Nervous About the Fed

Because its stated plan would be a disaster with zero inflation...

A CHEMIST by academic training, Charles Gibson spent a decade in the City of London as a mining analyst at Cazenove and a specialist mining salesman at T Hoare Canaccord.

Having written for MoneyWeek and The Business magazines, as well as The Evening Standard. Gibson is now an analyst with London-based Edison Investment Research – and he is nervous, he tells The Gold Report in this interview.

Because, Gibson says, the US Federal Reserve's statement that it would push the benchmark interest rate to 1.375% by the end of 2016 could send the US economy in the wrong direction for the sake of containing mostly nonexistent inflation...

The Gold Report: On December 16, the US Federal Reserve, as expected, raised its benchmark interest rate by 25 basis points. Somewhat unexpectedly, gold rallied on the news. In its year-end report, the World Gold Council, along with a number of experts who have talked to The Gold Report in the last year, said its research shows that higher interest rates are not necessarily bad for gold. Do you concur?

Charles Gibson: This rise in interest rates had been flagged for some time by the Federal Reserve; it was almost market orthodoxy that it was going to happen. The initial rally was a case of "sell on the rumor, buy on the facts," the reverse of the normal mentality. However, shortly after that, gold fell again. That, in part, was due to the fact that not only did the Fed put up the benchmark interest rate, it did so by the maximum amount, because there was some speculation that the rise might have been only 10 basis points. What continues to worry the market is Fed Chair Janet Yellen's statement that the Fed is looking at pushing the benchmark rate to 1.375% by the end of 2016, which suggests there are more interest rates rises to come over the next 12 months. That has renewed the nervousness in the market.

TGR: Why is the market nervous?

Charles Gibson: The issue of interest rates is not as simple as looking at interest rates in general. You need to look at real interest rates. You can have interest rates high and rising, but if inflation were higher and rising faster, then you would expect gold to go up. I was one of the ones who thought the Fed didn't need to raise rates. My analysis suggested that at the current mean level of inflation, one would expect interest rates to be higher. However, 0-25 basis points was within the normal range. Given the direction that inflation has been moving recently, there didn't seem to be any pressure from an upward move.

So I took the Fed's move to be political rather than economic. The Fed wants to head off the risk of inflation; however, with falling commodity prices and other signs, there seems to be little evidence of inflation in the economy. The Fed is trying to suggest a return to normality, but given the magnitude of what has happened in the eight years since the financial crash, we're still a long way from normality. That's where the potential interest in the gold market remains for the foreseeable future.

TGR: What rate of inflation would push gold higher?

Charles Gibson: At 2% or above, we would still be in negative real interest rate territory. That makes hard assets an attractive proposition. The FTSE Index was above 7,000 earlier last year but is now around 6,000. That would suggest a deflationary trajectory. If interest rates go up and inflation continues to fall, the outlook is probably more choppy for gold because falling inflation and rising real interest rates has historically created headwinds for gold.

TGR: As you watched Federal Reserve Chairman Janet Yellen deliver her speech at the Fed's press conference on Dec. 16, what were some of your thoughts as a gold investor?

Charles Gibson: For a long time the Fed has had to surf a difficult wave, and it has admittedly surfed it quite well, yet it's being slightly disingenuous with the market. The Fed seems to determine the entire mood and direction of the market, whereas once upon a time it created the background. These days everyone seems to hang on every last comma of the Fed's pronouncements. That gives it enormous power and influence. It's also a dangerous position. By setting interest rate guidance at 1.375% by the end of 2016, the Fed could send the economy in the wrong direction for the sake of containing inflation. The economy's ability to sustain higher interest rates and higher real interest rates is very limited indeed.

TGR: As gold prices approached six-year lows, so do silver prices. What's the thesis that pushes silver higher?

Charles Gibson: Gold tends to perform better in an environment where the value of money is being questioned; silver tends to perform better in an environment where there is macroeconomic growth. For silver to outperform gold, we need to see evidence of growth among the major consuming nations like China. But at the moment, these metals are caught in an almost perfect storm where the Fed is raising interest rates, while China is dangerously close to a debt deflation spiral. So you have a major consuming nation consuming less at the same time that the Federal Reserve is making real hard assets less attractive as an investment proposition.

TGR: Does that mean investors should lean more toward defensive equity names at this point?

Charles Gibson: In the current environment, one of the biggest headwinds for any company is financing. Assets that would have been financed three or four years ago might not get financed today. If you're invested in a company that can get financed, then obviously you stand to benefit from the upside, but you have to accept that there is a reasonable risk that it might not. Therefore, the sensible approach would be to go with a conservative asset allocation policy. Among the metals and mining equities, I would be inclined to direct investors toward secure, producing assets with limited funding risk.

TGR: Lithium carbonate prices outperformed gold and silver this year by a wide margin. Do you expect the trend to continue in 2016 and beyond?

Charles Gibson: By and large we do. Lithium has a tailwind in the form of a revolutionary shift to electric vehicles in the automotive industry as the world attempts to move away from fossil fuels, lithium will go from being a specialized mined metal to something quite mainstream. That transition is transformative for the economic dynamics for lithium.

TGR: Do you have a preference between brine and hard rock lithium deposits?

Charles Gibson: We've been looking at this issue. There is a perception that brines are the superior asset due to their size, and that is not necessarily true. The conversion of resources to reserves is often quite low with brine deposits if they are to be extracted using evaporation ponds, and when you take that conversion into account, it makes the sizes of brines similar to hard rock deposits. What is key is product purity because end-users have very high standards and need to be sure that the lithium used maintains adequate battery life.

TGR: Can you speak in broad terms about the advantages of owning stakes in a number of different lithium projects versus the typical discover-and-develop model employed by most junior mining companies?

Charles Gibson: Many companies appear as single-asset companies but they often have a number of other less-developed assets. They place the emphasis on one asset because it makes it a simpler story for the market to understand. At the bottom of the last cycle, in 2000-2001 when virtually all mining assets were underperforming, the heavy mineral sands were the one exception where investors were making money. That situation looks similar to the current market environment for lithium. The market dynamic is in a secular uptrend. The opportunity for investors is to exploit mispriced assets.

TGR: What about the rare earth elements component of that story? Is this mostly a lithium play or do the rare earths hold some value too?

Charles Gibson: They certainly hold some value. Over the last 10 years, the investment proposition for rare earths has proven difficult. The lithium story is much cleaner and easier to tell. Is there value in the rare earths? Yes, but there may be a relatively long burn in terms of realizing that value. I think it's more likely to come out in the wake of the development of the lithium assets.

TGR: Please give us a sentence that you expect will largely sum up the gold market in 2016.

Charles Gibson: I think there is the possibility that some major, macroeconomic perceptions may change quite materially and quite rapidly.

TGR: Thank you for your insights, Charles.