On the Breakdown in the Correlation Between Gold Price And The Federal Reserve’s Balance Sheet

Once upon a time there was a strong correlation. Then it broke:

20130921_gold1_0 (1)

Of course, we know that correlation is not and does not imply causation. But I think there was an underlying causation to the relationship that we saw, but it was not a superficial relationship of more asset purchases, higher gold prices. I think the causation arose out of self-confirmation; people noticed that the Fed was printing money, and believed that expansion of the Fed’s balance sheet would lead to price inflation (in ignorance of the fact that the broadest measure of the money supply was still shrinking in spite of all the new money the Fed was injecting into the economy, and the fact that elevated unemployment, weak demand, and plentiful cheap goods make it very hard for strong inflation to emerge). Many others believed that in the wake of 2008 and the shadow banking collapse, the financial system was fundamentally broken, and that the world might have to return to the gold standard. I myself believed that at the very least the West was in a prolonged Japanese style deflationary depression that in the absence of a return to strong growth might only be broken by very high inflation or a liquidationary crash.

Neither of these predictions — of imminent elevated inflation (or hyperinflation), and of imminent catastrophic financial system breakdown — have come to pass. Core inflation is close to its lowest year-on-year rate in history, and further financial system failures have mostly been prevented. So expectations have been shaken and are adjusting. Gold doesn’t produce any yield other than speculative price gains, but when gold is going up in price by around 20% a year it is still an attractive thing to hold to many, especially in an environment where its year-on-year speculative yield vastly outstrips bond yields and rates on savings. Once gold stopped going up by such a margin, investors had to sell their gold to lock in any speculative gain they might be holding onto, resulting in selling. And once gold started to fall, investors faced negative yields on gold, further spurring selling. This has meant gold has faced strong headwinds, and that is why its price has dropped by over 30% since its all-time high in September 2011, even while the Federal Reserve balance sheet continued to soar. Correlation broken. And in a market where the only yields are speculative gains, lost momentum can spell long-term depression as we saw for almost 20 years between 1980 and 2000.

Where gold goes from here is an interesting question. The main spur that pushes gold as an asset is goldbug ideology — the notions that it is the only real money, that it has intrinsic value, that fiat financial systems — and even modern civilisation in general — are fundamentally unmanageable and unsustainable and prone to collapse. As the technologies of capitalism, energy and production improve and advance, these goldbug views have been allayed and pushed to the margins as occurred in the 1980s and 1990s. In my view, their resurgence in the early 21st century stems almost entirely from the fact that real energy prices were rising, and real incomes falling. These two phenomena and their causes are complex and interconnective but essentially the energy infrastructure that brought the world spectacular growth and pushed all boats higher on a rising tide from the early 20th century to the 1990s began to come under strain — cutting into firms’ incomes, and individuals’ living expenses — and it has taken a long while for the market to even begin to equilibriate away from the increasingly-expensive old energy infrastructure and toward new infrastructures (initially increased U.S. production of shale, but going forward renewables especially solar). And while through financialisation and utilising insider-advantage much of the economic and financial elite managed to keep growing their incomes strongly, the vast majority came under stronger financial pressures and were only capable of sustaining their standard of living through debt-acquisition, which itself became a strain due to debt service costs.

As energy prices begin to fall (in what future economists may call a series of technology shocks), as private deleveraging proceeds strongly (with or without higher inflation) and as new cost-cutting technologies such as 3-D printing become more widespread real incomes will probably begin to rise again for the masses indicating a new supercycle of growth and pushing goldbug and other scarcity-concerned views to the fringes once more. We are, I think, moving inexorably to a world of superabundance, whether we like it or not. (Of course, in such a world assets like gold may still have a popular following to some degree, but that is another story for another day).

So even while the Federal Reserve continues to expand its balance sheet into the future in an effort to keep the US financial system liquid and further lubricate private deleveraging (and simultaneously chasing the elusive unemployment-reducing properties of Okun’s Law), the broken gold-Fed correlation is likely to break down even more.

26 thoughts on “On the Breakdown in the Correlation Between Gold Price And The Federal Reserve’s Balance Sheet

    • What do you mean and proof? I mean, selling “suppresses the price”, and since gold has started to go down a lot of people have been selling. But I assume you actually mean some organised conspiracy or something?

