UBS on the Driver for Gold: What is Gold About to Tell Us?

Courtesy of Mish.

An interesting article came my way from UBS analyst Julien Garran on the driver for gold. I do not have a link to share so excerpts will have to do.

Garran's article is one of the better one's I have seen. Unlike others, Garran does not cite jewelry, mining capacity, central bank purchases or sales or other similar (and wrong) notions that unfortunately are widespread among most analysts.

Commodities & Mining Q&A (by Julien Garran)

Q1. What drives gold?
A1. In the past, we’ve argued that international US$ liquidity is fundamental to calling first gold and then the industrial miners. In this note, we go a step deeper, arguing that gold is a call on excess returns in the US economy, the policy response and finally the impact on that policy on international US$ liquidity.

Q2. What is gold about to tell us?
A2. The key issues facing gold; excess returns in the US are under pressure as the strong US$ and falling energy squeezes cashflow. As wages pressures rise, weak productivity means that cashflows could be squeezed further. Both undermine credit conditions and threaten the longevity of the cycle. We believe the prospect of deteriorating liquidity magnifies the threat. That in turn is limiting the Fed’s ability to tighten policy and may induce it to ease in the future. We think the Fed has started to recognise that pressure with its dovish backtracking at the March meeting last week.

A1&2. In commodity strategy, we believe that a forthcoming rally in gold may warn us that declining returns could ultimately force the Fed into a new round of international reflation. We think the first step was likely the Fed’s dovish backtracking at the March meeting.

In the past, we’ve argued that gold behaves as a probability indicator of whether international US$ liquidity will be improving or deteriorating in six months’ time. Industrial commodities are a call on whether international US$ liquidity is rising now.

So to call gold, and then the industrial miners, we have analysed the key drivers of those flows;

  • The Fed
  • The US current account deficit
  • Bank’s asset buying/accumulation

In this note we go a step deeper – arguing that gold is a call on excess returns in the US economy, the policy response and then finally the impact of that response on international US$ liquidity. We contend that the state of economy wide excess returns ultimately determine the longevity of the cycle, and so it is the progress of excess returns, above the intermediate targets on inflation & unemployment, that ultimately drive monetary policy.

Right now, excess returns are under pressure from four main areas; The rest of the world is exporting deflation to the US.

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