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August 19, 2005
A Few Words on "The Conundrum"
-- the flattening of the yield curve
by Randy Strauss, P.E.
[based
on his original post: TownCrier
(8/19/05;
13:30MT - usagold.com msg#: 135117)]
A
risk-premium differential of only 0.6%
on 30-yr Treasury debt vs 6-month rates!
With our
U.S. currency serving as an international reserve asset at the
pleasure of those who hold it, what's to happen when these entities
become sufficiently displeased?
The following
is some food for thought in answering that while explaining the
so-called "conundrum" of the very flat U.S. yield-curve
(see chart above).
Fed Chairman
Alan Greenspan very likely sees the big picture personally, but
he has publicly been less-than-forthcoming in explaining the
flattening yield curve on Treasury debt instruments -- that is,
why interest rates on long-dated U.S. bonds have been brought
low and stay low, scantly above shorter-term debt, even as rates
on the short-term Treasuries are rising and as the cash dollar
itself continues to have every fundamental reason (government
and trade deficits considered) to weaken going forward.
Greenspan
had this to say on the subject in July 2005 Testimony before Congress:
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The third major uncertainty
in the economic outlook relates to the behavior of long-term
interest rates. The yield on ten-year Treasury notes, currently
near 4-1/4 percent, is about 50 basis points below its level
of late spring 2004. Moreover, even after the recent widening
of credit risk spreads, yields for both investment-grade and
less-than-investment-grade corporate bonds have declined even
more than those on Treasury notes over the same period.
This decline in long-term
rates has occurred
against the backdrop of generally firm U.S. economic growth,
a continued boost to inflation from higher energy prices,
and fiscal pressures associated with the fast approaching
retirement of the baby-boom generation. The drop in long-term
rates is especially surprising given the increase in the federal
funds rate over the same period. Such a pattern is clearly without
precedent in our recent experience.
The unusual behavior of
long-term interest rates
first became apparent last year. In May and June of 2004, with
a tightening of monetary policy by the Federal Reserve widely
expected, market participants built large short positions in
long-term debt instruments in anticipation of the increase in
bond yields that has been historically associated with an initial
rise in the federal funds rate. Accordingly, yields on ten-year
Treasury notes rose during the spring of last year about 1 percentage
point. But by summer, pressures emerged in the marketplace
that drove long-term rates back down. In March of this year,
long-term rates once again began to rise, but like last year,
market forces came into play to make those increases short lived.
Considerable debate remains
among analysts as to the nature of those market forces. Whatever
those forces are, they are surely global, because the decline
in long-term interest rates in the past year is even more pronounced
in major foreign financial markets than in the United States.
Two distinct but overlapping
developments appear to be at work: a longer-term trend decline
in bond yields and an acceleration of that trend of late. Both
developments are particularly evident in the interest rate applying
to the one-year period ending ten years from today that can be
inferred from the U.S. Treasury yield curve. In 1994, that so-called
forward rate exceeded 8 percent. By mid-2004, it had declined
to about 6-1/2 percent--an easing of about 15 basis points per
year on average. Over the past year, that drop steepened, and
the forward rate fell 130 basis points to less than 5 percent.
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Whereas
Greenspan goes on to offer "expectations of lower inflation"
as the most satisfactory explanation suitable for public
consumption, however, being not so constrained by a position
of official influence as is the Fed Chairman, the following is
my own attempt to offer a more candid assessment and suggestion
of the elements at work to bring about the "conundrum"
effect as witnessed.
Say, for
example, that entities such as China, or the euro-area, already
have their sights set on a paradigm shift away from a dollar-centric
reserve structure for their central banks' balance sheets.
Say, also, that they realize they are largely trapped in their
dollar position, a quagmire of dollar holdings which are too
large to meaningfully liquidate without invoking a precipitous
plunge in value on the U.S. Dollar/bond market. Effectively,
they would be left holding the bag -- sitting on a huge smoking
pile of worthless reserves, the marketplace having finally being
brought to acknowledge what these central banks (CBs) knew all
along.
