Does Falling Gold Prices Put An End To The Global Liquidity Story?

``It is easy indeed to fall into the trap of phony economic growth; as long as capacity utilization is below the normal level, demand expansions fueled by monetary and fiscal impulses increase economic activity. But the more the economy approaches full capacity, the more the effect on the production of real goods gets weaker and the effect on prices gets stronger. Eventually, this reaches the point when the monetary expansion only has inflationary price effects, and its impact on real production becomes nil.”- Antony P. Mueller The Stimulus Scam

Part of our incomplete sweetspot of inflation scenario has been gold’s recent sluggishness.

One analyst even suggested that because gold isn’t rising, then it must be a return of “risk appetite” has been providing support to global equity markets.

One Week Does Not A Trend Make

But the weakness in the gold market alone is not sufficient to suggest that this isn’t about a global liquidity story (see figure 4).

Figure 4: stockcharts.com: Divergences in Gold, Silver, Copper and Oil

Gold has fallen quite steeply down 2.84% this week.

While it is true that we see gold as a superb indicator for global liquidity, it would be a mistake and even naive to interpret one week of price action as a continuing event.

And importantly, any markets, including gold, can be affected by short term quirks or market specific events. For instance, the unresolved gold sales of the remaining allotment of the IMF can be a factor.

Yet, gold’s alter ego, silver has not shared the same quandary.

Also the strength in copper and oil, even if they are partly underpinned by the emerging market story, has also been a story of liquidity.

Proof?

According to Bloomberg, ``Emerging-market and high-yield bond funds each took in more than $1 billion in the week ended March 10, EPFR Global said, the most since the research firm began publishing weekly data on the sectors a decade ago.

``The inflows helped reduce the yield premium investors demand to hold emerging-market debt rather than U.S. Treasuries by 25 basis points in the period to 259 basis points, according to JPMorgan Chase & Co.’s Emerging Market Bond Index Plus. The gap was 258 basis points at yesterday’s close, the least since June 2008. A basis point is 0.01 percentage point.

``Developing nations have raised $28.9 billion from global bond sales so far this year, the busiest start to a year since 2005, according to data compiled by Bloomberg.”

Major emerging markets as Indonesia, India, China and Brazil has seen turbocharged money supplies (see figure 5)

Figure 5: News N Economics: Expansionary Monetary Policies in BIICs

And it does not stop here.

Global Liquidity Story Continues

We’ve been repeatedly saying that the record steep yield curves across the globe are likely to jumpstart the credit process, even in nations beset by credit woes. However the impact will always be uneven. And as we also been repeatedly saying these are the seeds to the next bubble.

Ignore the meme about falling “money velocity” as a reason for the alleged failure to restore the credit process out of the “liquidity trap”. Aside from being a flawed model[1], these experts disregard the incentives brought about by the “profit spread” of interest rates.

Of course we can add that they have been erroneously interpreting the neutrality of money from government expenditures, as well as, underestimating the increasing share of governments’ contribution to the economy.

Murray N. Rothbard explains the profit spread[2], (bold emphasis mine)

``In their stress on the liquidity trap as a potent factor in aggravating depression and perpetuating unemployment, the Keynesians make much fuss over the alleged fact that people, in a financial crisis, expect a rise in the rate of interest, and will therefore hoard money instead of purchasing bonds and contributing toward lower rates. It is this “speculative hoard” that constitutes the “liquidity trap,” and is supposed to indicate the relation between liquidity preference and the interest rate. But the Keynesians are here misled by their superficial treatment of the interest rate as simply the price of loan contracts. The crucial interest rate, as we have indicated, is the natural rate—the “profit spread” on the market. Since loans are simply a form of investment, the rate on loans is but a pale reflection of the natural rate.”

We believe that the profit spread dynamics is beginning to kick in.

This from the Wall Street Journal[3], (bold emphasis mine)

``Companies are aggressively borrowing in the debt markets once again—a sign of renewed confidence in the world economy following recent fears that struggling European countries could have difficulty financing their budget deficits.

``In the U.S., bond sales by companies such as Bank of America Corp. and GMAC Financial Services are on pace to conclude their busiest week since the beginning of the year. In Europe, borrowing by companies so far in March is already more than 60% of February's totals.

"It tells us that financial liquidity is very much on the rise," said John Lonski, chief economist at Moody's Investors Service. "No longer do corporations suffer from a dearth of liquidity. This puts them in a better position to take advantage of opportunities that arise."

``So far in 2010, U.S. corporations have issued $195.2 billion of debt, excluding government-guaranteed bonds, according to data provider Dealogic, up from $166.8 billion during the same period in 2009. The resurgence of the corporate debt markets comes after a shaky February, when several companies were forced to delay bond sales as worries about Greece's problems sent investors fleeing to safer assets such as U.S. Treasurys. Those concerns have subsided and money is again flowing into corporate bond funds, giving managers cash to invest.”

And this can likewise be seen in Canada “on pace to issue the most debt”, in Asia “lowest relative borrowing costs in more than two years and demand from international investors is driving Asian companies to sell record amounts of dollar- denominated bonds”, in Russia “Yields on Russian dollar bonds fell to less than 5 percent for the first time as rising oil prices boosted investor confidence”, in Turkey, and even in the PIIGS “Portuguese, Italian and Spanish companies are rushing to sell bonds, taking advantage of investors’ demand for corporate debt after Greece’s budget crisis froze issuance”. [Hat tip: Doug Noland]

In short, to attribute improving financial markets plainly to restored confidence is missing out the bigger picture. Money is needed to bid up asset prices, which accounts for as increased confidence levels or what the mainstream calls as the “animal spirits”. And the steep yield curve from zero bound rates, quantitative easing and massive deficit spending have all contributing to global reflation.

Nevertheless present activities do not suggest that gold has lost its efficacy as indicator for global liquidity.

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[1] See Velocity Of Money: A Flawed Model

[2] Rothbard, Murray N. America's Great Depression p.41

[3] Wall Street Journal Credit Market Springs to Life