Why the Gold Crash? The Failure of Inflation to Take Off

One of the key features of the post-2008 gold boom was the notion that inflation was soon about to take off due to Bernanke’s money printing.

But so far — by the most-complete inflation measure, MIT’s Billion Prices Project — it hasn’t:

AnnualInflation

To me, this signifies that the deflationary forces in the economy have so far far outweighed the inflationary ones (specifically, tripling the monetary base), to such an extent that the Fed is struggling to even meet its 2% inflation target, much less trigger the kind of Weimar or Zimbabwe-style hyperinflation that some gold enthusiasts have projected.

The failure of inflation to take off (and thus lower real interest rates) is probably the greatest reason why gold’s price stagnated from 2011 and why gold has gone into liquidation the last week. With inflation low, investors became more cautious about holding gold. With the price stagnant, the huge gains that characterised gold’s rise from 1999 dried up, leaving more and more long-term investors and particularly institutional investors leaving the gold game to hunt elsewhere for yield.

I myself am an inflation agnostic, with deflationista tendencies. While I tend to lean toward the notion of deeply-depressed Japan-style price levels during a deleveraging trap, price levels are also a nonlinear phenomenon and could both accelerate or decelerate based on irrational psychological factors as much as the level of the money supply, or the total debt level, or the level of deleveraging. And high inflation could certainly take off as a result of an exogenous shock like a war, or series of natural disasters. But certainly, betting the farm on a trade tied to very high inflation expectations when the underlying trend is largely deflationary was a very bad idea, and those who did like John Paulson are being punished pretty brutally.

The extent to which this may continue is uncertain. Gold today fell beneath its 200-week moving average for the first time since 2001. How investors, and particularly institutional investors react to this is uncertain, but I tend to expect the pendulum to swing very far toward liquidation. After all, in 2011 most Americans named gold the safest investment, and now that psychological bubble is bursting. That means that for every goldbug buying the dip, many more may panic and sell their gold. This could easily turn to a rout, and gold may fall as low as the cost of production ($900), or even lower (especially considering gold’s high stock-to-flow ratio). Gold is a speculation in that it produces no return other than price rises. The last time gold got stuck in a rut, it was stuck there for almost 20 years.

However, my case for physical gold as a small part of a diverse portfolio to act as a hedge against systemic and counterparty risks (default cascades, Corzine-style vaporisation, etc) still stands, and lower prices are only good news in that regard. The financial system retains very many of its pre-2008 fragilities as the deregulated megabanks acting on margin continue to speculate in ways that systematise risk through balance sheet interconnectivity. Another financial crisis may initially lower the price of gold on margin calls, but in the long run may result in renewed inflows into gold and a price trend reversal. Gold is very much a barometer of distrust in the financial, governmental and corporate establishment, and as middle class incomes continue to stagnate and income inequality continues to soar there remain grave questions over these establishments’ abilities to foster systemic prosperity.

40 thoughts on “Why the Gold Crash? The Failure of Inflation to Take Off

  1. I thought you were a biflationist :)

    I wonder about what shadow banking might have to do with this: rehypotecation, securitization and other fractional-reserve-like operations applied do paper gold increasing percieved supply of gold, ending up at CME hedged with shorts… these shorts seem naked to goldbugs but if CME accepts any gold IOU then these shorts are eligible. this could go on for some time keeping prices low. I don’t believe in outright manipulation. I think lower prices must come from some systemic feature we haven’t identified. what do you think?

    • I thought you were a biflationist

      Correct, over the whole economy there are always biflationary/polyflationary trends. Which is one reason why I am such an agnostic about the question of putting a single figure on prices.

      I think lower prices must come from some systemic feature we haven’t identified. what do you think?

      I think lower prices are definitely real and based on people selling the various varieties of gold (especially paper). I think there was a psychological bubble from 12 years of straight price rises, and as more people piled into gold as a “hedge against inflation”, this translated into higher prices. As the expected inflation hasn’t materialised, less people are piling into gold, and finally this has led to the phenomenon of falling prices. This may be exacerbated by large paper shorts, but so what? That’s how the market works. If real demand for physical gold was so much higher than paper short demand then the shorts would get obliterated.

