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The recent action by the ECB appears to have caught many
gold bulls off guard. A common interpretation of the impact that a potential
quantitative easing program would have on gold prices was that it would be
very bullish. This argument was based on the concept that money printing is
bullish for gold, and that QE1 and QE2 by the Fed triggered major rallies in
the yellow metal. Whilst we do not dispute that QE1 and QE2 by the Fed were
indeed bullish for gold, we strongly disagreed that the ECB would introduce a
program that would spark a major rally. In fact we went further, predicting
that what the ECB was going to do was in fact highly bearish for gold, and in
this article we will endeavour to explain why.
The Devil is in the Detail
There are some key concepts to understand about what the
ECB is doing and how that differs from the generic QE programs implemented by
the Fed and other central banks. Whilst the Fed’s QE programs led us to the
view that gold prices were heading higher during the years 2009-2011, there
are seemingly minor but actually crucial differences in the ECB’s QE led us
to reaffirm our view that gold prices were heading south.
When the Fed first implemented QE their goal was to
stimulate the economy by keeping long term interest rates low and injecting
cash into the financial system. The Fed targeted buying long term Treasuries
(US Government debt), aiming to push the price of that debt higher and yields
lower. This would ensure that longer term borrowing costs were kept low
in order to stimulate the economy.
The ECB is not trying to get long term interest rates
lower; these are already at all-time lows. They are not buying government
bonds. Instead the ECB is engaged in a program of purchasing Asset Backed
Securities (ABS) with the objective of incentivizing banks to lend.
An ABS is a financial security backed by a loan, lease or
receivables against assets other than real estate and mortgage-backed
securities. For investors, asset backed securities are an alternative to
investing in corporate debt. They are similar to the Mortgage Backed
Securities (MBS) that the Fed began purchasing with QE3. Just as the Fed
bought MBS with the aim of stimulating lending in the housing market, the ECB
is attempting to target corporate lending by purchasing ABS.
ECB QE is More Like The Fed’s QE3 Program
As one will recall, QE3 by the Fed was actually very
bearish for gold. If this sounds counter-intuitive, and it is somewhat,
particularly given a backdrop where pumping money into the system had been
bullish for gold. Although QE3 had been put under the same banner as the
previous two programs, the change in its detail actually had the reverse
impact on gold prices. We recognised this subtle difference and the vastly
different implication it had. This resulted in us aggressively shorting gold
and gold mining stocks through 2013 and largely contributed to our 92% return
during that year.
Therefore, we see the ECB’s QE program as negative for
gold prices. The program will stimulate corporate borrowing and economic
expansion, but will not drive interest rates lower and will be bearish for
gold. We therefore went short gold into the ECB meeting and continue to think
that gold prices are biased lower.
There is also the currency implication; with QE by the
ECB potentially further weakening the Euro it therefore strengthens the USD
as a knock on effect. It is harder for gold to rally in USD if the USD is
getting stronger.
We think that those who view QE as bullish for gold are
missing the point and overlooking crucial technical details in programs. All
QE is not the same. QE1 and QE2 by the Fed were perhaps the most similar, but
they had very different implications compared with Operation Twist and QE3.
The ECB’s QE program is also a different beast. It is vital to understand
these differences and their implications on financial markets. Placing all
these stimulus programs under the same category simply because they have the
similar acronyms is a reckless investment decision; one must work to
understand the finer details.
Price Action Speaks Loudest
If one has not been convinced by the above arguments,
then the recent price action should put the final nails in the coffin for
those who view the ECB’s QE as bullish for gold. Gold prices have
broken through key support levels and now have their sights set on our $1180
target.
When one considers that gold prices have tumbled despite
a weaker US payrolls print, increasing tensions in the Ukraine and Obama
announcing air strikes on Iran, it becomes clear what a weak position the
yellow metal is in. Those geopolitical factors should have supported gold,
and indeed they have provided bumps in the price throughout the year, but the
bearish implications of the ECB’s QE program have dwarfed these bullish
headlines.
In silver the technical picture looks even worse, with
the critical support zone around $18-19 in serious jeopardy.
Whilst both gold and silver may get a minor bounce back
given their oversold levels, any bounce should be faded and used to add to
shorts given the overwhelmingly bearish macroeconomic backdrop.
Fed Meeting Adds Fuel to the Fire
The Fed meeting this week is unlikely to provide any
relief to gold bulls. The US Dollar has been gaining against other currencies
this week in expectation that the Federal Reserve may use this meeting to set
the groundwork for an interest rate rise next year. Discussion of rate hikes
are bullish for the USD and bearish for gold.
We will be looking for Yellen to remove the phrase “considerable
time” from the statement as a signal the Fed stands ready to begin hiking
next year. It could even be replaced by a phrase indicating the timing of
hikes is data dependant, but given that payrolls have been printing at over
200k on average for over a year we think this would be a strong signal that
the Fed stands ready to hike, particularly now that tapering is coming to an
end. A hawkish Fed discussing future rate hikes will force gold to test $1180
sooner than many might think.
Where to From Here
Given a new QE program by the ECB that is bearish for
gold, a Federal Reserve that stands ready to increase interest rates next
year and a very weak technical picture we continue to hold the view that gold
and silver prices are currently at unsustainably high levels. The next big
support for gold is at $1180 and this could be tested very soon should Yellen
have a hawkish tone. Whilst gold and silver could have a small bounce from
these levels we think that any attempt to move higher will be feeble and
short lived, therefore this is move to be faded and used to add or initiate
short positions. Over the medium term we see gold trading down to $1030 and
therefore we will most likely maintain a core short position until that level
is reached. For our weekly market updates, trading signals and model
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