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The intention of The Golden Chalkboard is to feature a focused selection of data or rare commentary that I think will be useful to enhance your insights into the gold market and the monetary system.

miner49er (9/11/05; 19:48:16MT - usagold.com msg#: 135872)
The double-edged sword cuts more than one swath?

A while back when TC posted his thoughts on the "conundrum" that Alan Greenspan made reference to -- this stubborness of the long end of the yield curve in USTs to behave like history and the textbooks say it should -- I engaged a very dear friend in this discussion. I posited how Mr. Greenspan's CB colleagues probably were biting their lips, as they (as well as Alan) know there is no conundrum, and that there are tools in the toolchest to keep the long end under control. They know the mechanics of why the yield curve is flattening. What Alan is, is frustrated. Frustrated because the mechanisms to keep the curve normal are not in fully in his hands at this time. This presents a dilemma, more than a conundrum. I want to look at 3 elements that work to keep the long end strong.

On the one hand, and most superficially, is that there are still plenty of people that still genuinely, and not without substantial argument, do not see an inflationary period ahead, but one of disinflation or deflation. Individuals such as these still control a ton of money in their portfolios, and are still betting on a strong bond market in the foreseeable future. Chiefly the argument centers around vast over-capacity, and competitive pressures manifest in downward pressure on wages globally. One of the best articulated statements of this viewpoint can be found in Van Hoisington and Lacy Hunt's quarterly reviews that you can find online at hoisingtonmgt.com.

While this is the most superficial (because it is most obvious) of the components in this analysis, it is not trivial. Globally there are still a lot of people that are (have to be) very cautious with what they do with the gargantuan sums of money under their control, and to buy into an inflationary viewpoint, which will only come about with a full paradigm change in the monetary superstructure, is something these people cannot hastily buy into. Whether they get caught short is a matter of discussion. Nonetheless, these enormous sums of money change direction very slowly.

Second in consideration, would be the overwhelming dominance in the financial markets of leveraged speculation. The vast proliferation of these entities have made it valid to say, "it IS different this time." And, I contend that while precedent is there in numerous instances, even in the recent past, for a rate curve inversion, it will be very difficult for this to happen in this day because of the dominance of leveraged speculation that has positioned itself in various arbitrage and spread bets in anticipation of a continuation of a normalized yield curve relationship.

The chief reason that we have this seemingly endless cycle of capital flows that keeps the US capital account flush, is the existence of hedge funds. Without the hedge funds, foreign entities would have only three basic things to do with imported dollars: 1) short term cash holdings -- bills, notes, CDs; 2) long term dollar denominated securities -- bonds, equity holdings, real property; or 3) sell dollars into the forex markets.

In this world, the conventional text book economics 101 principles would work out quite well. Banking intermediaries, risking disproportionate maturity mismatching would only be able to borrow short from the foreign entities, and lend into longer dated notes to capture the spread to just such a point before they went out of bounds in terms of risk. The dollar holders would be forced to accept smaller yields, and the lending intermediaries would demand higher returns. The resulting steepening of the yield curve would put downward pressure on the dollar, making dollar consumers pay more for imports, and make dollar exports more competitive. Just like the text books say. Foreign dollar holders would also be more likely to just sell dollars into the foreign exchange markets, putting further downward pressure on the dollar. There may then be times when foreign holders would find good value in longer dated securities, or outright business ventures, and this would take place in conventional market-driven terms, again with textbook macro- and micro-economic principles at work.

The presence of the leveraged speculator throws this all out the window. When conventional borrow-short-lend-long, the cornerstone of traditional banking, starts to become lopsided, the ability to offload the risks inherent in disproportionate maturity mismatching is presented by the leveraged speculator. (Securitization of the loan portfolio is another way this is done, to great advantage of the lenders, and has also worked tremendously in keeping the cycle of capital inflows going for so much longer than conventional wisdom ever could have foreseen. And even the life of securitization of loan portfolios has been extended way beyond convention by the transformation of these loan portfolios into synthetic entities, and divvying up the risk in the security into tranches -- different flavors for different investor tolerances...)