Therefore, since the CBs do, in fact, know that they are
largely trapped in this position, if they had anyone brighter
than me on their staff, they would already have been well-advised
to take measures to make the best of it.
That is to say, they would be advised to abandon their old tenets
of central banking which favor liquidity (i.e., short-dated Treasury
bills and notes) on the grounds that liquidity has become
a minor concern in contrast to the valuation concern.
Subsequently, they would be advised to shift their U.S. debt
holdings out to the long end of the yield curve so as to eke
out the highest possible interest rate earnings for as long as
the system holds together.
In doing so, yes, they would cause the seemingly "unnatural"
flattening of the yield curve, but it is indeed quite
natural if you are seeing it as described here.
Furthermore, in bringing down the long-dated interest rates,
these clever CBs would be causing the rest of the ill-informed
world to have and maintain an unfounded high level of confidence
in the strength and fate of the dollar.
This, you should agree, would play into the CBs advantage as
it buys them time, allowing them to achieve a greater shift in
their reserve structure than they would have be able to otherwise.
That is, in keeping the long end of the yield curve strong, the
confidence this inspires for the dollar in global markets helps
them liquidate the shorter-term holdings into strength, and more
importantly, the illusion of a fundamentally strong dollar helps
keep the gold market liquid.
As we've explained before, gold can flow most easily when regular
investors aren't excited. And to be sure, a network of CBs who
are determined to achieve a necessary reallocation of vital gold
reserves certainly isn't going to let those competing investors
get excited and interrupt their gold flows by something as mundane
as a runaway gold price when it is so easily controllable through
their banking network and the current pricing mechanism.
Thus, I would say to you, use this current era to your full advantage
-- use the carefully-crafted illusion of the strong dollar and
the carefully-crafted illusion of weak gold to shift out of the
overvalued paper and into the underpriced metal.
When the day arrives that the CBs have achieved an adequate degree
of reallocations, their escape from the dollar quagmire will
be effectively accomplished as a sudden elevation in the Mark-to-Market
value of gold holdings (upon a "free (physical) gold"
pricing mechanism) will compensate their balance sheets for the
precipitous MTM losses of the dollar piles which are still on
their books.
The only real question is, why don't you hear this tale in any
other venue or hall? It could be that some things are simply
not meant to be known to a wider audience.
Time will tell.
- Randy Strauss
EPILOGUE
Subsequent
to publication of this commentary, I received an e-mail from
an associate of mine (we'll call him "Jon"), and in
our exchange some of these points were elaborated upon in a manner
that bears repeating here for further
elucidation debunking the 'conundrum'.
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To: Randy
From: "Jon"
Date: Tue, 30 Aug 2005
Greetings to
you, Randy!
...You know
how I like to emphasize FOA's comments on the selling down of
gold ... as a deliberate effort by non-US$ forces to apply stress,
by not even letting the escape-valve increases take place to
the extent the US$ interests would like.
Is this not
a possibility here as well? Could certain foreign CBs be involved
in a maneuver to keep buying the long end down, not to create
an illusion of stability, ultimately, but instead to apply (gently)
more and more stress...?
...Whatever
they do has to cause an unmistakable exposure of the incredibility
of $ asset prices -- either too high (bonds-stocks-R.E.), or
too low (commodities, and gold). And, what they do has to come
from an activist posture.
If the long
end refuses to budge, even in the face of further rate hikes,
then I think we may be seeing a deliberately offensive move on
someone's part...
With demand
still high, but the dollar un-revitalized, cost-push inflation
will be allowed to become very real, driven by fuel prices....
And the gold
markets must still languish.
This is the
kind of stress that has to eventually discredit the paper gold
market paradigm. And this is what is essential -- the unmasking
of these grotesquely hideous credit and asset inflation monsters
into manifest consumer price inflation, and not re-morphing them
it into another deflationary cycle of international defaults
and crashing overseas markets as fickle speculative cash moves
effortlessly on to the next thing.
