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||Michael J. Kosares
"There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million can diagnose." - John Maynard Keynes
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Michael J. Kosares, the author of these articles, has more than 40 years experience in the gold business. He is the founder and executive director of USAGOLD (both the website and gold brokerage service), the author of three books on the gold market, and the editor of "News & Views, Forecasts, Commentary & Analysis on the Economy and Precious Metals," the firm's client letter. He has written numerous magazine and internet essays and is well-known for his ongoing commentary on the gold market and its economic, political and financial underpinnings.
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– Rudyard Kipling –
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Shortsighted Fed Policy
Fuels Continued Rise in Gold
by Jonathan Kosares
“Washington doesn't agree on much these days, with one glaring exception: that the U.S. is facing a long-term fiscal crisis. The federal government's debt is now $13.8 trillion and is projected to hit $20 trillion by the end of the coming decade-when it will be the highest level as a share of the economy that the U.S. has seen in 50 years. In September the International Monetary Fund warned that the U.S. is moving dangerously close to a point at which spooked markets will send interest rates on new borrowing to devastatingly high levels. As it is, the government is on course to spend $1 trillion per year on interest costs alone-about a quarter of all federal spending. ‘We are accumulating debt burdens that will rival a third-world nation within 10 years,’ says David Walker, former chairman of the nonpartisan Congressional Budget Office. ‘Once you end up losing the confidence of the markets, things happen very suddenly-and very dramatically. We've seen that in Greece, we've seen it in Ireland, and we must not see it happen in the United States.’" - Michael Crowley, The New York Times
The Federal Reserve's recent shift to the direct purchase of long-term Treasuries carries far-reaching implications for domestic economic stability, potentially causing systemic fractures that could dwarf any short-term benefits to economic growth. While the Fed’s goal is to avoid the scenario described in the quote above, it has created undeniable moral hazard, simultaneously fueling irrational, unpredictable and unsustainable distortions in the market. The Fed is at risk of causing the very end it seeks to prevent. If investor confidence in the bond market is permanently eroded by these policies, the United States could follow the path of Ireland and Greece and, as a result, elevate gold ownership from intelligent diversification to practical necessity.
In late 2008, in the wake of the financial crisis, the Federal Reserve elected to embark on an unprecedented (in the United States) stimulus plan known as Quantitative Easing (QE). At first, the Fed focused its purchases on Mortgage Backed Securities (MBS) in an effort to directly reduce mortgage rates and in hopes of reviving the housing market. In March 2009, the Fed expanded QE, allocating an additional $1.15 trillion in bond purchases. This time, instead of continuing to purchase only MBS, the Fed allocated $300 billion directly to the purchase of long-term Treasuries. At the time, this decision was buried in the rubble of the bailouts, and passed with little notice or worry to its significance.
How a rational, freely trading bond market operates
On November 3, 2010, the Federal Reserve approved a second round of Quantitative Easing, dubbed in the market as “QE2”. In QE2 the Fed will directly purchase $600 billion worth of long-term Treasury Bonds, while reinvesting an additional $250-$300 billion by rolling over maturing assets. The Fed also decided against a specific end date to these operations, leaving open the possibility of additional future purchases. In contrast to QE1, which focused on Mortgage Backed Securities, QE2 constitutes a direct intervention in the US Treasury market. This difference is significant.
To understand how intervention in the bond market can have such far-reaching consequences, it’s worth a brief discussion on how a rational, freely trading bond market would operate. When an individual investor buys a 10-yr Treasury note, he is essentially agreeing to lend the US Government his money for ten years, and the government, in turn, agrees to give him more back than he gave them in the first place. The difference the government has to pay is a reflection of the perceived risk associated with lending the government a certain amount of money for a certain length of time. That risk is quantified by the interest rate. In a free market, if the interest rate offered to the market didn’t adequately compensate investors for the risk they felt they were taking on, the government would be unable to sell bonds at that rate. Due to a lack of demand, the US Treasury would have to offer higher interest rates until that risk/yield relationship came into balance and demand returned. This basic interaction of the risk/yield relationship and demand establishes a fair market valuation on an ongoing basis.