      I think the additional functions of physical gold (lack of counterparty risk) merit a larger spread with paper gold, too.

  2. I think your explanation for the price move in gold is plausible in theory, but I don’t think it fits the abruptness of the the moves in the last two trading days in practice.

    Friday someone dumped 400 tons of gold onto the market in less than half an hour. Try to put yourself into the mind of someone who owned a large, market-moving position in gold and either needed or wanted to liquidate that position. I don’t know about you, but if I am selling something, I want to get the best possible price for it, and I assume that is universally true.

    So if I wanted or needed to sell 400 tons of gold, and assuming that some kind of panic liquidation event was not already happening (as it was not friday morning), I would try to do it in somewhat smaller chunks rather than dumping it all at once. In fact, this is how institutional traders buy or sell market-moving quantities of assets. They use sophisticated trading bots with sensitive algorithms that carefully offer as much at a time as the market can handle without pushing the price against their own financial interests. The last thing a large trader who owned gold would want to do is dump a market-overwhelming quantity in one fell swoop, absolutely guaranteeing that they would be getting an increasingly worse and worse price for their assets as the sales rout continued.

    I’m not trying to push a conspiracy agenda. But if you are looking for a reasonable explanation for the “gold crash”, it seems to me that lack of inflation could well explain the consistent drift lower over the past six months, but it doesn’t seem to me to offer a viable explanation for massive dumping like we have seen in the past two days. I could come up with an explanation that fit those facts better than inflation expectations, but then I’d have to go all tin-foil hat on you.

      • That’s certainly possible. A little scary though if people who can move 400 tons of gold at a time are so hair trigger that they decide to move all 400 tons in half an hour vs. spreading it over the course of a day or two, to their extreme financial detriment. One might hope that people responsible for quantities of assets that large would be a little more level-headed in their approach to the market. Hope not a great strategy, I’ll admit, but still.

        • 400 tons is Central Bank power. And Central banks employ calm bureaucrats.

          Someone needs gold to be relegated as a barbarous relic.

          I am coming around to Bernanke’s theories. Ever expanding production needs money to be printed to back it up. Without doing so causes deflation.

          The problem with deflation is there are losers (Conglomerates that collapse) But the people who save, get cheaper goods.

          Eventually once most suppliers go bust, production equals demand and price stabilises, but people still get more product for their efforts, via efficiency gains.

          But all the cars look the same!

      • John & other chart experts: don’t zerohedge’s charts make a strong case that a prompt S&P plunge is likely to follow the current gold price drop?

  3. John: I (not an economist) have to agree with PJ Vandal’s comment just above. But what could be the cause(s) of the “abruptness” of dumping > $17 Billion of gold OTHER THAN conspiracy? Liquidity crunch of private or government holder(s)?

    What about silver?

  4. A single seller is not going to create such a massive panic in a multi trillion USD market unless there is something real to panic about. It could very well be that somewhere was a real life version of Margin Call movie; people realize the support for the market wasn’t there, and wanted to be the first people out of a burning theater. Good for them, knowledge should pay off.

    If money that central banks are printing isbeing given to banks, and those banks are just using it to destroy their debt, then that money printing is actually *destroying* money which causes deflation. This is counter-intuitive. This could very well be happening in the US, EU, or Japan. Its hard to understand where “money” goes in all this obfuscation.

    • A single seller is not going to create such a massive panic in a multi trillion USD market unless there is something real to panic about.

      Bingo.

    • Its about the volume, not the number of individuals. That size cannot be absorbed within that short period of time. In any other stock, the market would be halted and the seller thoroughly questioned as to motive because intent is sure like market manipulation. No rational seller seeking to unload 400 tonnes would sell it all at once in a 1 hour interval. It would be spread out over weeks and months. Yet it has been done over and over again. Just much more heavy handed today.

      Once you hit the stop losses, you have funds buying on margin forced to liquidate. And whoever is doing it have unlimited funds and the backing of the government, so no small fish will fight it. Governments don’t care about the fluctuations of the paper market. They just keep accumulating. Its just with us small fries that worry and fret over every gold movement.

      Also, you never see similar action in any other market because its blatant manipulation. Show me any other chart where a market is slammed this hard so suddenly on no news. Can’t. only happens in the gold market.

