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It Won’t Go UP Forever, Either!

Stocks traded higher overnight and held those levels into the open, with bonds under pressure. Clearly, there was more than a little whiff that today’s announcement from the Fed would include some kind of policy concession to the weak economy. Many Street strategists expected an outright declaration of further asset purchases. Such a feeling probably should be categorized as an occupational hazard of working in institutions (both buy side and sell side) that have been built to sell products, which is clearly easier when markets are rising. Strategists tend to think that what matters more than anything to them – rising markets – must also be equally important to policymakers.

But this Federal Reserve, while it has been more explicit than any other about how the “wealth effect” makes life easier for them, at least deserves credit for recognizing that there are other considerations. For example, it was worth thinking about whether QE2 had any lasting impact, added anything to growth (although the Fed claims the same 2 million jobs saved that the Administration does for its fiscal policies), or was the most efficient way to accomplish its aims. Honestly, I too doubted whether the Committee would be able to resist what the Street was clamoring for, but at least we can say they did that.

So what, exactly, did they do?

The Federal Reserve committed to keep interest rates “exceptionally low” until at least mid-2013. That was just what the market was already pricing, so it’s not exactly a market shock to bond guys. The explicit nature of the promise is interesting, because it means that even if inflation starts up, the Fed cannot move rates for two years (unless it wants to permanently lose this as a tool, since if it reneges after one year and hikes rates, no one will ever trust them at their word again). Some wiseacres noted that they could tighten a little and it would still be “exceptionally low,” but this is like debating the meaning of “is.” We all know what they mean – rates can go down, but not up, for two years.

The folks on financial news kept using words like “the Fed gave us a very grown-up sounding statement,” and that’s very sad if clearing that hurdle was a surprise! But it’s also wrong. What grown-up would ever say to a child “I promise that I will not miss any of your soccer games for two years”? Really, Dad? You mean if I get on a traveling team and play around the country, and you have a presentation to the President of the United States, you’ll skip that for my soccer game? Gee, that’s great.

That’s not grown-up at all. It’s selling an option. If it works, then the Fed has gained very little – the market was already pricing that probable outcome anyway. If it fails, it could fail spectacularly with the Fed having to choose between inflation at 5% (or more) or reneging on their promise!

Since the result was drastically less in immediate liquidity than many investors assumed they would get, the stock market initially dove while bonds rallied suddenly and dramatically. I think some bond investors didn’t initially realize that the market was already priced for this result, but there were probably also some mortgage-hedging-related flows into a very illiquid market! Bonds settled back by the end of the day, with 10-year yields finishing down 8bps at 2.24% (basically where they had been just after the Fed announcement) and 10y TIPS down 10bps at 0.05% (they traded at negative yields all the way out to 10 years, briefly!). Yes, folks, TIPS out-rallied nominal bonds, which makes sense when the Fed has intentionally disarmed itself in the fight against inflation.

Even if the town is really calm, the sheriff isn’t helping anyone if he disposes of his side arm…is he?

Curiously, stocks rallied, hard, after turning negative for a few minutes and then waffling for a bit. The cause of the rally is likely due to one of three things: (1) Fed Model people saw drastically lower yields, and listened to CNBC chirping about the “dramatic rally in Treasuries” long after the rally had rolled over and returned to the starting line, and assumed that the equilibrium level for equities should be higher. I sort of doubt this, but it’s possible. (2) Shorts were forced to cover. Well, maybe, but I would be surprised if there were many weak-hands that went short into an FOMC meeting that was supposed to produce QE3. I may be wrong. (3) Some analysts seemed to think that this was a “down payment” and makes QE3 more likely at future meetings. I think that’s just plain wrong. There were three dissents even to this mildly-dovish decision: Kocherlakota, Fisher, and Plosser. That doesn’t mean that QE3 is impossible but the hurdle is much higher than investors think!

In any event, 4.7% on the S&P is a nice rally. Is it sustainable? I doubt it, but as I wrote yesterday the market wasn’t going to go down in a straight line. I believe we will see new lows – although probably not tomorrow!

The dollar set back, which seems strange when you consider the Fed did less in terms of pumping liquidity than had been expected. But I think the currency is reacting to the central bank’s unconditional surrender to whatever happens with inflation.

Many commodity markets were closed or nearly closed when the Fed action took place, so we will have to wait and see how they open tomorrow. Crude ended up below $80, and now that it’s falling the Fed cares about it. But precious metals, industrial metals, and softs rallied, leaving the indices basically unchanged on the day.

