap, so they must be able to accommodate China’s flows.
It’s taken almost two decades, and the GLD ETF only has $68 billion of market cap. No where near big enough for China to make a dent.
Just for kicks, let's think about gold mining stocks. They own hundreds of thousands of ounces in the ground, surely their market cap is enough to facilitate the Chinese buying.
Every stock in the NYSE ARCA Gold Miner Index has a total market cap of $345 billion - and even if China were to take all these companies over, they haven’t even solved their “ledger” over “real asset” problem.
To achieve the goal of 25% of their FX reserves shifted into gold in three years, the Chinese could buy:
A whole year of global gold production, plus…
All of the GLD ETF, plus…
Every stock in the NYSE ARCA Gold Miner Index
Getting a sense of the problem the Chinese have?
Grabbing the blue stack
Some analysts dismiss gold because it’s not large enough to accommodate Central Bank balance sheets. Instead, they say; “why bother with gold? Might as well just buy productive ‘real assets’ like copper or oil.”
I don’t disagree that this will be one result of the shift away from the “ledger economy.” Productive “real assets” will be bid for years to come. For a wide range of reasons.
But, there is no reason Central Banks won’t also buy gold.
In fact, given the difficulties in transporting and storing large amounts of commodities, it would be logical to assume that gold would be the first leg of this shift from “ledger” to “real.”
Sure, it’s likely to send the price of gold soaring, but the world is changing quickly. I hesitate to give props to another Russian melomaniac leader, but that fellow from the Beatles1 sure knew what he was talking about when he said; “there are decades where nothing happens; and there are weeks where decades happen.”
The world has changed in ways that are so profound; the market is having difficulties processing it.
Over the years, I have forecasted that we will have a week when gold rises $1,000. I feel more strongly about this call today than any previous time I have said it.
Long-time MacroTourist readers know that I am not one to focus on technicals, but I have the privilege of listening to CornerStone Macro’s (now Piper Sandler) Carter Worth. The other day he highlighted gold, and his argument was so compelling, I’m reproducing his squiggles.
In 2010-11, gold experienced a massive descending triangle, which resolved with a break of the $1,500 level. Many expected 2020-21 to conclude the same way.
However, last month when gold broke out, the pattern changed. Instead of breaking down, it exploded higher. This was especially powerful as sentiment was washed out. Few were positioned for this strength.
A strong technical pattern with underweight speculative exposure is the stuff that great bull markets are made from.
The technical picture might be improving, but many are worried about the Federal Reserve’s tightening cycle, which should start tomorrow at this month’s FOMC meeting.
Well, remember back to my piece PRICE ACTION AROUND FIRST RATE HIKES. Contrary to popular wisdom, typically this first hike is not the start of a period of gold weakness.
In fact, it’s just the opposite.
And that’s probably helped by the fact that over the past five tightenings, the USD dollar has often sold off after the first rate hike.
The war in Ukraine has caused a massive flight into US dollars, which has pushed up the value of the greenback over the past month.
I’ve been patiently waiting to sell US dollars, and I am sticking to my plan to start a USD short position today.
However, what I like even more is to buy gold.
It’s time to really lean into the position.
I have bought an overweight position of gold futures at around these levels, and I will also be aggressively adding gold mining stocks.
Here is the GDX Gold Mining ETF over the past couple of years:
It’s gone nowhere, and these stocks are cheap.
One final thought. Since the COVID-crisis bottom, the Bloomberg Commodity Index has outperformed gold.
Although there is no reason commodities and gold cannot rally together in the coming months, I feel better buying the laggard. The commodity trade feels crowded, while gold has only started to garner attention.
There are lots of reasons to own gold, but if Central Banks change their attitude about financial assets as I expect, then the move in this “real asset” could be explosive - the likes we haven’t seen since Wall Streets Bets discovered GameStop. Don’t laugh. For the past two years, all the mistakes have been underestimating right tails. I won’t make that error with gold.
Thanks for reading,
Kevin Muir
the MacroTourist
Just kidding folks, I know that John Lennon didn’t say that. I’m pretty sure it was actually a Liz Lemon from 30 Rock quote. My apologies.