Gold and the USD

As we have shown in previous blogs, the relationship between the US Dollar and Gold is complex and not quite as simple as it is often described.

The complexity of the relationship can be seen in the following chart, which shows the monthly % change in the Gold price against the monthly % change in the USD effective exchange rate index ranked by decile from 1980–2014. The 1st decile is the 10% of observations where the USD had the largest monthly decline (and vice versa): so, in the decile of largest monthly USD declines the Gold price rose, on average, 3% and in the decile of the largest monthly USD increases the Gold price fell, on average, 1.9%.


The graph shows, on average, that dollar weakness tends to correspond with gold strength but dollar strength doesn’t really hit gold prices until it becomes serious (i.e. out in the 10th percentile). There is no clear symmetry in the relationship between the USD and Gold prices.

With a number of identifiable, and negative, tail risks, including:

  • BREXIT fallout;
  • Extreme US equity overvaluation;
  • Chinese Yuan devaluation risk;
  • Saudi Riyal devaluation risk;
  • US recession and Global deflation risk;
  • Persistent Yen strength and the increasing frailty of the Japanese banking system and;
  • the perilous state of Italian Banks;

we can see many reasons for US Dollar strength.

Whilst modest monthly USD appreciation has little or no impact on Gold, we can see an environment where that “normal” decline in Gold at extremes of USD strength fails to materializes, where Gold and the USD both rally on rising risk aversion.

A stronger USD and rising Gold price will, no doubt, puzzle many investors used to the “normality” shown in the next chart, which shows the frequency with which the Gold price fell within each USD decile: so, for example, in the 10% of months where the USD had its biggest increases the Gold price fell 72.5% of the time and, on average, by 1.9%.


With large USD declines, the Gold price only fell 22.5% of the time.

The breaking of this relationship will, in our view, signal the loss of confidence in the ability of Central Banks to ride to the rescue of an overleveraged, deflationary biased and horribly unbalanced global economy with a crude assertion that all that ails the economy and markets is a lack of liquidity.

Alongside Gold versus USD, we also need to watch the relationship between European Bank stocks and US Treasury yields. Falling European bank stock prices mean just one thing: lower US Treasury yields.


So, look out for a rising Gold price, a stronger USD, falling European bank stocks and declining US Treasury yields simultaneously. It’s one very large canary!

Déjà vu

Last August, and again earlier this year, Chinese devaluation and the threat of a more serious decline in the Yuan (combined with USD strength) sowed the seeds of brief periods of significant drawdown in Global equity markets: the Global Index fell 12% in the month after last August’s trivial devaluation, and almost 14% in the weeks leading up to mid-February, when Yuan devaluation fears again re-surfaced.

Despite net outflows continuing apace through the first quarter – almost matching the entire outflow in the first 11 months of last year – and heavy Central Bank intervention, together with some tightening of controls at the margin, the Yuan actually strengthened in a move (vindictive, some speculators might say!) designed to head off speculative pressures and provide reassurance that all is well in the East. Another $1trillion in loans helped, but that’s neither here nor there in China these days. Move along, nothing to see here…

But we know differently. We know that you simply cannot grow credit $2.5 trillion annually with no corresponding nominal income growth; we know you cannot add capacity where there is already too much capacity; and that you cannot grow bank balance sheets at a rate annually equivalent to 40% of nominal GDP. Not if you want to keep your exchange rate fixed, you can’t.

And that’s where recent developments are interesting, the Chinese officially target the Yuan against the CFETs index – against a basket of 13 currencies (about one quarter USD weighted) and the Yuan has depreciated 1.3% since the end of March (5.9% year to date). From the mid-January low, the Yuan appreciated 2.1% against the USD through the end of March but has depreciated 1.2% versus the USD subsequently. They’ve unwound half the appreciation of the prior weeks.

Quietly, and under the radar, the Chinese have been letting the Yuan slide against the CFETs basket and, probably more importantly for the market, against USD.

Graph 1

This USD strength is seen in the broad USD appreciation in recent weeks: the next chart shows the percentage of currencies in the US effective exchange rate basket that the US has appreciated against in the last 20 days: the USD has appreciated against 80% of the currencies in its own basket.

Graph 2

We are seeing broad USD strength, broad Yuan weakness and, significantly, the Chinese quietly letting the Yuan slide against the USD.

This feels like déjà vu from our standpoint.

The global economy is already at low altitude, the median annual growth rate in our broad national sample is just 1.9% with over half growing less than 2% annually, and appears to be losing speed, again over half have growth slowing. Another round of Yuan/USD weakness into that mix is likely to precipitate just the same reaction as we saw last summer and earlier this year. Perhaps it’s time to seek out that tin hat again…

US Corporate Profits

Corporate profit data made for some really grim reading after the Easter break.