      • Seller may have panicked, may have faced a marginal call themselves and been forced to liquidate. We need hard proof and lots of it before we start crying conspiracy.

        • People love a conspiracy. If something doesn’t jive with the whole “gold/silver to the moon in a couple months” belief, then it must be evil manipulation. People need to separate their love of financial Schadenfreude from reality.

          By the way, in the long term (just like in 1975 looking past the upcoming slump) one can make the case that gold is still a great investment. This distinction is basically lost on 99% of “stackers”.

        • Personally, I am not arguing in favor of a conspiracy per sé. And I definitely do not believe that every downturn in the gold market is the result of an evil cabal. Nor do I believe that all of the selling that has happened during the last two trading days was agents of government dumping naked short contracts on the market.

          But you are throwing out some conjecture: “seller may have panicked, may have faced a margin call” etc. And then you say you need lots of hard proof before crying conspiracy. But why is that? I can come up with tons of explanations for the selloff that have nothing to do with anything that you proposed as potential reasons for the selling and nothing to do with any conspiracy. Fat fingers, mice in the mainframe, aliens from mars. Pretty sure that you don’t know what it really was. And I am totally sure that I don’t know.

          So why throw out any particular explanation a priori?

          Now I know that nobody would do anything like collude to manipulate Libor, the most consequential non-government interest rate on the planet whose every basis point effects the price of hundreds of trillions of USD-worth of derivatives. And of course the Fed is clearly dedicated to an un-manipulated, free-market reserve rate. And US banks would never do anything like robosign millions of mortgage documents, rendering them legally null and void in order to avoid the cost of making those documents good, and if they did, surely the bank regulators would come down on them VERY HARD. So of course we can agree that nobody would conspire to try to manipulate a market with billions of dollars at stake.

          Right? So maybe it would make sense not to throw out any particular explanation a priori and instead, if your aim is to explain “why the gold crash”, to try to find an explanation that best fits the actual observed data given the actual incentives of the actors whose behavior generated that data (to whatever degree we can know it). And in this case the data I am talking about is not the general downtrend of gold over prior months, but what I think you are referring to as the “gold crash” — i.e. the massive liquidation over the past couple days.

          To me, the idea that someone suddenly decided to dump 400 tons of gold on a market that could no way absorb that volume all at once out of the blue – on no gold-bearish news (that I am aware of) prior to the retail open (so before any margin calls would have gone out yet; and without any other markets falling apart that would have been likely to generate a margin call in any case) stretches credulity. That they would do so knowing that it would cause them to get the worst possible price for the gold they were selling stretches it a lot further. I can understand why someone might do that in a moment of emotion after panic selling had already started. But out of the blue? That doesn’t make sense to me.

          On the other hand, there are some big players in the gold market who were heavily short who stood to profit significantly if they could manipulate the price of the metal down in a manner that would catalyze significant further selling beyond what they themselves had to do to get the ball rolling. Now that is an incentive to dump that I can totally understand. That makes perfect sense. And that is also – or at least it used to be – the definition of illegal market manipulation.

        • In any other market, such actions would be market manipulation. You see it happen in JPM stock and you would have a public outcry of market manipulation and illegal shorting. Only in gold can it be done and yet praised on every blog and clown tv as an I told you so.

        • And btw, your reasons are laughable. 15% of gold supply mined that year is traded within a few short hours. So how many people own that much gold contracts that are suddenly facing liquidation all at once and then decides to unload at nearly the same time.

          One or two big traders? With 400 tones of gold contracts? Whats the VaR on that? Only plausible answer is manipulation.

          The reason as to the manipulation is up to you. But you’re blatantly ignorant to disregard such manipulation as conspiracy theory.

        • All markets are “manipulated” by people participating in them.

          If you’re so sure gold is worth more than the current spot why aren’t you grateful as hell for the chance to buy the dip? The person who it has hurt is the “manipulator” who liquidated too far and too fast.

  5. Pingback: Why the Gold Crash? The Failure of Inflation to Take Off | gold is money

  6. I’ve always thought the markets [even corrupt ones] are a great metaphor for all things knowable in life, that is, there is no way you can [really] predict their movement because the number of variables involved is obviously more than what anyone can figure [actually it’s infinite].