Timothy Geithner, US Secretary of the Treasury
Ben Bernanke, Chairman of the Federal Reserve
Now, consider the impact of direct Fed purchases: The presence of a ready buyer for any Treasury auction forces the yield the US government has to offer to attract buyers of its debt to remain artificially low. Essentially the government need not offer what would otherwise be the real market rate to sell its bonds. Since the Federal Reserve cares little for what interest rate it receives, especially because its goal is to drive the rate down, it skews the natural impact that demand, or lack thereof, has on setting a fair market rate. As this process continues over and over, the risk/yield relationship becomes increasingly distorted. The theory that the Fed adheres to is that this distortion is a net positive, in that it will bring down long-term rates, thereby stimulating the economy by rejuvenating credit markets. Of course, that conclusion is predicated on the hope that the economic growth garnered will fuel increased confidence (lower risk) for the market, thereby preventing a rate explosion after the Fed steps aside. In this perfect scenario, the end achieved would be a rebirth of economic growth, with no functional compromise to the stability of the Treasury market.
It is a slippery slope though, where any number of risks could give way to a whole new set of problems. If, on one hand, the Federal Reserve’s methods prove ineffective or too costly and it is forced to remove its support, the market will naturally recalibrate. Given the litany of fiscal and economic risks associated with our destructively high debt-to-GDP ratios, existing interest payment obligations, and stagnant growth (partially the result of the failure of these policies), the interest rate the government would need to offer to attract buyers of its debt, especially its long-term debt, would soar. This is, in a nutshell, what happened in Ireland and Greece. Interest payments on our debt would go from expensive to oppressive, and could dwarf all other government expenditures. A literal snowball effect would ensue and the scenarios described in the quote at the outset of this article would become a reality. Solutions would include higher taxes and reduced spending, ushering in a prolonged period of low economic growth, just like the austerity measures have caused in Ireland and Greece.
"We’ll do it until it works"
Granted, this is exactly what the Fed seeks to prevent. The greater likelihood is that the Fed will resist stepping away from the Treasury market altogether, employing a “We’ll do it until it works” attitude. But even if the recovery were to suddenly blossom, the Fed would likely continue the quantitative easing program, fearing economic growth may not be sustainable on its own momentum. The last thing the Fed would want is for the US to immediately slide back into a recession upon the discontinuation of its Treasury purchases. This attitude could easily lead to a permanent continuation of Fed open market operations.
The longer the Fed directly purchases Treasuries, the more distorted the market will become, and the more the economy will come to depend on Fed intervention. By skewing the risk/yield relationship, the Fed might ultimately undermine free market demand and eventually position itself as the primary buyer of US Treasuries. In the end, it is unknown whether this policy would even prevent the snowball effect described in the first scenario above and masthead quote. By fueling further distortions, and ultimately undermining the legitimacy of the Treasury market, the transition back to equilibrium might prove only to be substantially more painful.
Regardless of the course of action taken, the Fed and US Government are placing a risky bet on the success of these policies. Other countries have tried to paper over their financial problems, as the United States is now, only to ultimately have the free market expose their financial fractures. This was the fate of Ireland and Greece. For those countries, bailouts eventually prevented the market from imposing an oppressive borrowing rate and helped forestall an outright default. But if the United States were to follow this path, the most important question of all needs to be asked: If the lender of last resort is no longer able to borrow money, who stands ready to bail it out?
The Federal Reserve’s actions over the past two years suggest a sort of hubris, reflecting an apparent belief that its interventions are somehow immune to any negative consequences. To the point, during his interview on “60 Minutes”, Ben Bernanke was asked how confident he was that his policies would yield results and how sure he is in his ability to control the situation. “100 percent,” was his answer.