      • Perhaps something like this: http://en.wikipedia.org/wiki/Washington_Agreement_on_Gold

        I’m no goldbug. But I do wonder: if gold’s price is headed inexorably downwards, why don’t central banks with small gold holdings sell them off in advance? Strikes me as a prisoners’ dilemma… OR central banks still think of gold as an ultimate reserve asset which can be used in a crisis (think of Korea’s use of privately donated gold to repay the IMF in the late 90s). In which case, central bank actions (BRIC purchases and central bank maintenance of reserves) tell us that gold is still in some sense “money.”

  1. People and institutions are afraid. The way to keep the economy liquid is to GIVE INDIVIDUALS money (businesses can and will always borrow). Giving people money necessitates a lot less continual money creation and hence a lot less monetary inflation than loaning it to them. The economy’s most basic disequilibrium is that the system creates more prices than it does individual incomes to liquidate those prices. The solution to that most basic problem is a gift to individuals. Simple. Too simple for nearly all economists to understand. Couple this gifting of money with a general discount on prices to participating merchants and you’ve bracketed the entire productive process with an equalizing macro-economic mechanism and eliminated any cost push or demand pull inflation.

    Central planning! say the orthodox libertarians. No, central planning is a bureaucrat deciding how many size 8 shoes to produce. A Dividend and Discount are macro-economic mechanisms that free the individual (and the system) to make “free” market THEORY, free in fact.

  2. Hi Aziz. Can you (or anyone else here) explain in layman’s terms why the monetary supply is shrinking even though bond purchasing continues?

  3. Ah. I understand that “money supply” refers to all the cash in circulation plus the money actually deposited with banks. And “monetary base” is that, plus “commercial banks’ reserves that are maintained in accounts with their central bank” (wikipedia here). But in the post you linked to (“Even after all the QE, the money supply is still shrunken”) you seem to indicated the opposite: ” the Fed does not control the money supply. It controls the monetary base, which influences the money supply but the big money in the US economy is created endogenously through credit-creation by traditional banks and shadow banks.”
    Care to clarify?

  4. John – Great post again as usual. People must hate you for your negative analysis towards gold (l’m also pretty bearish short term). But gold will have its day (in the next 5 years i think – when the next global recession bites) at which point all the goldbugs will come out and say “I told you so.” Keep up the good work!

  5. Hi John,
    sorry I have to dissagre with your analysis on gold. Ths is a vey western centric view point. China and india (amongst others)are importing large quantities of physical gold – much of it driven by private demand, the western populations are not doing the same. They perceive the current price crashes as a buying oppertunity, The buying rate for gold in these economies is higher than world production (the situation for silver is if anything worse) How this will play out in the long term is hard to say but I feel it will not play out so well for the western economies if we continue down the economic path we are following.
    Our price discovery mechanism for mant items including gold is fundamentally broken – how can the price of something be determined by paper heavily leveraged and by people who are not actually using the materials, this is not supply and demand – this is speculation, and its doing real industries real damage by artifitially raising the prices of many commodities (although not gold and silver). I Use tin and lead at my work and have watched the price fluctuate for no apparent reason – on the lead front prices went up when lead stocks were climbing – according to traditional supply/demand therories that should not happen.

    • What if the people buying gold in India and China are mistaken? With lots and lots of people piling in and with gold producing no actual yield other than speculative price-gain yields this makes gold fragile to bouts of selling and correction. One small correction can lead to a larger surge of sellers as people seek to lock in gains by selling (those could be Westerners, or Indians, or Chinese people, or anyone). This is also true for stocks and bonds and real estate and other yielding assets, but to a much lesser extent than gold, because these assets do produce a return (rents on capital, rents on property, dividends, etc).

      I see a lot of mythologising of the behaviour of the Chinese and Indian populations, this notion that they are right and that foolish Westerners who reject gold are wrong, but maybe they are the ones buying a bubble this time?

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  7. Hi John,
    what if they are right?
    and as I`ve said before much of the purchasing by gold bugs is a form of insurance not speculation, I`ve more silver than gold as I cannot afford much gold but with ongoing government interference with everything money related its one “asset” they cannot take from me, – unless they want to use a metal detector and dig my garden for me

    • If the people buying gold in India and China are right, then the price will go up until a sufficient number of them start taking profits. At which point, the price will go back down again.

