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Gold, Interest Rates, and the Great USD Short Unwind


In the backdrop of a US consumption bubble collapse, the dollar is rallying, gold is falling, and real interest rates are rising while nominal rates are falling.

The financial media likes to frame the markets into simple, data-driven, cause-and-effect nonsense producing high-frequency asset allocation shifts such as risk-on/risk-off and the great rotation out of bonds and into stocks. They discuss whether money is flowing in and out of these assets and why this may be happening. Market price action is much more complicated than this elementary portrayal, but at the same time, much simpler when broken down to the basic transaction.

On April 8 in Bond Yields Are Falling Because the Consumption Bubble Is Imploding my point was to show that the bond market was discounting something much more complicated than a short term shift in capital allocation, yet the reason behind this discount was as simple as long term adjustment in how the US consumer finances spending.

Consumption and household debt didn't just rise in relation to the size of the economy, they also rose as a percent of income. Credit was used to subsidize income in order to increase spending which in turn drove GDP growth. For decades the US economic growth engine that we all love to brag about has really just been an exercise in consuming stuff we didn't need with money we didn't have. This generational trend is now in reverse and potentially so massive that it transcends monetary and fiscal policy.

Household Debt Vs.Current Account Balance

The following week out of nowhere the price of gold tumbled 6.3% with most of the move occurring on Friday when the metal fell $80. On Monday the selling intensified in an outright collapse as gold fell $130, completing a two-day 14% meltdown. Many participants were struggling to rationalize the selling. Was this simply a byproduct of Bank of Japan QE policy? Was it due to Cyprus' need to sell gold to finance the bailout? Maybe John Paulson's hedge fund was blowing up. Some event attributed the selling to asset allocation into stocks. I knew better.

The consumption bubble implosion thesis is predicated on a very simple concept that will unfold in a very complex manner. Put simply, the US consumer is entering a cycle whereby consumption is no longer financed with assets and credit, and now will be financed with income. The complexity is how this cycle plays out in global financial markets.

The US consumption bubble has been the engine behind global capital flows, and the machine works in a certain way. You can think of the global market as one giant balance sheet. Our deficit is their surplus. Our spending is their income. Our liability is their asset. That's all simple. What's more complex is how the capital flow reverses and what it means for currencies, commodity prices, interest rates and risk premiums.
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