Gold prices have been under pressure lately but still showing signs of life as they brush off the latest economic data. Investors are betting against the yellow metal in mass, but time may be running out for the shorts, depending on how quickly things change. Daniel Oliver of Myrmikan Research, who writes extensively about credit bubbles and economic cycles, tells ValueWalk that he sees gold prices heading north of $10,000 an ounce.
Q2 hedge fund letters, conference, scoops etc
History repeats itself... over and over again
In his August update, Oliver highlighted the many bailouts the U.S. government has had a hand in over the decades. He noted the credit cycle that repeats over and over. Inevitably, the Federal Reserve ends up printing money and devaluing the U.S. dollar to bail out the speculators responsible for bubbles. Indeed, it seems like lessons are never learned from the past because regulators are often doomed to keep repeating it.
This time around, Oliver said he's waiting to see the first sign that the current credit bubble is about to pop. He generally looks at such bubbles through the lens of Austrian theory, and he notes that whenever regulators raise interest rates, credit bubbles inevitably pop. Thus, it's only a matter of time before the current one pops.
He's waiting for "some small bank to roll over, or reports of a rouge [sic] trader at a large bank, or a pension fund to collapse," all of which could be signs the credit bubble is about to pop. We already know that many large pension funds in the U.S. are close to collapsing, so that certainly wouldn't a surprise.
Will it be pensions... or the Turkish lira crisis?
For example, Central States Pension Fund expects to be insolvent within seven years, while CalPERS and CalSTRS are both facing extreme levels of unfunded liabilities. The pension crisis is only expected to get worse in the coming years. In fact, the entire pension industry seems like a classic case of what Oliver has been writing about: officials kicking the proverbial can down the road so they don't have to fix a problem which can only be fixed by making an impossible decision.
Oliver's actually betting on the Turkish lira crisis as the event that pops the current credit bubble. He notes that the country has high levels of debt denominated in U.S. dollars and euros. Thus, as the lira collapses, Turkey's dollar-denominated debts become unpayable because the lira is worth half the number of dollars it was worth a year ago. That means the country's dollar-denominated debt has doubled in the last 12 months.
Looking at gold prices from a different angle
One of the most interesting parts of Oliver's commentary on how the popping of the credit bubble will impact gold prices is the way he looks at the Federal Reserve's gold holdings versus the rest of its balance sheet. He explained that over time, the percentage of the Fed's liabilities which can be backed by its gold holdings changes over time, based on macroeconomic events.
He pointed out an interesting idiosyncrasy in the way the Fed values the gold on its balance sheet. The central bank only values gold at about $42 per troy ounce, which means it estimates the roughly 261.5 million fine troy ounces of gold it's holding (according to the U.S. government's July 31 status report) to be worth only about $11 billion. However, the actual market value of all that gold is closer to $311 billion based on current gold prices. (Think what the government would do to a private citizen or public company that did their books like this!)
Here's what all this means for gold prices
Oliver uses these numbers to estimate the percentage of the Fed's balance sheet that's backed by its gold holdings. He estimates that based on these numbers, the U.S. government's gold holdings back only about 7% of its balance sheet, but this percentage peaks whenever a bubble pops, which enables him to monitor credit bubbles.
Whenever a panic strikes the market, this ratio goes through the roof. For example, it surpassed 100% in 1980. Oliver explained that the average percentage of backing the Fed's gold holdings provide is 28% of the central bank's balance sheet, so there is much ground to cover before reaching that point. However, he does expect the same cycle to repeat itself again and result in a sort of "enhanced version of a 70s-style repression."
"It is in the nature of market panics that they accelerate," he wrote in his August letter. "The Fed must respond soon or watch the whole post-2008 recovery crumble."
He added that if the Fed does react, then gold will "bounce hard," and "there is a chance the Fed can play the same game it has played since 1980, printing up another round of the credit cycle. If the general pattern holds, gold would likely run above $3,000 and then fall back as speculative juices take over. If the Fed does not respond in time or forcefully enough, gold may take a deeper plunge, but it would open the door to a complete liquidation of the system, including the Fed itself," he warned.
When that happens, he sees gold prices going to $10,000 an ounce, although the timing of all this playing out is unclear at this point. Oliver said if the Fed is successful at creating another round of the credit bubble, then it could be a decade before gold prices go that high, but if we've already seen the last round, then it will likely be bad news for speculators who are short gold.
Time is running out for gold shorts
So whether it ends up being the pension crisis, the Turkish lira, or another major event that pops the credit bubble, gold prices will still be impacted dramatically, and probably not in the direction most speculators are expecting. Citing data from Bleakley Financial Group, CNBC reported this week that speculators are increasingly betting against gold. For the first time since the end of 2001, speculators are net short the yellow metal.
That will put speculators betting against gold in a world of hurt if they don't get out before the crash. Oliver added that it may make sense to short gold in the near term, but at some point, the expansion must end like it always does. When that happens, it will be bad to be short gold. For now, we're in the longest bull market ever (as of Wednesday), so there is still time left on the clock for shorting gold. We just don't know how much time is left.