    Reality suggests that each moment is completely unique, determined by the infinite number of events preceding, so the markets are just like everything else, except we acknowledge our ignorance in this instance, whereas we believe we can understand [nearly] everything else.

    In the end, it matters not whether gold goes up or down, only that the lot of the common man improves, that our species makes some sort of movement forward in the overall picture.

  7. I don’t think that a failure of inflation to take off is the right way to look at this, because gold is more fundamentally affected by the real interest rate. In that context, low to negative real rates constitute bullish conditions for gold. This basic condition still holds, although since late 2011 the real rate has risen a bit. Specifically, the real rate has risen from nearly -4% in late 2011 to -2%. Given we’re still in a fundamentally bullish condition, that rise would manifest itself on a chart as a correction in a bull market.

    This is exactly what the gold chart looks like, from 1999 to now – a 11-12 year rise followed by a correction which is going on 3 years. I’ve been bearish since gold failed to retake 1800 last September, but I only documented that in Feb. I’ve been looking for a move to 1100-1200, but time wise I expected it to inch lower and not plunge. Perhaps it might inch lower the rest of the way. But the 1100-1200 region is key for me as there is plenty of support there, including the 50% retracement of the entire move since 1999.

    Enough technicals though. Fundamentally and psychologically, I think that it’s best to characterise September 2011 as the end of the first leg of the bull market as opposed to the end of the entire bull market. The reason is slightly convoluted, but it stems from your observation that the deflationary forces outweigh the inflationary ones. As we all know, the existence of the deflationary forces is owing to the bursting of the last credit bubble, which central bankers are now trying to reflate. In keeping with Hayek (and later De Soto), booms can only continue as long as the rate of credit expansion is accelerating. Looking at the credit statistics from the Fed (http://research.stlouisfed.org/publications/mt/page14.pdf), one can see that the rate of credit expansion has plateaued over the last 12-18 months. Also note similar plateaus over the 2005-2007 period, the period during which the last bubble burst.

    What I’m suggesting is that the settings for another massive deflationary leg are materialising. This goes beyond gold of course, so to focus on gold, that does mean prices are to fall, like they did in 2008. The fundamental situation though is what determines whether the fall is a correction or a secular trend change. And that fundamental (the real interest rate) is in turn determined ultimately by how much central bankers are willing to let the market reprice assets. What you are essentially saying by declaring the bull market over is that Ben Bernanke will suddenly turn into Mises overnight allow deflation to run its course. Everything he’s ever done (2008 in particular) indicates that he will not do this. Thus in the face of a new deflationary leg, he will have to go even bigger and harder (as per Abenomics) to recreate a boom, consistent with the Austrian view that credit must rise at an accelerating pace to sustain said boom.

    Basically the Schiffs of the world are skipping a few steps and going straight to the end game when they make forecasts of gold going to $5000. They are banking on the fact that each deflationary spell will be fought with more and more easing than before and that at some point the psychological limit of trust in the currency will be broken. I agree with this view, but I’m also a trader. So I can’t necessarily ‘skip steps.’ It’s important to keep the big picture in mind though, and contrary to the Weisenthals and Krugman, the Austrian interpretation still holds. I’m working on a longer post that fleshes this out a bit more, which I”ll share with you guys when I finish.

    • I don’t think that a failure of inflation to take off is the right way to look at this, because gold is more fundamentally affected by the real interest rate.

      The inflation rate, of course, being one half of the real interest rate.

      Specifically, the real rate has risen from nearly -4% in late 2011 to -2%. Given we’re still in a fundamentally bullish condition, that rise would manifest itself on a chart as a correction in a bull market.

      According to St. Louis Fed data, real interest rates are now above 0.

      Enough technicals though. Fundamentally and psychologically, I think that it’s best to characterise September 2011 as the end of the first leg of the bull market as opposed to the end of the entire bull market.

      How long do we have to wait for the second leg? Two years of price declines? Three? Four?

      As we all know, the existence of the deflationary forces is owing to the bursting of the last credit bubble, which central bankers are now trying to reflate. In keeping with Hayek (and later De Soto), booms can only continue as long as the rate of credit expansion is accelerating. Looking at the credit statistics from the Fed (http://research.stlouisfed.org/publications/mt/page14.pdf), one can see that the rate of credit expansion has plateaued over the last 12-18 months.