Gold had a wild ride, swinging in a $60 range before closing up about $30 (+1.7%). Silver, on the other hand, dropped nearly 4%! It is rare to see two precious metals move so far in opposite directions.

Gold right now – well, some would say always – is in its own world. I am being asked almost daily for my opinions about the gold market. (Incidentally, I can tell you from experience that whatever I say, after this point, will irritate the gold bugs even if I come out as extremely bullish the yellow metal.) I usually respond with approximately the same thing: Gold, like any commodity, will experience a ~0% real yield over time. Right now, that’s not at all a disadvantage since real yields on bonds are zero or worse for ten years, but it is equally true for gold and for other commodities. I prefer to diversify into lots of commodities, even if there is one I happen to think is the “best,” in exactly the same way that I wouldn’t invest in just one stock even if I thought it was a great stock.

But the argument from gold advocates goes that gold is fundamentally different from other commodities, in that it has been and still is used as hard currency itself, so it benefits from being a hard currency and also a superior store of value. Corn doesn’t do this. Then the gold advocate usually says “that means that if the world economy collapses and we go into deflation, it will do well; if we enter a spiraling inflation, then it will also do well.”

As someone trained in economics and finance, I am automatically suspicious of win-win propositions. If I win in all circumstances, then the price of the game should move to reflect that. In the simplest circumstance, if I toss a coin and pay you $1 if it comes up heads and $1 if it comes up tails, how much will you pay to play the game? You’ll pay very close to $1 (especially if you are bidding against someone else). In finance, win-win situations also manifest with a hidden “lose” situation. For example, in this case it could be the case hypothetically that if we entered neither inflation nor deflation, but took a middle road, you would lose a whole lot.

I am not claiming that is the case, but my point is that we need to resolve the whole win-win thing in a rational market context. But I think I have a creative way to look at the value of gold that preserves the gold advocates’ argument but also demonstrates that it isn’t a sure path to a riskless investment.

Suppose I offer you a call and a put, both struck at $374 (today’s closing price) on Apple Inc (AAPL), and I charge you nothing for that straddle. You like that bet, because it is a free win-win, and you accept. If the price of Apple goes to $400, you will win $26 because the call is ‘in-the-money’; if the price of Apple goes to $350, you will win $24 because the put is ‘in-the-money’, and so on.

Now, let’s fast forward a few months. Suppose Apple is now trading at $500. Do you still have the straddle? Yes. Is it still a win-win situation if Apple goes up or down?


No, now you clearly want the stock to keep going up, because while you will eventually win on the put if Apple plummets, you will first lose all that you have made on the call.

This is, I think, analogous to the situation with gold. If it is trading at $400 (for example), then I am much more willing to believe it is win-win. But right now, it is a deep in-the-money call option on inflation and an out-of-the-money put option that is nearly worthless. For the deflation-floor value to be realized, gold prices will need to fall a long ways.

The charts below illustrate what I am talking about. The first chart (Source: Bloomberg, Enduring Investments) shows the 10-year forward price level implied by inflation swaps (projected from the the then-current price level), plotted against the gold price. As you can see, when forward expectations rise then the gold price also rises and vice-versa; moreover, over time both of these charts should march more or less to the upper-right as long as the price level (think of it as the CPI index value, currently around 226) continues to rise. At times, the relationship is tighter than at other times, but overall it is surprisingly tight I think.

Gold tends to move with the forward price level through time (but with a beta above 1).

The next chart (Source: Bloomberg, Enduring Investments) shows the same time period but as a scatter plot. The forward price level is on the bottom and the gold price is on the left. I have fitted it with a 2nd-order polynomial curve, and I would suggest to you that it looks a lot like the stylized hockey-stick of a call option.

By golly, this DOES look a little like a call option.

Let’s rewind to 2008, when deflation fears were palpable. If the deflation put value of gold had been “in-the-money”, then gold should have been rising in price when the forward price level was falling. It didn’t. However, it did remain surprisingly stable, suggesting perhaps that we were near the “strike” where the call and put had similar ‘deltas.’

I think there may well be something to what the gold advocates say, in other words, about gold having a dual nature as store-of-value as well as inflation-hedge. However, with gold prices as high as they are, they are almost entirely a bet on inflation…at least, until they’ve fallen maybe $1000 first!

Now, I am an advocate for commodities in general, so I don’t mind having just the call option. I think that the case for higher inflation became stronger today when the Fed promised not to fight it for two years even though core inflation ex-housing is already on track to be at 3% by the end of the year. There is a reason that TIPS, as rich as they seem, still outperformed nominal bonds today. The “tail outcome” of much higher inflation, that depended on a blunder from the Fed to really have much value, just became much more plausible because we’ve gotten just exactly that blunder.

