Gold goes for it

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Roula Khalaf, Editor of the FT, selects her favourite stories in this weekly newsletter.

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Gold keeps rising, dammit

I’m a cash flow guy, and so I don’t like gold. This is proving to be an expensive preference:

Stocks are having a great year. Gold, which recently passed an all-time high of $2,500 an ounce, is having a historically great one. It’s not just that gold has beaten the S&P 500 by a couple of percentage points. It’s that gold investors have earned these returns owning an asset whose main benefit is that it is uncorrelated with stocks. It’s a hedge for goodness sake! Bonds, the other classic (and more rational) hedge, are miles behind.

What, a humiliated gold sceptic has to ask, is going on here?

Part of the rally is easy to understand. The dollar is weakening in anticipation of US interest rates declining, and gold is priced in dollars. Real rates have been falling since May, so the opportunity cost of owning gold is down. Add to this the usual (vague) points about geopolitical, economic and/or fiscal uncertainty, and the basic ingredients for a strong gold price are in place. The fact that global central banks have begun to increase reserve allocations to gold adds a meaningful tailwind.  

Another possible support: China’s poor economy. Chinese retail investors don’t like local equities and have been burnt in real estate. But they need a place to park wealth. As my colleague Robin Harding wrote recently, “with the outlook so gloomy, it seems wholly rational for Chinese investors to flock into bonds and gold”.

David Rosenberg of Rosenberg Research is confident that gold will hit $3,000 before long. Not only are all the usual building blocks of a rally in place, but gold is under-owned. US households have the highest ever allocations to equities and need a hedge. They don’t trust bonds — perhaps rightly, given the fiscal outlook. It’s “an under-owned asset”, he says. Bob Elliott of Unlimited Funds agrees. He points out that because there is a relatively small and slow-growing amount of gold available, a minor investor shift could move the price a lot.

Yet James Steel, chief precious metals analyst at HSBC, is more nervous. He notes that:

• Across trading venues, volumes have been thin this summer

• Silver and platinum are not following gold up, as they usually do

• The high price has recently “taken a sledgehammer” to physical demand in China, India and the US coin and bar market

• Recent price moves appear to have been driven, instead, by financial buyers in the west seeking a hedge; when the US election is settled and the future feels more certain, what happens to those buyers?

• Everyone is already pricing in a lot of Federal Reserve rate cuts 

• Central bank buying has been strong in recent years, but fell between the first and second quarters; central banks, like Asian retail buyers, are price sensitive

All music to a grouchy gold bear’s ears. Readers fortunate enough to own the stuff probably feel differently.

The origin of 25 basis point cuts

Why does the Fed always move its policy rate in increments of a quarter of a per cent? Why not tenths, thirds or halves? 

Because it has worked, and now we’re used to it. From Gary Richardson at University of California, Irvine:

In the 1990s [the Fed] switched to actually targeting the federal funds rate . . . Alan Greenspan [gave] directives to the trading desk to target a specific federal fund rate, but they realised you cannot be incredibly precise. So they settled on a smaller increment [of difference] to target, and then communicated that out to the market. They settled on 25 basis points as minimal steps to make, and that worked, and the [open market] committee decided to keep using it.

The federal funds rate is as much — or more — about communicating with the market than hitting a specific rate level that will influence the economy by a particular amount. Increments of 25 can be thought of as the language of the Fed. A 25bp cut or increase says: “The economy is changing at a normal pace, everybody can relax.” A 50bp or 75bp change says: “This is a serious situation and we are taking strong action.” Sending a clear message, in a market lingua franca, is more important than the rate itself.

(Reiter)

X’s debt

The seven banks that funded Elon Musk’s acquisition of Twitter (uh, sorry, X) have taken big losses on the $13bn of debt, The Wall Street Journal reports. The banks have already taken writedowns, but with X at war with its own advertisers and the economy softening, the value of the loans could fall more. Even if Musk turns things around and the loans return to par a few years from now, the deal will remain a nightmare from a return on capital point of view. Why don’t the banks sell and move on? Post-Dodd-Frank banking is about capital efficiency, and there are plenty of distressed asset funds that would be a natural home for this stuff.

Three theories:

• The banks always knew the loans were loss leaders. They were a way to get into business with the world’s richest man. Musk runs a lot of companies. Better deals in the future, as adviser or lender, are the true prize. Selling the debt and upsetting Musk jeopardises that.

• Debt losses don’t matter in cash terms. Hung debt is about bank accounting. Musk has not actually defaulted and they are still receiving large interest payments. Why give up a steady stream of payments?

• The marks the banks have taken on the loans are very gentle, and selling would reveal how bad things really are. Better to delay and pray.  

Another question: why doesn’t Musk, with a net worth estimated at more than $200bn, buy back the debt at a discount? If he believes he can fix X, he can buy back dollars for (say) 70 cents and save on future interest payments. Two theories on this:

• He isn’t liquid enough. Musk funded the original deal with margin loans on his Tesla holdings, but the value of Tesla stock has almost halved since. Musk was recently granted about $56bn in Tesla shares as incentive pay, but there are still some legal questions, so the money is not in his wallet just yet. And selling his newly acquired equity could cause Tesla’s stock to fall, angering the shareholders who gave him the payout in the first place.

• He thinks there are better uses of his money than buying X debt at a big discount, possibly because he knows X debt deserves a big discount.

Any possibilities we are missing? 

(Reiter and Armstrong)

One good read

Plant messiah.

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Letter in response to this newsletter:

Golden opportunity to realise boons of bitcoin / From Zach Pandl, Head of Research, Grayscale Investments, Stamford, CT, US