      Don’t fully agree. Booms seem to be able to continue on stable and high credit creation. Acceleration is more of an issue in preordaining Minsky Moments and downturns. Stock market boom continuing on stable circa 5% y-o-y credit creation, even while gold is lowered.

      What you are essentially saying by declaring the bull market over is that Ben Bernanke will suddenly turn into Mises overnight allow deflation to run its course.

      No, I’m suggesting that even in these deflation-reflation market people are gravitating away from gold which doesn’t produce anything, to assets that can produce something from index funds (yes, this is a very naive move) to farmland, energy and factories, etc. The first serious gold price falls in decades has potential to greatly exacerbate this.

      Thus in the face of a new deflationary leg, he will have to go even bigger and harder (as per Abenomics) to recreate a boom, consistent with the Austrian view that credit must rise at an accelerating pace to sustain said boom.

      The correlation may not be as simple as more money, higher gold prices. That certainly wasn't true during the last gold bear market.

      It’s important to keep the big picture in mind though, and contrary to the Weisenthals and Krugman, the Austrian interpretation still holds. I’m working on a longer post that fleshes this out a bit more, which I”ll share with you guys when I finish.

      I’d dispute whether the “Austrian interpretation” is really that gold prices will go to the moon soon. That is certainly the interpretation of some self-described Austrians, but I would argue they do not understand the work of Menger and Bohm-Bawerk. Austrian economics is about the subjective theory of value. This means that markets may decide to reject gold as a store of purchasing power for a while to come, until the market has truly bottomed out. It means that Fed liquidity may find other targets to inflate.

      • “The inflation rate, of course, being one half of the real interest rate.”

        Right, but I’m saying the real interest rate is the one of the fundamental determinants of the gold price, so only looking at part of that determinant isn’t sensible. Inflation really didn’t ‘take off’ from 2001 to 2008 either, yet the price went from $250 to $1000, because real interest rates fell below 2% and stayed there, apart from temporary spikes higher, which coincided with the corrections in the gold price. Financial media and speculators always talk about inflation, that isn’t the whole picture.

        ‘According to St. Louis Fed data, real interest rates are now above 0.’

        http://research.stlouisfed.org/publications/mt/20130401/mtpub.pdf

        Page 8. What you have to see for this to be a fundamentally bad thing for gold is that chart above 2-3%, and you must believe that the Federal Reserve will allow it to persist there.

        ‘How long do we have to wait for the second leg? Two years of price declines? Three? Four?’

        We’re already going on 2 years come September. Technically corrections in the primary trend can take a third or half or even more of the time of the primary up move took. Look at the 70s for reference. The first leg was about 3.5 years into late 1974. Then the price fell 50% over the next 18 months. Then from 1976 it exploded. The real interest rate fundamental was bullish the whole time, but it included a 50% drop in the price. What changed the fundamental picture was Volcker making sure real rates skyrocketed and stayed there.

        As for my comments about booms, they were more general in nature. Booms can ‘continue’ on the same way an appliance continues for a few milliseconds after its unplugged, however the source of the booms sustenance is gone. The housing boom burst in 2006, yet stocks still rose until late 2007, and other markets kept going until mid 2008. As for people selling out of gold to go into ‘productive’ assets, I think that will happen eventually, but that now is premature. I think anyone making that trade nright now is going to have to ride out another period of falling prices first.

        ‘This means that markets may decide to reject gold as a store of purchasing power for a while to come, until the market has truly bottomed out. It means that Fed liquidity may find other targets to inflate.’

        I agree with the first part, but in the sense that the ‘while to come’ is more consistent with the 18 month decline in the 70s, versus the 20 year decline following 1980. Fed liquidity for me, at least in the next phase of this Great Re(de)pression, will be faced with the task of preventing another 2008 style leg of deflation from happening as opposed to trying to further inflate other markets. I’m of the view that it’s more or less happened already and we’re in a period of plateauing before a massive decline. The Fed will have to step it up immensely from here.

        • “Inflation really didn’t ‘take off’ from 2001 to 2008 either, yet the price went from $250 to $1000, because real interest rates fell below 2% and stayed there, apart from temporary spikes higher, which coincided with the corrections in the gold price.”

