How Gold Can Move Higher Even If Inflation Is Low

Over the last fortnight we have been concerned (some may say obsessed) with the mixed signals the financial markets were sending. The equity markets, gold and oil all have been sending signals of robust growth and increasing inflation. At the same time, bond yields remain low suggesting a slow growth low inflation environment.

The picture became a little clearer with the release of industrial production, capacity utilization, and CPI.
As expected industrial production ticked up again in August as the economy began to produce once again. However, we are concerned that this could be the last uptick in industrial production for quite some time.

Long time readers will attest to our penchant for the M1 multiplier. The strong correlation with industrial production makes the M1 multiplier a valuable tool when trying to forecast the direction on the economy.

Our research indicates that 96% of the time the M1 multiplier increases an increase in industrial production occurs six months later. In February 2009, the M1 multiplier not only ticked higher but also crossed above the critical 1 level. And like clockwork, industrial production increased in August. However, since February the M1 multiplier has been stuck below 1 with limited upticks, suggesting that the August IP number may be the last increase we see for a while.

Adding to evidence that we are headed for a slow growth low inflationary environment is the capacity utilization report. Last month capacity utilization increased from the record low of 68 recorded in June. An increase in capacity utilization has marked the end of every recession since 1970.

In August, capacity utilization increased once again which adds to the suggestion that the recession is over. Moreover, the largest increase in CU was in the utility sector, implying factories are using more power as they ramp up production.

However, capacity utilization is also suggesting that these same factories are operating at levels WELL below capacity.To be sure, the increase in capacity utilization was not as robust as the global equity markets are implying. Recall that the cash for clunkers program did not begin until the last week in July so any increase in automobile factory utilization did not have a major impact until August. The minor increase in CU is evidence that cash for clunkers had a minimal impact on factory production.

Given that production resources are not strained and labor resources are still considerably slacked we believe that inflation is far from a reality. Furthermore, the most recent CPI number indicates that our analysis is on track. The primary driver of the slight increase in CPI was gasoline prices which accounted for 80% of the move.

As we head into the 4th quarter it is likely that the YoY CPI comparisons rise. However, we caution that these increases may simply be due to fact that gasoline prices bottomed in December 2008. Therefore, much like same store sales the comparisons can be skewed.

The currency markets essentially ignored the deflationary data released by the Eurostat. YoY CPI fell -0.20% over the last month. Moreover, the core rate remained steady.

However, on the US CPI data the dollar fell against the Euro. The currency markets are telling us that the US Federal Reserve will not need to raise rates to combat inflation anytime soon.

At the same time that the currency markets are suggesting a low inflationary environment, the energy markets continue to tick higher. November crude oil appears to be reacting to the positive industrial production numbers. More than likely the increase in utility capacity utilization has oil investors thinking robust recovery.

Prior to the CPI report TIPs yields were implying a 5 year inflation rate of 1.45% and a 10 year inflation rate of 1.83%. These rates of inflation are not consistent with higher oil prices and the messages from the gold market.

After the CPI report, TIPs yields are implying a 5 year rate of inflation of 1.54%, while the 10 year rate is indicated at 1.86%. The move is hardly a “spike” inflation, and is also curiously subdued given the rise in crude oil.

The US Treasury market may also be buoyed by the TIC data which shows that China and Japan continue to buyers of US debt. Additionally, increases in purchases through the UK and Caribbean banking centers suggests that China may still be using “disguises” to purchase Treasuries.

Now we must decide what to do with gold and determine why the yellow metal is trading higher. The major financial markets are beginning to listen to the data that suggests inflation is not a concern. There must be something else occurring in the gold market.

Our inclination is toward the argument that central bank sentiment toward gold has changed. Over the last two decades central banks have been net sellers of gold. Mindful of the impact on the tiny gold market the central banks have signed the CBGA to limit sales.

However, given the rise in gold prices it is likely that central banks have decided to hold gold and not sell. Additionally, the IMF has gold for sale that will likely end up in Chinese vaults. The combination of these events could turn the gold market from well supplied into a market in deficit. A move toward deficit would itself be enough to propel gold higher even in an low inflation environment. The change in central bank attitudes toward gold represents a secular shift in the market that should keep bullion well above $1000 per ounce.

Disclosure: long GLD and GLD options

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