Paradigm shift in gold’s relevance
Despite the dollar’s role as the world’s reserve currency, the lethal combination of a discredited Treasury market and an ineffective Federal Reserve could cause economic instability and significant erosion in the value of the dollar, potentially igniting runaway inflation. This gives compelling cause to the belief that there is an ongoing paradigm shift in gold’s relevance, both for the individual investor and, within the international monetary system. Consider some of the events and trends seen in the gold market since the initial Fed involvement in the Treasury market in March 2009 (the initial $300bln QE injection mentioned earlier):
1. The price of gold has appreciated dramatically – On March 18, 2009 gold closed at $895 per ounce. The next day (the date the Fed announced it would purchase Treasuries directly) it jumped $60. Following the November 3, 2010 announcement of QE2, gold jumped $90 in four days, ultimately reaching an all-time high of $1430. Gold is currently trading at the $1400 level, up 56% from the first announcement of direct Treasury purchases by the Fed – less than two years ago.
2. World Bank chief Robert Zoellick said in an article in the Financial Times that leading economies should consider “employing gold as an international reference point of market expectations about inflation, deflation and future currency values.” Zoellick said a return to some sort of currency link to gold would be “practical and feasible, not radical.” Zeollick’s comments were made three days after the announcement of QE2.
3. The dollar’s role as the world reserve currency is in question. “The dollar has proved not to be a stable store of value, which is a requisite for a stable reserve currency,’ the U.N. World Economic and Social Survey 2010 said. ‘A new global reserve system could be created, one that no longer relies on the United States dollar as the single major reserve currency.’” (Reuters) Countries have already begun to move away from US Treasuries in favor of gold, with China being the prime example. In the last six years, China has increased its official gold holdings 76%, from 454 metric tons to 1054 metric tons, vaulting them to the 5th largest gold holder in the world. Meanwhile, they’ve drastically curtailed their purchases of US Treasuries, as seen in the graph below:
4. In the 3rd Quarter filing with the SEC, three of the largest and closely followed hedge funds, Soros Fund Management LLC, Paulson & Co. and Touradji Capital Management LP listed investments in gold as their biggest holdings. David Einhorn of Greenlight Capital made headlines in July 2010 when he transferred his entire position in GLD, the gold paper ETF, to physical gold bullion.
5. Gold investment demand has exploded in the last two years. The large spike in demand in the second quarter of 2009 (seen in the graph below) was in direct response to QE1. It should also be noted in conjunction with this point that, by the end of 2009, combined ownership of gold ETFs, gold stocks, and physical metal still only represented less than 1% of all invested assets globally.
The gold market has already been profoundly impacted by the early stages of Quantitative Easing. As global investors and countries alike embrace the yellow metal in response to these policies, one can only project what will happen to the price of gold, and its overall role in the international monetary system. At a minimum, it will take some time to unwind what the Fed has already committed to in QE2. Add to it the potential for expanded operations in the future and it’s quite possible that we “ain’t seen nothing yet” in the gold market.
Short & Sweet
by Peter A. Grant, Senior Metals Analyst
There were several primary themes moving markets over the past month:
- The Fed launched into its second round of quantitative easing in November – dubbed QE2. The Fed plans to purchase an additional $600 bln in assets through the end of June 2011.
- US yields near 3-mo. highs as bond market seems inclined to hold Fed's feet to the fire over QE2.
- St. Louis Fed's Bullard says QE2 will be adjusted based on data. Might not need full $600 bln in new asset purchases.Boston Fed's Rosengren expects the central bank to buy the entire $600 bln of Treasuries. If necessary "we should take more action.”
- Me thinks the Fed is seeking to confuse on QE2, much like they did in the lead-up to 03 Nov announcement. Keeps market on its heels.
- Bernanke defends QE2, saying it could result in creation of 700k jobs over next 2 years. Where are the jobs from the much larger QE1?
- Fed's Bullard worries about disinflation in wake of below expectations PPI & CPI, but maintains full deployment of QE2 is data dependent.