          Sure it did. Look at housing, medical costs, higher education, government, banking, to name a few. As a matter of fact, it soared!!

          What could interest rates have to do with the price of gold? Interest rates are the supposed cost of money. Gold is NOT money in this system, no matter how much some people wish it would/could/should be.

        • Personally I recall back in 2000, after the Dot Com crash, an older friend going into gold, saying gold will be a great investment as the world was ending. I never took his advice, and now in hind sight I realise he was one of those scared types who was influenced by bloggers (Gold Bug leaders) who had taken positions and were needing to “Stimulate” demand.

          The internet is one big pump and dump. Saw it with Bitcoin. Gold is no different.

          The fact that Chinese and Indians were lining up to buy gold, tells me real demand is well above $1500. So it is a store of value. But in a deflation cold hard cash is th ebest investment, as you can swap it for fire sale assets. Real wealth accumulation.

    • “What you are essentially saying by declaring the bull market over is that Ben Bernanke will suddenly turn into Mises overnight allow deflation to run its course. Everything he’s ever done (2008 in particular) indicates that he will not do this. Thus in the face of a new deflationary leg, he will have to go even bigger and harder (as per Abenomics) to recreate a boom, consistent with the Austrian view that credit must rise at an accelerating pace to sustain said boom.”

      Steve, you have left out [perhaps] the most important ingredient in this toxic recipe, the fact that money is loaned into existence in this monetary system. If for no other reason, the amount of money created [credit] must be enough to pay the existing interest due on global debt.

      So, the entire global economy is one BIG Ponzi scheme. One hundred years of central bank inflation [in the U.S.] has [obviously] inflated everything, from penny-candy to gold. If you can determine where the price of gold should be, then you have the calculating skills of a zillion supercomputers.

      Again, the only yard-stick worth a damn is measuring who the average person is doing. The rest is theoretical/statistical masturbation.

    • Personally cash is the best situation to be in, because once real deflation sets in, liquid physical cash (Not in a bank) is what trades you real hard assets. In a real collapse where the Government issues new currency, A ten pack of cigarettes can buy you a lot of assets at desperate moments.

      Hyperinflation will not set in. The world has too many resources that can easily be traded. From Adolf Hitler’s Mein Kampf, hyperinflation is caused by zero production, and wage payments (Government transfers) coming in. Recall the Weimar government paid workers to strike, with international loans. Could you imagine if the Chinese Government paid its workers not to work?

      Unless China’s manufacturing base is wiped out, or a deliberate embargo sets in, production will continue.

      I think deflation will be the norm, going forward. deflation in consumer goods (The worlds conglomerates competing for market share) dumping goods, with increased consumer savings rates and government austerity.

  8. we used to be so habitually bullish on gold. now look how much we changed. if we were to travel time and say all this to our past selves, we’d got beaten up ;)

    does only me feel spooky about this?

  9. Gold was a bubble and I think it still needs to correct further downward. I think much of the increase in price came from levered speculation(like from John Paulson’s funds). Gold is a rock that is dug out of the ground. If you want protection against inflation, look to productive assets, not useless rocks. Keynes called gold a barbaric relic almost a century ago. Gold was a barbaric relic then and it’s still a barbaric relic today. I think a good price for gold is around $800-900, I wouldn’t even think about touching it until it hits that price.

    If you’re worried about inflation, get into productive assets. Not rocks that have clearly become speculative in their pricing by the market.

  10. John, nice format. The easier it is to read, the better. Few style points when it comes to serious bullshitting. :)

  11. I personally think that inflation targeting of 2-3% is wrong. I feel that with today’s inter-connected global trading world, deflation would encourage rationalisation of in-efficient industries. For example the auto industry has too many competing players.

    We would have a deflating currency and increasing real wealth through ever expanding production and efficiency gains.

    Gold would be a medium of exchange, that would back the currency. We could return to copper tokens. We don’t need gold in day to day trade.

    The point being a real commodity backs the money, and goods are ever increasing in volume, thereby lowering real prices.

    Gold was snapped up by Indians the other day, so it still has a store of value at $1500 an ounce (Retail-street price)

    Try buying physical!

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s