Russian President Medvedev at the St. Petersburg International Economic Forum on June 18, 2010:
The State should not tear apples from the tree of economics. What it should do is help to grow our apple orchard…
Gold price hit an all-time intraday high of $1266.50 per troy ounce even as stock markets around the globe continued their recent upward journey. This is one of the two scenarios I had said were possible in the markets; the other of course being a rising stock market with falling gold prices. Unfortunately, the former is what is happening right now and that, to me, is not good news. Many have written about the equity markets being driven by liquidity, there is an even more interesting way to look at it.
The S&P 500 index closed at 893.04 on June 22nd 2009 while gold closed at a price of $920.6 per troy ounce. That would peg the index at being worth about 0.97 ounces of gold on that day. A year later on June 18th 2010, the index had risen over 25% to close at 1117.51. However, gold had far surpassed that by rising a massing 36.5% to close at $1257.2. The index, measured in gold now stands at 0.88 ounces of gold. So even though the index has risen, the investor has been left poorer. My interpretation is a little different though. I’d say that the entire (or substantial) rise in the index has been driven by liquidity provided by the various central banks, primarily the US Fed and the ECB as has been most of the rise in gold. However, the excess 11% rise in gold price is probably a good measure of the fear for further inflation, or rather currency devaluation which the easy money policy is pointing towards. How much further gold will rise depends on how far the fears will be exaggerated and how long the central banks take to start increasing interest rates. I will only feel confident about any real recovery when the momentum in gold slows down and the S&P 500 recovers to somewhere over 1 ounce of gold.
In India, the story works a little differently. While interest rates in India are also being kept fairly low, gold in INR terms hasn’t appreciated as much because of the contrarian effect of FII money inflow which keeps the rupee bouyant and gold prices a little in check. The increased liquidity is showing up elsewhere though, with food inflation staying stubbornly over 10% for over 2 years now. Right until the middle of 2009, the Government refused to admit to inflation at all with persistent reports of low inflation citing the wholesale price index which was close to zero for much of this period. When food inflation was finally recognized as a problem, it was attributed mainly to supply side problems citing low output in the previous year. Towards the end of 2009 and early 2010, the supply side problems had supposedly eased but food inflation doggedly continues above the 10% mark with the actual number for April 2010 standing at 14.8%. While this has led to increased speculation that the RBI shall move to increase interest rates soon, Governor D. Subbarao has maintained a stance that interest rates will not be hiked immediately as “other measures” have been taken to control liquidity in the market. My concern remains that even though liquidity may have been mopped up by issuance of Government bonds to finance the deficit, the deficit spending itself is a crucial source of the persistent inflation, not least being the spending under the National Rural Employment Guarantee Scheme.
While central bank madness continues in Europe and in the US, I think quick steps need to be taken to increase interest rates even at the risk of slower economic recovery in India. Even though we depend on western demand to a certain extent, I think prudent monetary and fiscal policy can make India the preferred destination for external capital and hence can sustain our recovery even with higher interest rates domestically. On the other hand, economic recovery at the cost of skyrocketing food prices does not bode well for the internal security of the country. Any increase in economic activity can quickly be offset by social unrest if food inflation is not checked soon.
Since the Greek/Euro crises broke out in earnest some time last month, the German Bunds and US Treasuries have seen increasing demand (and falling yields) as people pull out money from “risky assets” and park them into “safe havens”. This has been the typical behavior in all recent panics, but somehow, this time around it makes little sense to me.
US 2-year treasuries are currently yielding about 80 basis points (or 0.8% per annum). Not only is this ridiculously low for ordinary times, it sounds even worse given the extent of Quantitative Easing being undertaken by the Federal Reserve. As the Fed puts more and more money into circulation, I’d expect severe inflationary pressures; or equivalently for international investors, a severe deterioration in the value of the US Dollar. Except against the Euro. Which brings me to the German Bunds. The case of German Bunds is even more baffling. The reason why German Bunds are in favour right now is because of panic for the Eurozone and the Euro itself. In my mind, that is precisely the reason why German Bunds are a bad investment, particularly at low yields of 2.65% p.a. for the 10 year bond. With a currency facing potential deterioration of 20% or more (the Euro hitting parity with the US Dollar is an oft-discussed possibility), why would someone invest in a fixed income security yielding 2.65%? One reason would be that for a lot of institutional investors in the Euro-zone, investing all (or most) of their corpus in European instruments might be mandatory. They have nowhere else to go and so they buy debt from the least-likely-to-default Eurozone country. But what about others? I’d imagine that they should be buying commodities and gold. That is probably the only safe bet at this point.