Now, the bank can have its cake and eat it too, by finding someone that will take on the risks, for the lucrative rewards, by derivatizing the bet. While the bank still secures and commands the monumental notional monies, they carve up the agreement to define and parcel out the risk element, in this simple example the interest rate risk. The LS is happy to be able to earn the spread on other people's money -- notional amounts his own typically highly undercapitalized venture holdings could never secure outright. And these bets would not be practical or profitiable unless they are made in such super-sized quantities. He is betting he can augur the trend, and In a day when it behooves CBs to be more transparent, the LS has been largely successful in these bets. So far a win-win.

Foreign dollar holders can even bypass the banks and deal with the hedge funds directly, if they so wish. This has tremendous impact on the exchange rate of the dollar, and helps explain why we see this anomaly also present itself so frequently: that when the long end burps and experiences a short term precipitous drop, the US dollar usually goes up very suddenly and strongly. Despite there being a secular trend of dollar devaluation, these short term movements indicate the presence of large amounts of leveraged betting from foreign speculators.

Two things cause the recovery of the long end, and the strengthening of the dollar: 1) betting strategies and formulas calculate the downward drop as an aberration -- too much too soon -- and the betting strategy says to buy into this temporary weakness; 2) LS players get margin calls, and have to liquidate non-dollar holdings, and compete suddenly for dollars, exposing temporary shortages in dollars and causing the often sharp spikes in dollar recovery we see on an intraday basis. These dollars going into margin accounts typically buy liquid dollar securities, the proceeds of which then go into bonds which are now temporarily "underpriced" to avail themselves of an advantageous spread -- this too usually by other LS's -- and things return to "normal" with the mechanics of simple arbitrage.

Not complicated really, but it seems few people consider the impact of this activity, not so much for its existence, but for the absolutely incomprehensible volume of it, and the impact it has on the indices.

The leveraged speculators -- despite all the words to the contrary -- are 100% indispensible in this paradigm, and the US dollar faction has no choice but to support them at all costs. Without the LS, the cycle of capital flows we have seen as something of a financial phenomenon, allowing us to run trade and current account deficits of unheard of proportions, would never have happened. And, from it, we can never return. Since IR bets overwhelmingly dominate the compostion of derivative bets, we can no longer tolerate any sustained inversion of the yield curve. So, unless the long end decides to follow the play book, there is a very real ceiling ahead for the short end.

Frustrating, and a dilemma. But no conundrum.

The third thing to look at, which may be the smallest in terms of quantitative contribution, but perhaps much larger in terms of potential influence, is what our TC pointed out a few weeks back -- the plausibility that foreign banks may be buying more long dated US securities with their dollars, then previously. The statement he emphasized amounts to the first edge of this two-edged sword. I.e., the public statement of "confidence" in the dollar, by their willingness to hold long dated debt. But, in the same vein that we perceive foreign CBs supporting the current paper gold regime to publicly give the impression of dollar credibility (first edge), while at the same time never letting the gold price rise enough to successfully hedge dollar devaluation or systemic price inflation (second edge), might the more potent reason such a strategy be employed in the treasury market be to confound the US strategy of slow but steady IR hikes? Might a deliberate strategy to keep the long end down, serve as another catalyst to expose the untenableness of the U.S. financial system, the grotesqueness of the face under the mask?

As noted above, the Fed effectively has a ceiling on the short end, unless they can "wag" the long end, lest they risk inversion, and chaos in the derivatives' markets. The Fed wants to keep raising rates in nice measured teaspoons for 3 chief reasons: 1) to allow time for portfolio adjustement -- chiefly among the dominating LS community; 2) to cause a slow leak in the super-hyper-inflated housing market (and the associated refi dislocations); and 3) to provide more wiggle room for a subsequent period in which they will want to lower rates again to restart the economic engines.

So far, lenders have scarcely stopped for a moment of silence in respect to rate increases. The long end remains almost iron cast within a range, and the housing/refi markets, encouraged by this, continue their party unfazed and unabated. Thinning spreads from crowded trading among LS's, are met with stronger doses, as the difference is made up with even more volume, which is readily found from ever increasing trade deficit dollars, and readily lent to an endless appetite for mortgage lending.

Would that Alan could control all levers in the airplane, and bring it home for a "soft landing." But alas he does not. Like spoilt children, the LS's control the parents, and will get whatever they want. So, the long end does not budge, and cannot be forced by a Fed induced inversion, because this could mean catastrophe.