- Is anyone surprised Bernanke has turned to the alleged job-creating potential of QE2 in attempt to quiet recent criticism from politicians?
- Bernanke hints that if surplus countries stimulated domestic demand, US might not need über easy monetary policy.
- FOMC Minutes show Fed’s growth forecasts revised significantly lower. Unemployment expectations revised higher.
- So what does the Fed do if dollar gains resulting from eurozone deterioration derail its quest for inflation? Ramp up the QE2?
- In wake of payrolls miss, I'm envisioning Bernanke on the horn with the DC Office Max, getting a quote on more paper & ink for his presses.
- Bernanke on 60-Minutes: "We’re not very far from the level where the economy is not self-sustaining,” said the man buying $600+ bln in US Treasuries.
- With US economic recovery "very close to the border" of sustainable and unsustainable, Bernanke hints more stimulus may be needed.
- Bernanke says, "we're not printing money, just look at the money supply.” I am, and I see a rise in M2 to an all-time high of $8.8 Trillion.
- 8 million+ jobs lost, trillions in bailouts, stimulus, QE & Bernanke concedes, "We've only gotten about a million of them back so far."
- Wondering what makes Bernanke think more QE is going to result in a different outcome. What was Einstein's definition of insanity?
Summary: One has to wonder what might be prompting the Fed to think they will get results different than those achieved with the much larger QE1 program. Fed Chairman Bernanke indicated in a 60-Minutes interview that more stimulus may be needed. Is QE3 in the queue? To be followed by QE4, QE5…? Clearly Mr. Bernanke is setting the stage for further devaluation of the dollar in his quest to manufacture inflation. That should in turn continue to have a positive influence on the price of gold, as prudent investors seek to preserve their wealth. This topic is discussed in greater detail in this month’s feature article.
US consumer confidence has edged higher in recent months, reaching 54.1 in November. While that's certainly better than the mid-twenty readings from early last year, it's only a modest improvement from last Christmas, and still way off the recent 111.9 peak in July of 2007. Perhaps consumers are merely feigning confidence and turning to their credit cards to provide a little holiday cheer in the wake of two pretty crummy Christmases in a row, as evidenced by the recent expansions in consumer credit after 19 consecutive monthly contractions. However, with a sluggish economy and unemployment still stubbornly high around 10%, there is little to warrant full-fledged jolliness.
EU Sovereign Debt Crisis
- Eurostat confirms latest upward revision in Greece's 2009 budget deficit at 15.4% of GDP, up from 13.6%.
- Austria threatened to withhold its contribution to Greek bailout package, claiming Greece hasn't met commitments to EU on public finances.
- No resolution to Ireland debt issues prompts collapse in euro to 7-wk lows.
- ECB's Honohan expects Ireland to take a large EU/IMF loan.
- Irish PM Cowen confirms bailout talks are under way. Looking for best possible deal "to improve the situation" and "provide certainty."
- Irish bailout announced. Spreads jump and euro tumbles, suggesting the market has not been mollified. Focus shifts to Portugal next.
- EU's Rehn on Ireland bailout: "It is likely unfortunately to imply tax increases." Without its low corporate tax structure, the Irish economy would really be in trouble.
- Bailout plunges Ireland into political turmoil. A little something extra to go along with their financial turmoil.
- Europe deeply fears contagion, which means everyone will get bailed-out, no matter the cause.
- Spanish yields soar on weak auction. Spread with German bunds reach record wide. Indicative of contagion.
- Ireland reveals 4-year austerity plan. Cuts include €2.5 bln to welfare. Corporate tax spared…for now. VAT hiked to 22% in 2013 and 23% in 2014.
- EU member nations pressure Portugal to seek a bailout in hopes of preventing contagion to Spain...because that worked so well with Ireland.
- ECB's Axel Weber assures eurozone rescue fund is sufficient. Governments "will do everything to keep the [euro] alive."
