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Exter’s Pyramid and where to from here?

22 May 2015

Gold prices have been in retreat this week, giving up some of the gains from their recent break above USD $1200oz. After closing out last week at USD $1220.50oz (London PM Fix), the market has pulled back, with gold currently sitting at USD $1207oz, down 1.1% for the week.

Silver has been a little more resilient, effectively unchanged for the week, though down from where it was on Monday, when it had pushed as high as USD $17.70oz

For Australian dollar investors, the decrease in the AUD, which is now back below USD $0.80, has supported the market, with AUD gold now trading for $1529.13, whilst silver is sitting at $21.90.

The pullback has been disappointing for gold bulls, who were hoping the metal would push higher after last weeks rally, and has served as a reminder of the still difficult environment for precious metals, and why dollar cost averaging is still the most appropriate strategy for investors.

Strong housing starts data out of the United States this week (the strongest since 2007), alongside a rally in the USD were partially responsible for the pullback, with US economic data, which has been weak all year, slightly surprising to the upside this week. Commodity prices were off a little too earlier in the week.

All up, this seemed to knock the wind out of gold’s sails, and were seemingly a more important driver for the precious metal market than the release of the minutes from the last Federal Reserve Open Market Committee (FOMC) meeting. Those minutes, which were released mid-week, were overwhelmingly seen as dovish, with the market increasingly pushing back their expectations of when the first Fed interest rate hike will be.

Some of the key comments in the minutes were the following;

• Many participants judged that the pace of improvement in labor market conditions had slowed. The March increase in payrolls had been smaller than expected, and the unemployment rate had remained steady.

• Many participants noted that measures of inflation averaged over several months or more continued to run below the Committee’s longer-run objective.

• Several participants noted that the foreign exchange value of the U.S. dollar had fallen back somewhat over the intermeeting period. Nonetheless, the value of the dollar had increased significantly since the middle of last year, and it was seen as likely to continue to be a factor restraining U.S. net exports and economic growth for a time.

You can read the full release here if you would like.

On top of this, we also had Fed uber-dove Charles Evans talking, with the President of the Federal Reserve of Chicago stating that he didn’t think there should be any rate hikes in 2015. He is also keen not to see any rate hikes until the Fed ‘overshoots’ its 2% inflation target, stating that: “There aren’t any serious costs of modestly overshooting our inflation target–particularly considering how long inflation has been below our target".

Evans doesn’t think we’ll see 2% inflation for quite some time, so he’ll obviously be advocating for more expansionary policy for some time.

One could have expected the precious metal complex to be a little firmer in the face of such dovishness. The fact that it hasn’t rallied further, and the fact recent physical flows out of Asia have dissapointed will be worrying for some, and a trip back below USD $1200oz can’t be ruled out, especially if oil and other commodities pull back further, or if the USD starts rallying again.

The technical picture for the market isn’t giving a clear reading necessarily, though earlier in the week gold did fall back through a couple of key moving averages.

So where to from here

As discussed above, a pullback below USD $1200oz wouldn’t be a huge surprise, though it would likely accompany a fall in the AUD, which would help support prices for domestic investors.

Saxo Bank had a couple of excellent pieces out this week dealing with the outlook for gold. First up was there chief economist Steen Jakobsen, who sees a rebirth of the commodity bull cycle. Jakobsen expects commodities to outperform other assets, and sees gold heading toward USD $1425oz this year.

Were that to happen in an environment where the AUD fell to 0.70, we’d be talking AUD $2000 gold and above.

You can see the interview where Jakobsen shared these views here.

Overnight, Ole Hansen, head of commodity strategy at SaxoBank, had an excellent article out, pointing out the narrow trading range either side of USD $1200oz that gold appears to be stuck in.

Explaining the moves of the past few weeks, Hansen noted that;

“Increased volatility in secure European government bonds and speculation that the US Federal Reserve is in no hurry to raise interest rates anytime soon, combined with a weaker dollar, were the key drivers behind the recent run to the top of the current range. The subsequent recovery of the dollar, verbal intervention from the European Central Bank with regard to its current bond buying program and stronger than expected US data have once again sent the metal back to the starting point.”

Most interesting in the Hansen article was the following chart, which shows both long and short gold positions for money managers on the COMEX, with the net position and gold price overlaid.


As you can see, long positions are showing no signs of exuberance (i.e. there aren’t that many people betting on rising prices), with positioning similar to where it was in 2013, when prices tanked and hardly anyone was bullish.

Short positions on the other hand are looking extended, and are at a level not dissimilar to that price crash period, when everyone wanted to bet on ever lower prices. Reductions in the number of short positions can occur quickly, and are typically accompanied by a gold price rally.

As such, a major change in the gold market, and a clear break higher may not come about as a result of plenty of people starting to get bullish on the metal. It might just be exhaustion, and a loss of conviction from those who’d previously been betting on prices going lower.

Hansen’s article can be read in full here.

Gold in the news!

It wasn’t just the team from Saxo Bank who were talking about gold this week. Adam Carr, who writes for the Eureka Report and Business Spectator in Australia also had an article out this week. Titled “An inflection point for gold”, the key takeaway was that fears of a further gold slump appear to have abated, with support for the metal growing as investors need another asset for wealth preservation and a volatility hedge.

The report quoted some of the latest stats from the World Gold Council, which looked at the pick up in gold ETF buying, with Q1 2015 representing the first quarter since the end of 2012 that there was net positive gold demand from this sector of the market.

The report can be read here, though you will need to be a Eureka subscriber.

