Gold’s 5% increase last week was generally attributed to escalating tension in the Middle East yet at the same time the Gold Fields Mineral Services (GFMS) Base Metal Index rose 7.8%. Base metals should not respond positively to war since wars destroy capital and cause misallocation of available capital, both of which in the end are detrimental to economic growth and prosperity. What gold and base metals are doing is signaling weakness in paper money. Gold is a monetary asset and protects its owners against the devaluations of fiat currencies only, and massive amounts of institutional money have been allocated to hard assets as a hedge against a decline in the dollar.
Between January and May this year the GFMS Base Metal Index rose 51% and gold rose 38% as institutional investors lay big bets that the US dollar is going to tumble. Those bets were placed on the premise of Japan ending its policies of quantitative easing and zero interest rates, which have been widely expected for almost a year now. With the Bank of Japan’s new policy of transparency, the changes were announced well in advance of taking effect.
What is busy happening in Japan is far more important to the price of gold, the value of your house, interest rates, your job, and the value of the money in your bank account than what is happening in the Middle East.
Don’t get me wrong; I am not downplaying the current Middle East violence. Personally I believe that the Third World War has already begun and that our lives are going to change dramatically over the course of the next several years as the War spreads and gains momentum. For starters you can expect further confiscation of your personal liberties, whatever is left of them.
This commentary, however, is not about liberty or war; it is about markets, money and gold. During previous wars and skirmishes the gold price seldom responded positively for very long. Any rally in the gold price due to conflict was usually (very) short-lived. So if the current rally in the gold price is merely due to Israel and Lebanon bombing each other, and fear that the violence will spread, then we should all sell into the rally for it will soon end.
On the other hand, if it has more to do with Japan raising interest rates for the first time in five years, marking the end of an era of yen-stimulated liquidity, then the rally could have legs (see last week’s commentary for more on the yen and the yen-carry trade). The weakness of the dollar against the yen (one of the few currencies that the dollar was weaker against last week) can be directly attributed to Japan raising interest rates and not Middle East turmoil.
As I said, base metals have rallied spectacularly during the past six months and the sell-off that commenced in May has essentially been erased. Base metals are rallying again. Now, if war is in our future you can bet economic growth is going to suffer. Also, with the US, Europe and Japan raising rates we don’t even need a war to take the wind out of the economy’s sails.
But if the base metal bets were made on the premise that the dollar will weaken, what about traditional base metal demand? Slower economic growth and the end of the real estate boom will cause reduced demand for base metals and weakness in base metals prices. Copper has no business trading where it is. Neither do zinc, lead, nickel or many other metals. They became over-bought as institutional investors tried to find hedges against dollar weakness. Perhaps there is still so much institutional money out there looking for a hedge against the dollar that base metals prices will double again, but, being a contrarian, I would not want to bet on that.
Base metals prices are so far ahead of themselves that I believe there is substantial risk of a meltdown in that sector. Because institutional money seems to have been allocated across the spectrum of metals, I fear that a severe correction in base metals could drag the gold price down as well.
So what will happen first? Will the dollar collapse causing more money to be allocated to metals thus pushing metals prices even higher, or will base metals correct dragging gold down with them?
First published on Kitco.com (www.kitco.com)
By Paul van Eeden
Paul van Eeden works primarily to find investments for his own portfolio and shares his investment ideas with subscribers to his weekly investment publication. For more information please visit his website (www.paulvaneeden.com). If you would like to read more from Paul, you can sign up to get his weekly commentary at https://www.paulvaneeden.com/commentary.php.