Why gold crashes as global turmoil continuesJuly 8, 2013: 2:38 PM ET
In times of turmoil, gold is considered a safe haven. So why is it still crashing now?
By Moshe Silver, Hedgeye
FORTUNE -- Gold is down more than 25% from its recent highs, leading some observers to declare it on track for its biggest one-quarter decline since the Bretton Woods system collapsed in 1971.
This is a bit misleading: the average price of gold in 1971 was around $40 an ounce. The following year it was $58. By 1974, the year of the Arab oil embargo, gold averaged $154 an ounce. By taking the dollar off the gold standard in 1971, President Nixon kicked off one of the great risk markets in history, allowing speculators to flee from the occasionally useless (currency) to the utterly useless (gold) whenever the prices of really useful things (oil, food) went up.
The dollar collapsed after Nixon took it off the gold standard. Treasury Secretary John Connally cheered, saying the U.S. "took charge," precipitating the dismembering of the Bretton Woods exchange rate system. Nixon went on national TV and said closing the gold window would stabilize and strengthen the dollar. The following day -- a Monday -- the Dow had its biggest one-day gain ever (33 points -- those were the days!).
Fast-forward to today as the price of gold fades, even as global turmoil continues. Here are four news items to consider in evaluating gold's decline:
Egypt. While media pundits wonder what effect the turmoil in Egypt may have on global markets, we think the impact on the U.S. is likely to be slight. At less than $2 billion, the amount of foreign aid the U.S. gives Egypt annually doesn't factor into arguments over budgets and deficits.
Where this might grab our attention is in commodities. Egypt is not an oil producer, but fear that the unrest could close the Suez Canal has speculators looking at oil prices. Hedgeye financials senior analyst Jonathan Casteleyn says the price spread of Brent oil (a proxy for European and Asian demand) over West Texas crude (WTI, a measure of North American demand) came down recently as new pipeline capacity expedited WTI flowing through to refining. What used to be around a $20 premium declined to about $5, indicating speculators are now out of this trade.
Casteleyn says oil speculators run after price, and a bit of unrest could pop the Brent/WTI spread back up if the tension builds. Americans would feel that at the pump, but we don't foresee anything like a concerted OPEC price hike if that were to occur.
Brazil. The famously laid-back nation, currently enjoying its lowest levels of unemployment and highest levels of general prosperity in history, has exploded in demonstrations with over a million people marching and chanting in more than 100 cities across the country. Despite her "street cred" as a former guerrilla who was herself imprisoned and tortured under the military dictatorship -- and despite her winning praise for her unprecedented sacking of half a dozen cabinet ministers for corruption -- Brazilian president Dilma Rousseff has not been able to co-opt the demonstrators. The current unrest doesn't look likely to be brought under control any time soon. So why isn't gold going up, with this unrest in our backyard?
Turkey. For our money, this is a much higher-stakes game than the one being played in Egypt. Prime minister Erdogan has said he is at the end of his patience, an unsubtle warning to demonstrators. Turkey, where the army famously held religious fundamentalism in check for decades, is undergoing severe social friction as Erdogan has jailed senior military officers and members of the press.
The recent protests were sparked by the government's plan to dig up a popular park in the heart of Istanbul, the site of an annual celebration of the legacy of Kemal Ataturk, founder of the modern secular Turkish state. Secular-minded Turks, among them many devout Muslims who support the separation of mosque and state, fear the encroachment of religion into politics as Erdogan takes steps to control his citizens' private lives.
Snowden. The government is supposed to push the limits of what we find acceptable -- the press is supposed to uncover and challenge. This is what makes free debate. Edward Snowden may not have done much lasting damage to America's intelligence capability -- we suspect one knock-on effect may actually be to turn up unsuspected hiding places as bad actors try to burrow deeper.
Still, what the government does is nothing compared to what we blithely allow to be done to us for fun -- and not even for profit. Or are you really comfortable with the thought that Facebook (FB) knows your personal information? It's a global company with personal information on over one billion people, taking in over five billion dollars in annual revenues (none of which you receive, even it is generated by selling your personal information), and controlled by one person answerable to no one -- and who doesn't even need a warrant.
So why is gold going down? With all this uncertainty and instability in the air, you would expect that gold would be perhaps the single asset viewed as a safe haven.
The Financial Times recently reported that demand for gold is likely to soften further "as investors see less need to insure against QE." Hedge funds are dumping the gold they bought because it was a smart move at the time. They knew it was smart, because they heard that hedge fund legend John Paulson bought gold. And in case you haven't heard, Paulson is down 54% on his gold fund, but at least he makes his own mistakes, unlike all the me-too funds whose main research thrust is finding out, What Is Paulson Buying Now?
Hedgeye's director of research Daryl Jones recently returned from a tour of Canada, where he found money managers unwinding successful commodity hedges. "In the short run," says Jones, "that means diversifying more into U.S. equities" and looking to ride the updraft from strength in the U.S. dollar. One Canadian manager says Canada's major gold companies are overvalued in the market now and that their overextended hedges could hurt them if gold prices snap back from the latest plunge.
"Global markets are seemingly stabilizing," writes Jones, noting that even Spanish 10-year bonds have backed off after peaking at over 5%. Meanwhile Jones notes that, despite prognostications and pleading, the Fed failed to hold the 2% yield line on the 10-year Treasury. "If the market truly begins to price in the end of QE," says Jones, "the bloodbath in the bond market is likely in early days."
The other side of the Treasuries coin is fundamental strength in the U.S. economy and a strong dollar. Add to this other trends we have noted lately: emerging market outflows (good for investment in the U.S.), an improving jobs picture, and accelerated household formation.
It seems the positive economic news in the U.S. may be enough to offset overseas concerns, making gold less compelling. In an increasingly positive environment, it seems other folks' bad news just reaffirms the good news at home.