  • Post Tax non-Financial Corporate Sector Profits Down 19% y/y


Why? Employee compensation share in output rising very rapidly now and crushing margins.



  • So, margins and profit growth going exactly as the historical data set would imply:

3-year outlook


5-year outlook


  • Unit profit data confirm the story.


All this from nose-bleed valuation – based upon valuation measures with a strong and consistent historical relationship with forward returns… and with the “China Crisis” still looming.




A little goes a long way

On the face of it, a 25 basis point (bp) increase in the US federal funds rate (the interest rate at which banks trade their excess reserves) looks pretty benign and inconsequential. Janet Yellen appeared to play down the consequences, but any student of economics knows that a little bit of tightening can go a long way under extreme circumstances.

Unfortunately, these are extreme circumstances and, in combination with liquidity developments outside the US, the US Fed just tightened global liquidity conditions very aggressively.

The first chart shows the relationship between the monetary base (under the control of the Fed: notes and coins + required bank reserves + excess bank reserves) and the short term interest rate.

On the vertical axis is the interest rate and on the horizontal axis something economists call the “liquidity preference”, which is simply the amount of monetary base per unit of GDP (or, in other words, how much “money” supports each dollar of gross domestic product).

  • At very low levels of interest rates the opportunity cost of holding money becomes trivial/near zero and so more money is willingly held.
  • At very high levels of interest rates the opportunity cost of holding money is very punitive so less money is willingly held.

Money moves faster around the economy (works harder) when interest rates are high and more slowly around the economy (works less hard) when interest rates are low.


Where are we now?

Well, unfortunately for the Fed, we are out at the far right of the chart with rates near 0 and liquidity preference at a record 22/23 cents per dollar of GDP.

So what?

Well, as we noted, money works harder when interest rates go up so for the Fed to actually tighten monetary policy they need to remove liquidity (“monetary base”) from the system. Otherwise, paradoxically, by raising rates they will have eased monetary policy (made money work harder).

How much liquidity do they need to remove?

Well, let’s look at the chart. A 25 bp short rate implies liquidity preference (money/GDP) about 30% below the current level, around 16 cents from 22/23 cents per dollar.

Given that excess bank reserves held at the Fed are $2.58 trillion, or 65% of the total monetary base, it would imply that the Fed needs to remove around $800 billion in liquidity from the system.

Note: the relationship between interest rates and liquidity (the size of the Fed’s balance sheet) is non-linear. In short, each successive 25 bp of tightening requires less liquidity removal; the liquidity removal is highly front-loaded (this was noted by former Fed Board member Professor Charles Plosser as far back as 2011). So, the first 25 bp is the hardest, requiring the better part of $1 trillion of liquidity removal. The next 25 bp are a further $200 billion (approximately) and so on.


Indeed, that’s a lot of liquidity taken out of the system. That must have an impact on market liquidity, asset prices and the US dollar.

However, it gets worse. Look at the drawdown in global foreign exchange reserves (essentially, capital leaving the emerging markets).


Emerging markets are losing liquidity at an almost unprecedented rate just at the point where the US Fed is likely to be taking the best part of $1 trillion out of the system – global liquidity conditions are tightening severely.

As always, we will observe and respond as/when/if the Fed follows the path.



That time of year

It’s that time of year for forecasters to rejoice in the opportunity to produce forecasts for the year ahead. Economists like Christmas – it brings the gift of a spotlight for their year ahead projections. However, when those economic growth forecasts start landing in your inbox, it might be worth keeping the following simple charts in mind.

We look here at the US market (simply because it is the heartbeat of the market overall and is so influential, but the analysis holds equally elsewhere) and the annual relationship between the growth rate of the economy and the return on the S&P 500.

Chart 1 shows the annual nominal return for the S&P 500 from 1990 onward plotted against the annual nominal rate of growth in US GDP.

Quite strikingly, there is absolutely no relationship at all between annual nominal US growth and annual nominal US equity returns (look at those coefficients, zeroes everywhere).


Let us torture the data a little to see if we can squeeze something useful from it. Chart 2 shows the annual rate of growth of real US GDP plotted against annual nominal US equity returns.

No change, still irrelevant. Where the economy goes the market does not follow.


So, with that in mind, perhaps it is time to give your economist a break this year. Not surprisingly, we will not be winging our economic growth forecasts to your inbox.

It’s not the economy, stupid.

P.S. Here is the same chart for the UK.




It is the US… again!

May 8, 2015

The last two weeks in financial markets have been somewhat of a rollercoaster, with bonds, stocks and the US Dollar selling off in unison, wiping out several hundred billion dollars off global wealth in a matter of days. European bonds took a severe beating, which, as explained in one of our previous blogs, was inevitable considering that a large proportion of them were trading at prices that guaranteed a loss at maturity.