      There’s a fine line between insurance and speculation. If the goldbugs (Eastern or Western) are buying gold as a tiny part (<5%) of a balanced portfolio dominated by index funds and productive assets then the price of gold going into the floor is no issue and it is more insurance than speculation. If people are loading up on gold in larger quantities hoping to retire on it based on some thesis that there will be hyperinflation and gold will go to $20,000 an ounce, then that is speculation.

      • Fair comment,
        but the price is being manipulated by the western banks to keep it low.
        Also many people are not able to afford proper portfolis and save very small amounts – and why is 95% in index funds and productive assets a safer bet?

  8. I think you’re too quick to envision superaboundance without collapse on the way.

    neither Venezuela nor Argentina witnessed nuclear war nor mega tsunami.

    money-supply-contracion happens not because of disasters but because of recalculation. economic actors discover the warehouse being emptied by disaster/war and begin recalculation, withdrawing capital from use for starters to see what other parts of this distributed computaion systems come up with. a huge bubble, war, distaster or technological breakthrough implies economic maladjustment. actors begin “recalculation” which – in fractional reserve system means monetary deflation.

    such recalculation may originate from technological breakthroughs like 3d printing. hyperinflation is always man-made disaster in panic response to severe deflationary forces. imagine someone discovers how to make cars out of dirt. this would obliterate car industry as we know it within months. policymakers would simply think about symptoms, and these do not differ from recession. they’d try to contract it by printing to ease the pain.

    the advent od 3d-printing will obliterate global logistics industry any many others servicing it very fast. it might be the hyperinflationary trigger itself.

    since 1971 fiat-backed-by-fiat system has grown into mindnumbing size. the world is far too leveraged. it is only perception that holds it firm. what happens when that perception goes away? dollar hiperinflation theoretically could arrive without FED printing any further penny. the system is balooned enough anyway already. perception is the glue that keeps it together.

    what could destroy that perception? and what does this perception rely on? on perception of access to cheap fossil fuel. what could shutter this perception? Peak Oil perception? petrodollar issues in the middle east? perhaps this is why peace-nobel laureates insist on invading middle east so much… default on foreign bonds? mass US Treasuries sell off? defualut on FED assets? what would happen if global economic actors wouldn’t see a difference between US and Venezuela anymore?

    US debt bomb and expected Peak-Oil – wheather or not they themselves pose a huge problem – could shatter perception of stability of a system that is solely based on.. perception. we might get solar energy before we run out of cheap oil but if perception of oil issues pops out just before this happens, we could all have a Minsky Moment that makes us race for tangibles. and with so much tickets already printed, the ratio of ticket-to-stuff (aka price) could easily skyrocket.

    • Thanks for that Mantrid,
      Some common sense and reality.
      I read the article with an open mind but the author places an awful lot of trust on the over-leveraged financial institutions and their cohorts {who manage the gold prices via extreme “paper” manipulation}
      I’m not “locking in” any profits because these series of events haven’t run their course yet.
      Wait till “I’ve never recognized a bubble” Yellen takes the reins.
      I’ll check back in a couple years. Good Luck!

    • If one wishes to talk about perception, there is no limit to the fairy tales one might deconstruct. The financial system/economy is particularly easy pickings, but you can go any which way you desire if you wish to expose the non-sense that institutions and their parasitic minions ply on the populace.

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  10. hyperinflation does not necessarily require elevated inflation. In fact, deflation can precede hyperinflation. It is a tug-of-war between a central bank printing money like mad to prevent deflation and the people dumping all risk-assets to hoard cash. But the central bank always wins because it has unlimited ammunition.

  11. Like all the US government statistics, the Mx money supply numbers are all bogus. They even stopped publishing the only useful one M3 on March 23, 2006. I doubt the Federal Reserve even looks at the published numbers anymore.
    I also doubt the Federal Reserve will ever stop printing money on their own accord. The house of cards will surely collapse and China/India and/or Russia will ride in to save the day with a currency backed by gold. This president is more than happy to empty out Fort Knox just so he can keep the house of cards standing so the spending and redistributing can continue. Will Germany ever get their gold back?

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