Gold indeed seems to be attracting massive attention as it reversed it recent short downtrend and is back at $1215 per troy ounce having fallen to $1170. In Rupee terms, the story is much worse with prices reaching new highs of over Rs. 18,600 per 10 grams. It is here that I think there is some madness again. Part of the reason why fresh highs are being made in INR terms is the bulk pulling out of FII investments from the equity market, which is pushing down the INR against the USD. So while I remain bullish on gold in USD terms, I have mixed feelings about it in INR terms, mostly because I see INR weakness as only temporary and would expect a reversal if/when saner minds take over the market and money flows back out from the insanely over-priced US treasuries and returns to economies where genuine growth is taking place and long-term investors can get the biggest bang for their buck.
Of course, I don’t expect sanity to return too soon and I’d expect to see the INR trade atleast between 49-50 to the Dollar before money flows back in.
The fall Gold has taken from its recent high of about $1248 to a current level of $1170 is baffling. That is not to say that it hadn’t taken a real run-up over the previous few weeks. The point is that while equity markets continue to head south and US Treasury and Bund yields continue to get compressed, Gold, which should be the ultimate inflation/currency hedge is also taking the fall. Over the week ended 14th May 2010, I had expected one of two things to happen. One, Gold continues to head higher/stays stable at 1230-1250 levels while equity markets rise on low volumes. Such a scenario would have been a good time to sell into the rising equity market as Gold as a sentiment barometer still reflected serious risk-aversion. The other scenario would be a rising equity market with falling Gold. That would probably be a sign of recovery, or at least an improvement in sentiment and so the equity rally could be sustainable. Nothing, however, had prepared me for a falling equity market with a simultaneously falling Gold price.
From the Indian perspective, however, things make more sense as the recent Gold fall in USD terms has hardly translated into a fall in INR terms, while the benchmark stock market indices continue to fall. The principal reason is of course the departure of FII money from the equity market, which pushed the USD higher against the INR.
My own view is that this flight of capital into “safer” US Treasuries is the expected short-term behaviour. However, once things settle down into the “new normal”, whatever that may be, we should see a significant return of overseas interest in the Indian (and other Emerging) Markets. Unless we hit another wave of “irrational exuberance”, I’d expect capital to flow to countries with more transparent administrations, stronger enforcement of property rights and more predictable regulatory environments*.
The EUR/USD pair has also shown puzzling behaviour overnight with the EUR rising back from a low of below 1.22 back to 1.26 overnight. One explanation is the given the major Swiss National Bank intervention for defending the Swiss Franc, the ECB might do the same for the Euro. The shorts probably covered their positions and took their profits home. A fresh wave of panic might push it down again soon enough, though. The other important point is that we tend to forget that this is a currency “pair”. Two months ago, EUR/USD was a proxy for the USD against “a foreign currency”. Over the last two months, that changed into a proxy from the Euro against the world. However, given that things don’t look good either for the Eurozone or for the US, the pair is now looking like a see-saw trying to figure out which one goes down first, and harder. We should be finding out soon enough.
* The recent recommendation by the TRAI for linking the 2G spectrum fees to the bids received for the 3G spectrum are just one example of the regulatory unpredictability in India. Particularly for industries with hugh capital requirements like telecom, such fickleness would scare away a lot of long-term investors. Such behaviour needs to be kept in strict check if we want to be the preferred destination for foreign capital.
After about a million people telling me that WordPress beats blogger hands down, I decided to set one up for myself… so here we are. This looks good so far. I will need to figure out some way to add email-blogging support.