Panics in financial markets always show up unannounced, which makes it all the more interesting to understand ex-post what triggered these brutal moves. Friends of MONOGRAM have heard us mention many times that in essence, this is all about the US. The US drives capital and sentiment, and are therefore more often than not the culprit behind volatility bouts. All major crises in the last 30 years have started in the United States: the 2008 Lehman debacle, the 2000 Tech bubble, the 1998 LTCM bailout, and the 1987 market crash.

This time around, two factors seem to have been the catalyst behind the coordinated retreat in assets markets. First, a couple of fixed-income investment luminaries, Bill Gross of Janus Capital and Jeffrey Gundlach of DoubleLine Capital (who incidentally are both American), have been vocal about the inflated valuation of European sovereign bonds. Gross going on to call long-dated German bonds “the short of a lifetime”. This means that betting on these bonds going down is effectively almost a sure bet, the closest thing to free money.

Secondly, the US economy is going through a bit of a soft patch. This should in theory be favourable to bonds, and perhaps not so good for equities, but both asset classes have gone down. Why? Mostly because the US Federal Reserve said that this would not change its perception of the overall upwards trajectory of the US economy, and therefore it would not change its plan to tighten monetary conditions by the end of the year.

But perhaps the Federal Reserve is wrong. Perhaps the US, which has been expanding modestly over the last 6 years, is starting to turn the corner for the worst. This of course, would be supportive to bonds, although interest rates are so low that upside here is limited. This would also be a headwind to stock market performance, not only in the US, but also in Europe; and this is even if European economies finally break out of the stagnation world it has been living in for years.

Why is that? Because the US economy actually has a much larger influence on the fate of developed markets than the local economies themselves.  This means that what matters most to the performance of say, UK stocks, is not so much whether the UK is in recession or not, but whether the US is in recession or not.

To show this, we look at the performance of 5 local markets on a quarterly basis, selecting only the quarters when (i) the US was in recession, but not the local markets, and (ii) local economies were in recession, but not the US. Our sample includes France, Germany, Italy, Spain and the UK. Going back to 1992, our findings are crystal clear. The simple average annualised performance of local markets when we observe:

  • Local expansion and US recession is -22.0%
  • Local recession and US expansion is 13.1%.
1992 – 2015 Annualised Local Markets Performance
US recession France expansion -25%
US recession Spain expansion -13%
US recession UK expansion -21%
US recession Germany expansion -30%
US recession Italy expansion -20%
US expansion France recession 21%
US expansion Spain recession -1%
US expansion UK recession 21%
US expansion Germany recession 20%
US expansion Italy recession 5%

In light of these results, it is certainly worth keeping a very close eye on the fundamental US dynamic- and hope that the Federal Reserve is right. As former US President Bill Clinton once famously said- “It is (about) the economy, stupid”. That is right, it is about the economy … of the US.


Should we fear a strong US Dollar?

March 18, 2015

Towards the summer of 2014, the US Dollar, measured against a trade-weighted basket of currencies, started to rally. Fast-forward 9 months and this move has become parabolic, with US currency trades at a 12-year high and on course to record its best quarterly return since 1992. Part of this strength is attributable to the weakness of two of the US’s main trading partners – Japan and Europe. Both the Bank of Japan and the European Central Bank are in the midst of a massive-scale money printing program, a combined $120bn-a-month exercise, whose goal is to stimulate growth and boost exports through the depreciation of their own currency. In contrast, the US Federal Reserve has indicated that it might be considering an increase in interest rates, thus making dollar-denominated assets relatively and increasingly attractive.

Yet at 0.24% for one year, the yield on US government bonds is hardly mouth-watering. But in a world flirting with deflation this is almost as good as it gets for a safe asset since, according to JPMorgan, approximately 16% of global government bonds with maturity higher than 1 year trade at a negative yield. Buy a Danish or a Swiss bond and you are sure to get less than what you paid for when they mature. From a currency standpoint, American assets are therefore attractive. However, since a strong Dollar is an impediment to the competitiveness of US businesses, investors have reduced their US holdings mostly in favour of European assets. According to Merrill Lynch, the cumulative flow out of US equities has amounted to $50bn so far this year. Unsurprisingly, European equities have outperformed US equities by no less than 16 percentage points in 2015.

This rationale makes sense on paper, but as Thomas Huxley, a British biologist contemporary of Darwin once said – “the great tragedy of Science is the slaying of a beautiful hypothesis by an ugly fact”. This holds true for the hypothesis where a strong US Dollar is bad for US equities since a simple regression of monthly US stock returns against the performance of the US Dollar since 1980 shows that American equities trade completely independent to the performance of the Dollar. While it is true that the recent past (the last 3 to 5 years) shows a degree of negative correlation, two time series can be strongly negatively correlated while evolving in the same direction. This is what has happened to the USD and US equities – they have both gone up. In another exercise, we observed the average annual performance of US equities against that of the US Dollar by quintile and see results that are completely consistent with previous findings.


