Gold, Oil and the Bitcoin

by George Hatjoullis

Gold chart

The price of gold is making headlines again but this time for going down. The price has been going down slowly since August 22, 2011. It had already fallen around 22% by April 11, 2013. At the time of writing it is down around 39% from the 2011 all time high. This is a big fall and the drop in the last few days quite precipitous.

From a chart perspective (see above courtesy of IG Index) the conditions for a further price decline have been evident for a while. The proposed Cyprus gold sale appears to have catalysed this latest drop. The Urich acid crystals and gout analogy comes to mind again. The Urich acid level can be high for a long time without a gout attack.  Then some seemingly innocuous change crystallizes the Urich acid  and triggers an attack. The risk of an attack however is ever-present. So it can be with market prices, though in the case of market prices a sharp move up or down is possible. It may not be a bad thing, unlike a gout attack which is always bad (trust me).

Does the fall in the gold price matter? It does if you are long (obviously) but the wider significance may be positive. Gold is a form of private money. It becomes very popular as a store of wealth when confidence in fiat money is low. This is usually associated with economic and social uncertainty in some form and generally a bad economic environment. The fall in the gold price suggests confidence is returning to the fiat money system after a long period of concern. This is a good thing.

It is paradoxical that the gold price should collapse after the Cyprus crisis exposed the vulnerability of a large stock of fiat money, namely the stock of uninsured deposits in eurozone banks. Perhaps it is a sign that investors feel that this is a prelude to eurozone banking being moved back onto a sure footing. The causality is unlikely to be quite so linear but suffice it to say that the gold price does not tend to do as well in times of confidence and it is a sign confidence may be returning.

Of course, precipitous price falls in any widely held asset can bring problems in their wake. Not all gold investors hold physical gold. Many hold contracts based on the price of gold. Such derivative contracts often allow investors to make a bet on the price of gold with only a partial margin payment relative to the nominal value of the contract. Large falls cause large losses and margin calls. These losses can have ripple effects throughout the system if large and widespread (see my blog on market failure and JGBs). This is not expected in the case of gold but it is always worth keeping a wary eye on such possibilities.

Another important commodity price has also been quietly falling; oil.This is down around 29% since the high on February 27, 2012. Like gold, oil comes out of the ground but unlike gold, it is used up. Gold stocks just keep growing. Like gold, oil prices can also signal times of uncertainty, though specifically in the accessible supply of oil. Anxiety levels in this respect have diminished and so the risk premium has eased off. There is also considerable development in crude oil substitution taking place not the least being the exploitation of shale oil. The importance of the commercial exploitation of shale oil is that large deposits exist in less unstable geographic regions and outside of the OPEC cartel.

Lower energy prices are generally regarded as an economic positive and as a boost to GDP. If sustained then this development reinforces the generally positive signal from falling gold prices. It may help validate what equity prices have been signalling, namely that things are looking up. The initial reaction to all this turmoil was to trigger a negative reaction from equities. This partly reflects the ripple effects of sharp price moves but also the fact that gold miners and oil producers appear in equity indices. These stock prices have immediately moved lower whilst other beneficiary stocks may react more slowly.

The S&P 500 index did made a new high on April 11, 2013. It has fallen back since. It will almost certainly retest the April 11 high. If it can keep pushing the highs, albeit slowly, then a base may be building for a sustained bull market and a move away from the wild gyrations of the last decade. The omens are positive.

Finally a quick word on Bitcoin. It is a private money. Like all private money it does well when confidence is lost in fiat money. If gold is not doing well it is unlikely that Bitcoin will do well. However, this said Bitcoin has some interesting and unique features. It is created in Cyber space, much like fiat money. Gold has to be dug up. Bitcoin has no other function other than money. Gold has industrial and consumer use. Bitcoin is thus the closest analogue to fiat money that a private money can be. It is an interesting experiment that is worth watching from a distance.