- ECB's Weber says the worst of worst cases is Portugal and Spain require bailouts too, but says the "euro will not fail because of a difference of €145 billion."
- Spain's PM Zapatero calls out those betting against his country. Says "absolutely" no bailout. He may not be so 'absolute' if Portugal caves.
- Eurozone rescue plan sends bondholders running. Spreads blow out. Borrowing costs in periphery soar and euro tumbles.
- Der Speigel says German households still have an estimated 13 billion Deutsche Marks stashed.
- German exporters fear a return of the Deutsche Mark, as safe-haven appeal would likely drive up costs of their products. That would probably result in higher unemployment too.
- European company borrowing costs rise as contagion worries hit the corporate debt market.
- Some feel that printing euros may be the EU’s last hope to halt the crisis. Kick the can just like America!
- Trichet says special liquidity measures will be extended at least until 12 Apr. -- Can we please have some American-style QE after that?
- Spain and Italy, seen as at-risk of contagion, press for ECB to act. QE is what they desire.
- Europe is treading an all-too familiar path: Attempting to resolve a debt crisis by borrowing more.
- Europe needs a debt-restructuring mechanism, but it’s simply easier for politicians to just issue more debt.
- Subdued demand at German 2-yr Schatz auction. Bid cover was just 1.1. Bundesbank kept €995M for open market operations, or auction may have failed.
- Eurogroup chief Junker accused Germans of "simple" thinking and of being "unEuropean" for dismissing the notion of eurobonds.
- Fitch cut Ireland's sovereign debt rating 3 levels to BBB+ on "additional fiscal costs of restructuring and supporting the banking system."
- ECB projects debt to "rise across the Eurozone in 2011," and almost everywhere in 2012, except Germany and Italy.
- ECB predicts mean debt/GDP ratio in eurozone of 87.8% in 2012 with Belgium, Ireland, Greece & Italy all over 100%.
- Banca D'Italia governor Draghi worries about the fine line the ECB is walking: "We could easily cross the line and lose everything we have."
- Germany's Merkel rules out expansion of rescue fund and eurobonds, but warns "If the euro fails, Europe fails. That's very serious." Front-runner for understatement of the year.
- Italy’s PM Silvio Berlusconi calls no-confidence vote “madness.” Warns that vote will hurl Italy into the midst of the EU financial crisis.
Summary: The lull in the EU sovereign debt crisis since Greece took its bailout in May was a short one. In November, Ireland had a bailout thrust upon it by the EU, which in fact did little to assuage contagion worries. Borrowing costs rose throughout the periphery of Europe as the market fixed its sights on Portugal next and the EU tried to insulate Spain -- its fourth largest economy – from the threat. It is widely believed that Spain is too big to bail out, but the risks extend even further, to Belgium, Austria and Italy. Talk about the potential for a complete collapse of the union continues to circulate, which is weighing on the single currency. That will continue to drive gold demand in Europe, but a falling euro also thwarts US efforts to devalue the greenback, which may force the Fed to extend its QE program beyond June of 2011.
The pace of residential foreclosures slowed in November, but it wasn't because the housing market had fundamentally improved. Instead many banks put a hold on foreclosures amid swirling concerns over faulty paperwork and procedures. In fact, new home sales plunged by 8.1% in October to just 283K, down 80% from the peak of the housing boom. Zillow, an online real estate database, projects that home values will be off $1.7 trillion in 2010, worse than the $1.05 trillion loss recorded in 2009. Zillow estimates that $9 trillion in residential home equity will have been wiped out since the housing market peaked in 2006.
Fed Bailout Data Dump
- Fed releases data on the beneficiaries of its $3.3 trillion in crisis aid.
- Fed programs saw some 21,000 transactions. The Fed followed "sound risk management practices." They incurred no credit losses and expect no losses. – Yeah, thanks to mark-to-fantasy valuations.
- Fed bought hundreds of billions of dollars worth of MBS from foreign banks. Deutsche Bank and Credit Suisse were top two beneficiaries.