Asian borrowers in trouble

March 13, 2015

With the US dollar trading close to a 12-year high, over-leveraged Emerging Market currencies look very vulnerable. This is because Emerging Market financial assets (read debt levels) have approximately doubled since 2008. Asian countries in particular have pilled foreign debt at an accelerating pace with the year-on-year debt growth for the Asian block now reaching 35%.

From the perspective of an Asian investor, leverage makes sense. Borrowing large amounts of money in a depreciating currency means less capital to pay back at maturity. And low interest rates (US rates have been close to zero for 6 years) make for negligible interest payments. Asian countries have gorged on this bonanza and the jury is out as to whether this is going to result in a painful indigestion.

The moment of truth might be near. The US dollar is powering ahead as the US Federal Reserve (the “Fed”) has indicated that its next monetary policy move will be restrictive, not accommodative. The Fed is remarkably lonely here as 9 countries have lowered their main interest rate since the beginning of the year already.  Yesterday again, the Korean Central Bank reduced its key rate to a historical low of 1.75% and the Chinese are considering a similar move. With comparatively fewer dollars and more of other currencies in the system, the value of the greenback has to go up.  This is exactly what is happening, and this is happening quick- the USD trades 10% higher than at the end of 2014.

At MONOGRAM we are staying away from Emerging Market stocks, since a forced de-leveraging caused by a strong dollar will certainly translate into substantial downside in domestic equities. But should the going get tough, these assets will probably trade low enough to present a bargain. Until then, we prefer the safety of the US market.


Today’s US employment figures: Devil in the detail

  • 72% of job recovery is in over-55s
  • “Silver recovery” doesn’t augur well for a healthy economy

6 February 2015, London. Paul Marson, Chief Investment Officer at MONOGRAM Investment, comments on today’s US jobs figures

“On the surface, US employment numbers look strong today.  But dig below the surface and it’s obvious this is a job recovery only for the over 55s.

“There has been a total growth of 6% in US employment (or 8.2m new jobs) since the end of the recession in 2009, while jobs for over 55s have grown 22%.  This means 72% of new jobs are in the 55+ age group.

“Strip out the over 55s job growth, and employment is up just 2.1% – or 2.3m new jobs.  A job recovery for those looking to wind down as they approach retirement is hardly the sign of a robust and healthy economy.”

US employment growth since the end of the recession by age group

06.02.2015 Devil in the Detail

Euro QE finally launches but likely to be “Damp Squib”

  • QE in UK and US have failed to stoke consumer demand inflation
  • China continues to export deflation into the Eurozone
  • QE not likely to translate to increased private sector loans

London, 22 January 2015. In response to the European Central Bank’s (ECB) announcement of quantitative easing today, Paul Marson, Chief Investment Officer of MONOGRAM, argues the programme is unlikely to work:

The question is why the biggest private sector credit boom in history – prior to the financial crisis – did not generate consumer price inflation: at the start of the crisis, core inflation was just 2% in Europe and the US. The answer to this is crucial, and explains why quantitative easing in the US/UK has raised asset prices – but not consumer inflation – and why euro QE is likely to be unsuccessful in achieving the ECB’s inflation objective.

Graph 1: UK core inflation and five year annualised inflation following QE

26.1.2015 Damp Squib Graph 1

“That underlying core inflation rates in the US and UK are lower today than when QE started is due to tide of disinflation originating from China. Chinese manufacturing goods supply is growing much faster than Western and Chinese demand for manufactured goods. This means a glut of supply which increasingly pushes down manufactured goods prices. Since China accounts for 17.1% of the total increase in world merchandise export (excluding the Eurozone) from 2002-2012, it is increasingly exporting deflation. Inflation is low, and getting lower, because the world is awash with supply – a “positive supply shock” is more powerful than the modest “positive demand shock” coming from QE.

Graph 2: Chinese manufacturing sector supply/Western demand mismatch

26.1.2015 Damp Squib Graph 2

“The problem confronting the ECB is that peripheral banks have substantially increased their holdings of [non-productive] government debt and substantially reduced (productive) loans to the private sector, amidst ongoing balance sheet shrinkage: the ECB hopes to take those bond holdings down and encourage private lending, a policy that is unlikely to have meaningful effects from exceptionally low current bond yield levels. It is more likely that bonds will replace the bonds they sold with more government bonds!”

Graph 3: Change in PIIGS MFI Assets from 2008

26.1.2015 Damp Squib Graph 3