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Commodity Investing Shell Shocked
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Uncertainty over the duration of the U.S. Federal Reserve’s asset purchase program helped reverse what had been a stellar twelve-year run for gold. Gold led commodities lower during the past week as the yellow metal tumbled to $1,572.79 per ounce—a slide of 2.3% on the week. Traders have been nervously dumping gold as a variety of technical indicators including the appearance of a death cross coupled with the 50-day moving average falling below the 200-day moving had traders in the mood to sell.

Gold’s fall is likely to continue despite the 5.5% sell-off experienced so far this month as many of the factors supporting its rise appear to be rolling over. Ever since 2002, gold has been on an impressive march higher, soaring by nearly 500%, making it one of the best performing assets.

But the good times appear to be coming to an end. Adding to the selling pressure were reports that funds, including Soros Fund Management and Moore Capital, sold their holdings of gold exchange traded funds in the last quarter of 2012.

Supporting the price of gold over the last twelve years has been persistent worries about inflation or worries about fiat currencies being debased by central bankers printing dollars, yen and euro in wild abandon. As far as inflation worries are concerned, it's hard to see what all the fuss is about. Within the developed world, CPI inflation has been falling for some time and in the BRIC (Brazil, Russia, India and China) group of countries, inflation is below the levels recorded in 2011.

Fear of currency debasement has been the primary factor driving investors to pile into gold in recent years. Investors have reasoned that the build-up in the balance sheets of the largest central banks in the developed world would invariably lead to a tumble in their respective currencies and hence to higher gold prices. Unfortunately, its based on a misperception of how monetary policy is conducted.

For starters, money growth has been pretty sluggish lately—a necessary condition for currency debasement and inflation. When the Fed buys bonds it does not print money to pay for the bonds, but rather it credits the selling bank’s reserve deposit at the Fed. The $1.5 trillion of reserves are not money, nor are they counted in the nation’s money supply. A buildup in reserves can spark money supply growth if the banks are lending, but that the decision to lend is based on credit conditions in the broad economy.

So while the reserve balances have been building, the money supply in the United States has not been growing because there’s been no big upswing in bank lending. In fact, it was the been the collapse of credit during the 2008/2009 financial crisis that caused the Fed, Bank of Japan and Bank of England to begin quantitative easing to try and plug the gap left when commercial banks made credit less available. And while credit conditions in the U.S. have improved slightly in the past year, there’s still a long way to go before money growth hits its pre-crisis trend. There’s still plenty of time for the Fed and other central banks to reign in their balance sheets or to raise interest rates to constrain commercial bank lending should inflation threaten.

Others have suggested that the West is trying to inflate away their debts by encouraging letting prices surge. To some, the hyperinflation that the Weimar republic let build, is analogous to the situation in the U.S. today. To some, the solution to a high debt-to-GDP ratio is to simply let prices mover higher, thus increasing nominal GDP (the denominator), in essence inflating away the problem.

But that flies in the face of recent deleveraging episodes in the U.S. Between 1945 and 1970 and again from 1995 to 2000 America paid down debt with below average rates of GDP inflation. Recent budget deals in the U.S. suggest that current plans are calling for a substantial paring of annual deficits and the debt/GDP ratio.

A big factor supporting gold prices has been retail buying of physically backed gold ETFs. But these inflows into gold ETFs could head south in a hurry, particularly as the year unfolds and the U.S. moves past the steepest stage of fiscal tightening and the improving global growth prospects for 2014 begin to loom. Investor flows into gold ETFs have plateaued since mid-2011 as investors have cast an envious eye toward the improving fortunes in the stock market.

The fortunes of gold producers have been more dismal than those of the commodity itself as inability to deliver new projects on time and on budget coupled with poor operating results have led to a near 30 percent slide in the value of gold producing equities over the last year or so. Gold will glisten once more, but for now, the shine is off gold and savvy investors should look toward dividend paying stocks as the place to pick up badly needed investment performance in the year ahead.


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