I want to sell bonds, but I am not so foolish as to do it yet. Within a few days, perhaps, but I don’t need to hit the high tick. I never got a chance to buy my small weight in equities today – the market never showed the weakness I needed. So I remain very long commodities and cash, and very little position in anything else.

  1. Jim H.
    August 10, 2011 at 8:39 am

    ‘I think some bond investors didn’t initially realize that the market was already priced for this result, but there were probably also some mortgage-hedging-related flows into a very illiquid market!’

    You allude to an interesting point. Are Fannie and Freddie still in the Treasury market, desperately trying to hedge swings in mortgage yields and duration, while the market is wildly volatile? One shudders, imagining the chaos in the dealing rooms of these gigantic, leveraged zombies on an intravenous Treasury drip.

    Thanks for your interesting gold analysis. Lacking a yield or any obvious comparables, gold is extraordinarily difficult to value. Options theory is one way of extracting a relative value for it.

    From a pure seat-of-the-pants trading perspective, the commodity complex is displaying negative breadth. That is, most members (including important ones such as crude oil) are weak, while gold soldiers on alone into the mystic. Likewise, gold stocks are treading water. Technically, this is not a pretty picture.

    Meanwhile, the general sentiment on forums is that gold owners are now ENTITLED to an easy $20 or $30 a day in appreciation. (Silver owners are miffed that they aren’t getting theirs.) Like the Naz in 1999, or housing in 2005, gold never goes down.

    I’m a great advocate of gold as a component of a multi-asset class portfolio. But my trader instincts say that one day soon, gold is gonna get whacked by $100 an ounce to shake off all the new casual passengers hanging precariously on the outside of the bus.

  2. Tom
    August 10, 2011 at 8:43 am

    Did the Fed really “promise” not to fight inflation for two years? Seems like since early spring they’ve been discussing the methods they would use to unwind the easing, stating that they would right size their balance sheet first, then look to the Fed Funds target. A “last in first out” method.

    • August 10, 2011 at 8:57 am

      Well, they ‘promised’ not to raise rates, and if you drain reserves without raising rates you’ll eventually have to add reserves back again to keep rates down. I think they are committed at this point to right-size the balance sheet through run-off (since it’s just not feasible to sell their weight without causing very large dislocations in the market). One of the things they have been discussing is this method: guarantee low rates for a stated period of time. I think they consider that it is the least-disruptive to the orderly functions of the markets, and they’re definitely correct there. I’m just not sure they really understand the costs, because they really seem to think that inflation is going to go down.

    August 10, 2011 at 9:25 am

    The price of gold is determined by the following rule: for every one percentage point real rates differ from 2%, gold moves by eight times that amount per year.

    The problem with gold is the size of the market, its industial use (and it is so much closer now to its replacement cost), and the fact that its price is subject to politics / direct action by CBs and, hence, may be very volatile.

    Are there any commodity indexes that are NOT so volatile and available to retail investor?

    August 10, 2011 at 9:47 am

    Also, Michael, in the statement it reads

    The Committee currently anticipates that economic conditions … are likely to warrant exceptionally low levels for the federal funds rate at least through mid-2013

    Now, English is not my native language, but no matter which way I read it, I fail to see any firm committment to low rates on part of the FED…

    If it is so, then basically to me it means that FED anticipates disnflation / recession again and guarantees easy monetary policy backdrop to US fiscal overhaul programm that won’t be easy on busness

    • August 10, 2011 at 9:56 am

      It is certainly the case that the statement they made is linguistically pointless. They will “likely” leave rates low “at least” until mid-2013. You can’t have a statement of PROBABILITY in the same sentence as an ABSOLUTE statement. An English teacher would grade them poorly. My guess is that they inserted “likely” so that they wouldn’t have even more defections than they did, and yes it does give them wiggle room. But not much – the near-uniform interpretation has been that they ‘promised’ not to tighten for two years. If they back off of that, they will lose lots of credibility (well, I guess they don’t HAVE lots of credibility to lose, but they’ll lose some).

      So conceding the point a little, the statement was either vacuous – we think we’ll be able to keep rates low that long, but we’ll see, and you get nothing new today except our forecast – or restricting. In either case it’s bad for stocks; in the latter case much better for inflation-linked products and commodities; not sure on bonds.

