Gold From a Correlation Point Of View

Near term record high negative correlations between equities and gold. Looks like 2008 all over again.

If one looks closely at the data though, in 2008 the negative correlations peaked approximately a month before the Lehman event. On August 15th, 2008, the prior 50 trading day correlation hit -.59. At this point the S&P was still at approximately the 1200 area (before then plummeting to the 600s). When things really started to unravel, gold lost its magic touch as an effective hedge.

Swiss Devaluation Points To Similar Move For Yen

Per the SNB press release:

"With immediate effect, it will no longer tolerate a EUR/CHF exchange rate below the minimum rate of CHF 1.20. The SNB will enforce this minimum rate with the utmost determination and is prepared to buy foreign currency in unlimited quantities."

One can only wonder how fast a rate the Swiss National Bank will be accumulating foreign currencies with such a regime. Regardless, this points to signal the BOJ that such central bank policy is acceptable. I'd expect a similar move from the BOJ soon (should USDJPY of 85 be the target?). The immediate market reaction included a selloff in gold (now being bought back up). That reveals a bit concerning correlation traders' positioning (long CHF, long gold being the inverse hedge). Despite this, logically this is still a very supportive environment for gold. Fundamentally, a meaningful resolution (or capitulative conclusion) of the EU credit crisis will be likely the only near term threat to gold's ascent. Similarly, equity shorts unwound, but are now again falling. A Swiss Franc floor doesn't solve EU strife.

Gold indexed to 1913 CPI-indexed dollars

Not so cheap. Gold's purchasing power is at all time highs for everyone currently alive.

Gold bubble?

Usually in a bubble, investors are holding a bag.

Investors have been net sellers of about 100 tonnes in the last 7 months. The IMF has disposed of another few hundred tonnes. Yet gold price is higher by around 10% in the same period.

To put this into context, since December 21st alone, 2.2M ounces have been sold from the ETF, basically a bit more than an entire quarter of production from Barrick gold (the world's largest producer). The normal run rate of global recycling plus mine production is approximately 2.95M ounces per month. So in the same period, assuming GLD was the only source of outflow, total global absorbed gold supply was 5.15M ounces. If outflows continued at the current rate, the GLD ETF (the largest investor depository of gold by far) would have no gold in 18 months.

Supply increased 75% in the short term to see price only fall 4.5%.

Someone else is doing the buying, clearly.

Fed Funds Hike Expectations Update (December 2010)

I thought I'd go through the previous implied Fed Funds and Treasury 1 Year Forwards model and update it from August 14th, before QE2 policy was announced.
Here is a good cross section showing changes in expectations between then and today. So far, I'd say Bernanke has successfully steepened the yield curve, helping support future bank recapitalization. As well, it doesn't need to be stated (but I will anyway) inflation expectations are considerably different. That will obviously translate over to PPI and CPI in the coming months, given the recent commodity price moves.



And the number of rate hikes to expect in coming years, given market expectations derived from the yield curve:



Note: The horizontal axis is a date range of two years, with overlap per data point. The original model implied rate changes and rates starting at August 14th, 2010, whereas the second model is run 3 months later, so a slightly more accurate interpretation has December data square on 2011, 2012, etc whereas the original data represents August to August periods, starting August 2010-2011. Since this is framing a 30 year picture, I felt it would be unnecessary to reflect this 3 month offset. Imagine it if you need.

Home Supply Forecast (via New Home Sales)

Here is a long run look at population divided by number of annual home sales. From 1963 to 1995, there was a mean of 383.27 people in the US population per each new home built. Starting in 1995, the number dropped from 394 people per home to a record 229 people per home in 2005 (the building peak).

Assuming this population per production # is mean reverting, and the extra new housing supply was borrowed from future demand, it can be easily forecasted how much was overbuilt starting in 1996 and how long it will take for long run oversupply to return back to zero. This model establishes that new housing sales continue at the 2010 current average rate of 322K/year, and the US population grows 3 million people per year going forward. A netting out of long run oversupply does not occur until 2013. After 2013, new home sales should run at population divided by 383.27, assuming long run averages hold, or approximately 840K builds and sales per year at 2014.

These numbers generally concur with the yield curve forecasting a meaningful recovery starting in 2013-2014, as housing supply returns to long run balance.

Thoughts on Housing

Browse the web for today's financial news of "Existing home sales plunge 27%" and you'd think the world is ending.

It's not. This is simply a drop-off in transaction volume, and the news has already been telegraphed by falling agency debt rates. Average home prices are still 10% above 2010 lows, and just as in stocks, a fall-off in trading volumes do not mean the same thing as a price crash.

Common knowledge says tax credits catalyzed buyers to come out of the woodwork and move up the time-frame of purchase, borrowing future trading volumes into present periods. And as home transactions take longer and are done in much rarer frequency, it is likely volumes will remain anemic until enough time passes for the number of buyers to naturally replenish.

Granted, quantity traded is generally smaller on a higher price, so the volume numbers could be interpreted to convey lower prices lie ahead as the market re-equilibriates down in a post-tax-credit environment.

But expected returns on assets are in a nosedive, lending some countervailing support to asset prices. While 30 year treasury debt yields 3.57%, in local formerly overheated housing markets such as San Diego, even without being lucky enough to steal a discounted REO, one can easily buy entry level (under $200K) rental properties that yield 6-8% after expenses. In the mid range ($400-600K), yields hover closer to 4.5%-5%. It would make sense that these price ranges experience converging rental yields. On an indexed basis, a fall of the mid-ranged sectors may bring median prices down substantially, even if the low end strengthens (or holds up) considerably from here. In the face of a long run excess return of 350-400 basis points over treasuries with the added benefit of the asset being tangible and physically impervious to central bank monetary policy whims, the considerable value already in today's housing market can not be forgotten.

Given where risk-free yields are, there is no shortage of capital out there, and longer term arbitrage will continue to evolve all of these markets in better balance. Artificially higher pre-credit-expiration trading volumes in housing (almost an extra million units/year on an annualized basis) followed by a drop-off of similar magnitude (about minus a million units/year annualized) make sense. Given volumes were substantially elevated above norm for 3 months (September to November) out of 2009 and another 3 out of 2010 (March to May), it would make sense that we have up to 6 months (starting in July) of anemic volumes until normal trading demand returns. January 2011 should likely bring a return to the annual 5 million unit resale run rate.

Until then, lower than average agency debt supply (given that borrowers will have below-normal demand for new mortgages) combined with deflationary excitement means lower mortgage yields. Perhaps a 3.5% or 4% mortgage, provided by natural market forces, will be the perfect catalyst for the early round of 2011 home buyers.