... so we are
back I think to seeing the prescience of FOA. He both predicted
this type of activism, orchestrated (or at least tacitly blessed)
by central banks...
"Jon"
To: "Jon"
From: Randy
Date: Tue, 30 Aug 2005
YES, "Jon", ABSOLUTELY!!!
Force it far enough to ensure a global precipitation of meaningful
change.
And in addition, it is to be
hoped (and borne in the backs of our minds?) that American political
and monetary officials cannot possibly be so selfishly myopic
as to fail to recognize that America's surest path to sustainable
prosperity is not through continued propagation of the current
grave economic asymmetries and additional strains by these farcical
flows of hot money and resulting conditions of fincancial contagion.
To be sure, we (the U.S.) do
not eagerly give up the current privileges, and that's
why progress on the issue must ultimately be 'forced' by others
as you rightly describe, but one has to figure that some of our
monetary officials are at least intellectually 'on board' and
supportive of the end result, even if acting with every fiber
of their being in the meanwhile to both forestall and mitigate
the domestic pain we'll feel when our reserve-status privilege
is ultimately lost.
We, you and I, can derive reasonable
assurances that this view, this transition, is indeed the inevitable
pathway -- regardless of the outcome of short-term efforts by
the U.S. at mitigation on one hand versus the induced stresses
by foreign agents on the other.
How can we be so sure?
Because the adminstrative 'blueprint'
of these new "best management practices" has already
been conceived, drafted, and implemented by the BIS and ECB (among
a few others) and those practices, with appropriate fine tuning
of the blueprint, will surely spread among their colleagues over
time.
That is to say, gravitation
toward "common sense" and a "better way"
in and of itself becomes an irresistable force for the change
in reserve structure.
So the question comes down
to timing. Will we have it sooner -- with the additional application
of artificial forces of low bond yields and low gold in an inflationary
environment; or will we have it later -- how resistant and crafty
is the US/Fed at delaying the day on which the critical aggregate
balance shifts in the structure of international reserve paradigm?
Randy
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For related
'food for thought', see the following articles and comments from
the Discussion
Forum Archives:
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TownCrier
(08/09/05;
14:44:10MT - usagold.com msg#: 134774)
CBOT
aims to avoid repeat of June 10-year expiry woes
http://yahoo.reuters.com/
CHICAGO, Aug
9 (Reuters) - Some of the basic ingredients look the same, but
after a controversial expiration for 10-year Treasury note futures
in June, the Chicago Board of Trade hopes for a tamer outcome
in September.
That is especially so with the U.S. Treasury looking back at
events to sniff out possible wrongdoing...
Problems in June revolved around scant supplies of the cash
10-year note that was cheapest to deliver against CBOT futures,
and questions on whether holders of those notes were deliberately
keeping supplies off the market.
[...In June, low supplies of the CTD note led to a series of
"fails" in the cash market, when sellers of the security
were not able to deliver the note to buyers.]
Each contract represents a U.S. Treasury note with $100,000 face
value.
Stung by events in June, the Board of Trade on June 28 told regulators
it would change some of the terms of its Treasury futures contracts.
.....position limits will apply for the final 10 trading days
for expiring Treasury futures contracts. For 10-year note futures
the limit for any person will be 50,000 contracts.
For its efforts, the CBOT got a rebuke from the Futures Industry
Association, a Washington-based lobbying group whose members
include major investment banks.
...Separately, the Treasury is considering setting up a special
lending facility to address liquidity problems.
Traders need to be aware that the cheapest to deliver note is
"just one issue, and that futures might not always be able
to price off the CTD," he said. "Going to the next
cheapest note can be a costly matter, but it exists."
The June expiration showed that the CBOT has in some ways become
a victim of its own success.
Volume in Treasury debt futures is up sharply
while supplies of cash notes are relatively flat, increasing
the chances of bottlenecks at expiration.