- Fed helped prop up ten other central banks during the financial crisis. ECB borrowed money from the Fed 271 times for a gross rolling total of $8 trillion.
Summary: As part of the Dodd–Frank Wall Street Reform and Consumer Protection Act, the Fed was obligated to reveal the details of the $3.3 trillion in emergency aid it doled out in 2008 and 2009. Along with bailouts of the usual suspects, it was revealed that the Fed also bailed out foreign banks, corporations and even other central banks. It is now abundantly clear that the Fed is the lender of last resort to the world…which begs the question: Who bails out the lender of last resort to the world? This is a disturbing confirmation that the world calls on the Fed to provide global liquidity in the form of dollars when all hell is breaking loose. It’s easy; a couple keystrokes on a Fed computer terminal and voilà, trillions appear from out of nowhere!
- China’s Efforts to Curb Inflation
- China’s gold imports soar almost fivefold on inflation concern.
- China raised bank reserve requirements another 50bp, 6th hike this year. Talk of a rate hike persists.
- China CPI +1.1% m/m in Nov, up to +5.1% y/y pace, heightening markets anticipation of a PBoC rate hike.
- China is likely to continue increasing its gold position, which is presently a mere 1.6% of FX reserves.
- China raised bank reserve requirement by 50bp (effective 29 Nov), 5th such hike this year. Markets have been pricing in a rate hike.
- Chairman of China's sovereign wealth fund says China should not increase holdings of US Treasuries. - No problem. The Fed will pick up the slack.
- CIC chairman Lau says repercussions of a large sell-off of US Treasuries by Asian holders of US debt would be "inconceivable."
- China's fight against inflation – balanced against growth risks and risks of falling stocks – is a cautionary tale the Fed should heed.
- Stocks weighed by worries of further tightening by China; either more hikes to the reserve ratio or a rise in the benchmark lending rate.
- Jing Ulrich of JPM cites 47% rise in China's money supply since 2009 as a contributing factor to Chinese inflation. – Yep, that would sure do it.
Summary: Hot money inflows have become increasingly problematic in China, contributing to an uncomfortable 5.1% y/y inflation rate. China has focused on quantitative measures thus far in an effort to reign in price risks, but may ultimately have to resort to interest rate hikes. China and the world are understandably concerned that slowing the last major economic engine firing on all cylinders will have negative repercussions globally. Inflation will lead to ever increasing demand for gold within China as the PRC simultaneously continues to diversify out of paper assets into the yellow metal.
This Ed Stein cartoon initially ran around Christmas last year. If the five gold rings were a 'budget buster' then, Santa will have to scrutinize his budget even more carefully this year with gold up about 28% since last December.
Peter Grant spent the majority of his career as a global markets analyst. He began trading IMM currency futures at the Chicago Mercantile Exchange in the mid-1980's. Pete spent twelve years with S&P - MMS, where he became the Senior Managing FX Strategist. The financial press frequently reported his personal market insights, risk evaluations and forecasts. Prior to joining USAGOLD, Mr. Grant served as VP of Operations and Chief Metals Trader for a Denver based investment management firm.
Jonathan Kosares graduated cum laude from the University of Notre Dame, earning a double major in Finance and Computer Applications. He has been an account executive for the firm since 2002. If you would like to register for an e-mail alert when the next issue is published, please visit this link.
Disclaimer - Opinions expressed on the USAGOLD.com website do not constitute an offer to buy or sell, or the solicitation of an offer to buy or sell any precious metals product, nor should they be viewed in any way as investment advice or advice to buy, sell or hold. USAGOLD, Inc. recommends the purchase of physical precious metals for asset preservation purposes, not speculation. Utilization of these opinions for speculative purposes is neither suggested nor advised. Commentary is strictly for educational purposes, and as such USAGOLD does not warrant or guarantee the the accuracy, timeliness or completeness of the information found here.
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