Bank of America Merrill Lynch were also out with a report this week, which advocated higher investors holdings of both cash and gold. Warning of a potential ‘cleansing drop’ in asset prices, the bank warned that;

“The summer months offer a lose-lose proposition for risk assets: either the macro improves and the Fed gets to hike, which will at least temporarily cause volatility; or more ominously for consensus positioning, the macro does not recover, in which case EPS downgrades drag risk-assets lower.”

They then went on to state that; “Investors remain trapped in “The Twilight Zone”, the transition period between the end of QE and the first rate hike by the Fed, the start of policy normalization...until (a) the US economy is unambiguously robust enough to allow the Fed to hike and (b) the Fed’s exit from zero rates is seen not to cause either a market or macro shock (as it infamously did in 1936-7), the investment backdrop will likely continue to be cursed by mediocre returns, volatile trading rotation, correlation breakdowns and flash crashes. For this reason we continue to advocate higher than normal levels of cash, adding gold and owning volatility in mid 2015.”

The Bloomberg article where these comments appeared can be found here.

Considering the gold market is never short of a sensationalist headline, it was also unsurprising this week to see an article titled; “Chinese Gold Standard Would Need a Rate 50 Times Bullion’s Price”.

What was surprising was that it appeared in Bloomberg, and that this research was based on analysis carried out by Bloomberg Intelligence (not that lot of intelligence went into the report). The report stated that “a traditional gold standard, in which the precious metal backs the currency, is basically impossible at current prices due to the amount of metal needed and there’s no evidence the sixth-biggest bullion holder will adopt one.”

Whilst price targets of $64,000 an ounce will be sure to generate a headline, as will ‘projections’ that China will need 525,000 tons of gold at today’s prices to create a ‘gold standard’, this is largely useless academic modelling.

There is no question that China is building its gold reserve, and that it will continue to do so, alongside the encouragement they are giving their citizens to build up their own holdings. But ‘analysis’ (and I use the word loosely) like this doesn’t really add value to the conversation about the important role gold can play in investor porfolios, and why we should be accumulating it throughout this period of price weakness.

My own bullish position on where the metals will head in the coming years is well know, but that doesn’t mean I agree with every sensationalist gold headline forecasting untold riches ahead.

Here is the original article

Exter’s Pyramid and the Chase for Yield

Before finishing this week’s report, I wanted to touch on an amazing chart that was also produced by Bank of America Merrill Lynch. The chart, which appears below, shows the cumulative flows we’ve seen into gold and treasury inflation protected securities over the past 10 plus years, and compares this to the flows we’ve seen into dividends funds, real estate investment trusts, high yield securities and the like.

The chart can be seen below.


As you can see, over the past 10 plus years, there have been some $413billion invested in various high yield assets. That is more than 20 times as much as has been invested in gold and TIPS over the same time period.

You can also see the plunge in TIPS and gold investment since 2013, which would be both a result of the collapse in gold prices in Q2 that year, and the general disinflationary trends we’ve seen over the past few years, with inflation sensitive assets highly unpopular today.

But this chart did remind me of one of the slides I presented at the Australian Technical Analysts Associations national conference, which was held last weekend on the Gold Coast up in Queensland.

That slide was about Exters Pyramid, so named after John Exter, who was an American economist, member of the board of governors of the United States Federal Reserve System, and founder of the central bank of Sri Lanka.

His pyramid, an updated version of which is included below, is famous for how it separates asset classes by risk profile, with those at the base of the pyramid generally the most liquid, and the lowest risk.

As you move up the pyramid, the notional value of the asset class tends to get larger, but so does the risk. And when we say risk, we’re not just talking about volatility, or the potential for permanent loss of capital, but also risks like liquidity.


So, as per the pyramid, derivatives are riskier than private businesses and real estate. Private business on the other hand would be considered riskier than investments in listed blue chip stocks, if for no other reason than they aren’t as liquid or easy to sell. Below that are government bonds and Treasury bills, which at least in Exter’s time were very low risk.

Below that we have paper money. And below that we have gold, the very bedrock of the pyramid. The one asset that pays nothing, because it owes nothing. The ONE asset that can’t default or go wrong in the long run.

Most in the modern financial world disagree that gold is still the bedrock, though they never come up with a good reason why central banks still own 30,000 tonnes of the stuff, nor why they’re buying more. Those people would say that paper money is the base of the pyramid.

At a high level, if you strip back all the noise regarding what central banks and governments are doing when it comes to negative real interest rates and money printing, it comes down to one thing. They are trying to ruin the base of the pyramid, or at the very least scare investors out of keeping their wealth stored in paper money.

By destroying, or at least credibly threatening to destroy paper money, they’re hoping investors will be forced to speculate in assets further up the pyramid. The chart from Bank of America Merrill Lynch shows how ‘successful’ they’ve been, forcing investors to desperately clamour for yield.

But this can’t mask the reality that they are effectively forcing investors out of the frying pan and into the fire, for ultimately, the confidence people have in assets like government bonds and listed stocks ultimately relies on the confidence they have in the very dollars, or euros or yen those assets are calibrated in.

In my opinion, it’s far safer to go against the herd, and instead of speculating in assets up the pyramid, I’ll keep my money in the one asset below paper money in the pyramid.

Incidentally, back in the late 1960’s, just before Nixon abandoned the gold standard and kick started an era of high inflation, negative real returns on financial assets, and a huge rally in gold prices, Exter moved his portfolio to 100% precious metals

Not bad for a central banker

Until next week


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