^----(see url for full article)-----^
Randy's Note: It is my singular greatest hope for this
day that everyone here who reads this article will fully comprehend
it, and more importantly, will see the important applicability
to the 'liquidity' and pricing dynamics of the gold market.
R.
TownCrier
(8/9/05;
15:53:55MT - usagold.com msg#: 134779)
Gold
prices seen rising further on festive demand
http://www.business-standard.com/
(Mumbai) August
10, 2005 -- Global gold prices rose in the second half of July
recovering from a declining trend in the first half of the month,
a report by the National Commodity and Derivatives Exchange said.
There was a continued disconnect between the price of gold and
the dollar since mid-May... but the link became weaker over the
past three months.
The strong inverse relation between gold and dollar resumed in
the second half of July. The impact of soaring crude oil prices
on the world economy and the revaluation of the yuan weakened
the dollar and increased the value of gold.
...Another development seen supportive of gold is the strike
at South Africa mines, which many fear, may affect the global
supply, the report said.
^---(see url)---^
Randy's Note: This final point on supply effects out of
S.Africa recalls the general point from my previous post regarding
volume in futures markets being up sharply while supplies of
the underlying 'physical' deliverable are constrained.
As noted in the article, a mitigating source of liquidity to
bridge the futures market (price dynamic) with the spot 'physical'
market is through lending of the underlying asset.
(For that, please recall this excerpt, "the Treasury is
considering setting up a special lending facility to address
liquidity problems.")
In this financial world, with so much futures-driven pricing
going on in everything, and so much artificial supply as a result
of lending activities to provide, essentially, price-depressive
liquidity, how on Earth can an owner of an asset ever hope to
find a point of solid ground as a benchmark from which to assess
a relative value of his wealth?
That's where we perceive that the architects of a new IMS reserve
paradigm will turn to FOA's "free gold market" as the
bastion of stability and benchmark for the easy determination
of relative monetary values.
R.
TownCrier
(8/18/05;
14:11:22MT - usagold.com msg#: 135093)
Central
Bank Gold Agreement sales limit breached
http://www.mineweb.net/
LONDON (Mineweb.com)
-- The latest figures from the European Central Bank suggest
that the total tonnage sold to date in this, the first year of
the second central bank Gold Agreement, have reached 506 tonnes
against a limit of 500t.
...If we can assume that sales are now likely to drop right away,
then this does alleviate potential overhead pressure on the price.
It is perhaps worth pointing out here that official sector metal
is a boon rather than a bind to the gold market, especially now
that there is an element of transparency about some of the transactions.
To illustrate: annual gold fabrication plus bar hoarding demand
in 2004 was 3,410 tonnes against physical supplies from the mining
sector (net of dehedging) and scrap of 2,850 tonnes (GFMS Ltd.
figures). This produced a shortfall of 560 tonnes or 10.8 tonnes
per week, much of which was met by net official sector sales.
The market does actually need this material to come out if prices
are not to gallop higher to reach the appropriate market clearing
level and cause disorderly conditions - which could have repercussions
on long term stability.
Example: after the frantic conditions of 1979 when prices doubled
over six weeks, culminating in a spot price of $850 on January
21st, demand dropped like a stone (allied with heavy scrap return
in the early years) and it took until 1986 before fabrication
levels of 1978 were regained.
Furthermore a disorderly gold market sends distress signals to
the rest of the financial sector, especially given the amount
of liquidity available in gold.
It is also important to note that it is not necessarily clear
how much of this has come straight into the market or how much
has been sold to other members of the Official Sector it
is perfectly possible that some of these sales are transfers
between CBGA signatories and other official sector bodies, which
means that not all the metal necessarily reaches the private
market
^----(article at url)----^
Randy's Note: To be sure, much needs be done as paradigm
shifts are particularly challenging for those attempting to maintain
"orderly markets" through the progression.
R.
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