Gold: A Case of Mistaken Identity

Is gold a safe haven? A risk asset? Actually, it's neither...

IN THIS INTERVIEW, BullionVault's Head of Research Adrian Ash talks to Hard Assets Investor about what's driving gold right now:

Hard Assets Investor: Why is gold shedding its safe-haven status, especially with all this uncertainty going on with European debt problems?

Adrian Ash: Gold is suffering from a case of mistaken identity. Several times in the last 10 years it was mistaken as a risk asset. During the first phase of reflection after the dot-com bubble, you had the US cutting interest rates down to 1 percent, the European Central Bank to 1 percent and the Bank of England went to 2 percent, which at the time were pretty much historic lows for base rates. And gold rose alongside all the way. At the time it looked very much like a kind of happy, pro-growth investment, which very much jars people's perception of gold being a safe haven.

"Safe haven" is a bit of a red herring as well. Gold isn't a safe haven; it's an insurance policy. A safe haven is where you run as you try to get out of the fire. Maybe it's the fire escape, or maybe you're jumping out of the window. Anyone who's piling into Treasurys has to remember that the imminent cause of this state of the crisis now is sovereign insolvency.

Gold is not a safe haven if all you want to do is sit on it forever. That's why gold continues to attract longer-term flows. People assume that gold will go up automatically when other things go down. And that's not how it works. It wasn't true during Lehman Brothers. People assume gold works in a safe haven because that's a journalist phrase that is often applied to it.

HAI: Gold has been range-bound in the $1,600 area. Is this due to what's happening in Europe?

Adrian Ash: This is a pretty classic pattern actually for the bull market over the last 10 years. Gold ran away with itself over the summer. The rise to $1,920 looked very much like a rise in silver that we saw in the spring. Not quite as dramatic. When gold got to $1,920, it looked like the perfect storm. Now with inevitable pullback, I think the volatility suggest that conviction traders have gone AWOL.

What you haven't seen, of course, is a large amount of redemptions from the big gold ETFs. In physical bullion, you've seen stronger demand on the price drop. Here at BullionVault, we're now looking after 26 tons of gold bullion for our users. That's up by about 2 1/2 tons on the year. When gold races ahead of itself, pulls back sharply, shakes out the hot money, a technician would say it's consolidating. But I'm no technical analyst. All I see here is basically it's lacking short-term direction.

HAI: What's the biggest influence on gold right now?

Adrian Ash: Short term it's the Euro and what that means by definition for the Dollar. We are in very strong deflationary risk now. Monetary confidence is being shaken worldwide, and the Euro is the pinch point for that right now. It's difficult to think of a more deflationary event than loss of confidence in the monetary system.

HAI: Do you think at all about the worst-case scenario, where the EU is not going to be able to implement these plans because the populace says "no?" We are seeing some of that in Greece.

Adrian Ash: I think you're bang on the money there. If you look historically at situations like this, the one that seems most analogous would be the early 1930s. The last currency to really fall apart in this way was the sterling gold standard. Britain was effectively forced to abandon gold in 1931. The very imminent cause for that were reports of a mutiny by naval sailors in Scotland over unpaid wages. It's been characterized historically — particularly by Marxist and Socialist historians — as capitalists putting the squeeze on the British government, forcing it to impose austerity measures, such as reducing dole payments to the unemployed, reducing welfare payments. And this was a very nascent welfare state, of course, 80 years ago.

But basically, the government said we can't bear this, the populace will not bear this. And therefore the gold standard couldn't be defended.

Now, the big problem that we have today is that the creditors happen to be the taxpayer. If the banks default, then the banks will have to default on taxpayer deposits.

This is why we had the bank recapitalization in 2008, 2009. This was the driving force behind the Asian crisis resolution that the IMF implemented back in the 1990s. This was done to keep the bank creditors — the middle-class savers — whole. You could then destroy them with inflation, that's fine. But imminently right now, today, you've got to make sure that their bank deposits do not vanish.

The problem that you have now is that the taxpayer is both the debtor and the creditor. We've managed to get to a situation where we owe ourselves money. We've built huge excess capacity. And you can see this happening in China right now. A credit boom means that you are building tomorrow's capacity today. What are you going to build tomorrow?

You can do the Japanese route, which is you cover the country in concrete and you build roads and bridges to nowhere, which is literally a Keynesian response.

HAI: What mistakes are investors vulnerable to right now? Falling into the traps of old assumptions?

Adrian Ash: Nothing is nailed down. There are going to be situations in the way that the financial markets work where nothing gets you out of jail. There is nothing that means gold is guaranteed to work. If it were that easy, then there wouldn't be any opportunity to make a gain, because everyone would be aware that I just need to Buy Gold and it will be fixed. It's not going to work like that.

One mistake I know you can make is to over-trade. The only way to have really lost money in gold over the last few years is to have traded it. If you just hold your position and sat on it, you'd be much better off. You've got to be a very good trader to beat the returns that gold has delivered year after year.

Further to that, I would say a big risk is if you take on leverage. There's also the danger in a genuine credit crunch — such as we saw in 2007, 2008 — that if you are in a leveraged product, you're reliant on a broker keeping your position open, rather than owning the underlying. You might actually get closed out.

If you look at Lehman Brothers, an investment bank vanished, literally destroyed credit for the futures and options market. Quite literally, a prime brokerage vanished. One point — which a lot of people don't remember, though — is that overnight interest rates on leveraged positions went through the roof.

HAI: What are some of the other commodities you keep your eye on?

Adrian Ash: Obviously oil. It's a big input to the mining industry, for one. It's worth keeping an eye on short-term direction of oil. That's a very difficult call right now. Obviously we know that central banks are looking to push for inflation. And I think it's demonstrable that the oil spike of 2008 was a direct result of the Fed cutting interest rates in 2007. The idea that US monetary policy does not somehow impact commodity prices is absurd.

Similarly, I think copper is a proxy indicator for Chinese economic strength. Underpinning the short-term move in gold, you've obviously got very strong Indian and Chinese demand for bullion. There is very strong growth in those markets. Because all we've seen in the last 10 years is a very strong growing Chinese economy with concomitant strong growth in its gold demands.

So keep an eye on copper and maybe on shipping rates; those kinds of indicators for what's happening to industrial demand globally, particularly from East Asia.

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