  5. Frank R
    August 10, 2011 at 3:14 pm

    Gold: I tend to agree with Bernanke in that gold is an asset, not money per se. I disagree with your labeling gold as a commodity. A commodity is produced (grown, extracted from the earth, etc.), transformed into something useful and then consumed (rendered economically unrecoverable). Corn, oil, silver, etc are commodities, very much subject to the law of supply and demand. (Silver is rather unique due to historical monetary characteristics that substantially affects its price.) Gold is not consumed, except in tiny quantities. It is fabricated into various artifacts (coins, bars, jewelry, artwork, etc.), which can be re-fabricated repeatedly without reducing the amount of gold in the world. The quantity (mass) of gold inflates by about 1-2% per year, so the amount of gold continually increases. However, the amount of gold that changes ownership each year far exceeds the supply of new gold. Given that gold does not respond to price signals in the same way as commodities certainly does complicate its valuation. Maybe it really is a trustworthy store of wealth and the degree of uncertainty in the world (very high, now) is the price driver.

    • August 10, 2011 at 3:29 pm

      Well, I have to observe that that isn’t the CUSTOMARY definition of commodities. As Bob Greer first wrote in 1997 and Bob & I pointed out in 2008, commodities as an asset class are distinct from bonds, stocks, and other financial assets in that they are consumable OR transformable. There are a number of other commodities that are not wholly consumed (the metals), and I can’t imagine drawing a distinction on the percentage of the thing that is consumed.

      That said, while I think that gold is clearly a commodity (the other part of the definition is that one unit is indistinguishable from another unit, unlike one bond from another), I agree that it isn’t money. Being able to swap it for stuff doesn’t make it money unless everyone agrees on what it’s worth in a swap…and they don’t. So I’m with you on that point.

  6. Frank R
    August 10, 2011 at 4:02 pm

    Fair enough 🙂 But gold is certainly a ‘different’ commodity than all the rest, including silver. The available supply of gold continually increases. The CBs think it is an asset and are hoarding it as are many others. What value should be ascribed to it? I don’t have a clue. But, it certainly is interesting to watch the show. (Yes, I do own a small amount for diversification.)

  7. August 10, 2011 at 4:29 pm

    And fair enough back at ya! Thanks for the give-and-take.

  8. onebir
    October 22, 2011 at 1:01 pm

    Does it make sense to fit the curve on the scatter chart to all the points? It looks like the points falls into two separate sections, with those above $1100 gold quite distinct. That coincides with sept 08 – which would be a pretty sensible time for a regime shift for gold.

    I think you’d still get a ‘call option’ shape using only those more recent points – but the ‘strike price’ would be a quite a bit higher. There’d be less evidence of the put option part of the straddle – but that could just reflect not having gone into that territory during the relevant period.

    • October 22, 2011 at 1:14 pm

      That seems sensible. I’m sure I could deploy a lot more fancy econometrics on this to tease out a more meaningful relationship. Might be an academic paper in that some day. Your points are well taken. In this comment I was mainly trying to make a general point about the observation that “gold does great in deflations and inflations,” and to make a very general illustration of the proposition. Thanks for the thoughts!

  9. onebir
    October 22, 2011 at 3:37 pm

    I think you’ve made a point & wish I’d read this article before I went out & bought signficant amounts of gold in the $1800s. At least reading the scatterplot as having a shift variable (VIX? interest rate expectations?) I get the impression there’s a floor somewhere around $1200 rather than $800.

    Gold seems to attract extremists – so thanks for some neutral, thoughtful, data-driven analysis. 🙂

    • October 23, 2011 at 2:24 pm

      Thanks. I expect the floor should move over time…higher, presumably. So $1200 doesn’t seem crazy. I’d be really surprised to see if get there any time soon though.

  10. onebir
    October 26, 2011 at 3:39 pm

    The World Gold Council got Oxford Economics to do some econometrics for them:


    They come to similar conclusions to the parabolic idea in your chart; gold does best in inflation, pretty well in deflation, but not so well in stagflation.

    I can remember just enough about econometrics to see that the equation they settled on fits pretty badly post 2003 (they buried the residual plot on p40).

    I also wonder if restricting the gold price to be unit elastic wrt US CPI in the long run makes sense given:
    a) the changes in the CPI definition starting in the 80s &
    b) the declining weight of the US in world economic activity
    c) increasing incomes in developing countries where income elasticity of demand for gold seems to be higher than in most developed countries.

    But I guess the main point of the report was getting consultancy fees from WGC 😉

    • October 26, 2011 at 3:58 pm

      Ha! No doubt. Thanks for the link!

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