As such, the short end ceiling of about 4+% does not leave much room for any reversal into aggressive rate cutting to shove liquidity (financial adrenaline) into slumping markets. The current cycle of increasing deficits balanced by increasing capital inflows continues. If a soft landing could be engineered, and the real estate, and credit bubbles go phhhh... instead of pop, we might actually see the non-$ plans for a new monetary paradigm themselves get frustrated.

The ensuing disinflation or deflation, in a world already stuffed to the gills in over-investment, and low wages, with an infrastructure that architecturally channels money away from domestic development, and into furthering the dollar consumption cycle, cannot tolerate much more of a consumption downturn. With dollar hegemonics still stifliing domestic investment in foreign countries, the infrastructure is not poised to just turn its back on the current framework. Like it or not, the Fed's strategy, if left unchallenged, might still lead to another 97-98 crushing contraction in the non-$ world, and a hot money surge back into the $ world, and suddenly it's deja vu all over again.

This is a fear of the foreign CBs, who cannot tolerate another go round of this. This is why they must employ the second edge of the sword in the gold markets, and also very possibly in the Treasury markets. The existence of the derivatives leviathan, although out of control, by its nature allows the current paradigm to continue far longer than we can stay liquid (smile Mr. Keynes). A benign stance by foreign CBs only gives the Fed more ability to get its way, and more time.

What about high oil prices? Yes, a bit of a spanner in the works, but on its own only further promulgates the disinflation/deflation argument, as the inflation it causes only serves to further reduce demand. This would lead to stagflation globally, and the political pressure on the engineers of a new monetary paradigm, just might cause someone to blink, and then all would blink, and a frantic race to the bottom would commence (again), as few and less profitable exports are still better than no exports at all, so every nation state for itself.

The euro might in this world totter, as players still not fully recognizing the architectural independence of the currency from the nations associated with the currency, and still by the very composition of their portfolios, may take all sorts of reflexive action based on what they know, and not on the basis of what is being presented to them as new. This would mean a faltering of the euro, a return to the dollar, and suddenly the game goes into extra innings.

The gold markets appear to be drying up in terms of a willingness to supply just that extra measure of liquidity to keep a semblance of credibility. Volume in LBMA is continuously dropping, which keeps contract prices low by reason of demand -- not just oversupply. (Just mho, but it seems that the presence over the past couple years of more unusual coins in CPMs offerings, may be anecdotally an indicator of gold holders reaching deeper for something to put in the display window.)

So, if credibility is not fostered in the gold markets for much longer, and the dollar derivative beast is still able to suck foreign capital into a dollar hegemony vortex, what additional active behavior might be taken on the part of CBs to show a public face of cooperation, but engineer further exposure of a failing system? A surging gold market might indeed leave CBs free to start looking at successful lending into their own domestic markets, without fear of their reserves (as only dollar forex) contracting, as their gold would hold its own. But this would take time to manifest into actual plant and equipment, and too much possibility exists in the interim for destabilization. Hence, the desire for global CBs to extend the transition. This is also an achilles heel that dollar forces wish to play upon -- they know foreign countries cannot afford to lose the dollar export market just yet, and that they still have them by the proverbial short hairs.

So, it is incumbent upon foreign CBs to continue with 2-edged sword strategies. And in the bond market, it would seem that with little pain, they can buy up bond offerings left and right, and keep the long end at bay. This traps the dollar into a box. Even if the global economy sags into a painful contraction, the Fed's inability to aggressively provide liquidity for any sustained period of rate cuts, as well as the lack of a robust market interest in long dated US debt (foreign money market perception that it is over-priced -- due to artificial support from CBs as hypothesized, and magnified by derivatives activity), would permit at the very best a shadow repeat of the past, with the Fed pushing on a Japanese-like string in terms of reliquefying the credit markets, and only warm money rivulets into the dollar markets, instead of the hot seething lava flows of the past.

Without a reinvigorated dollar, the hegemonic paradigm it enjoys would suffer a significant blow, and out of the ashes would rise not one core hegemonic phoenix, but potentially a bunch of smaller phoenices, i.e., capital financing of a host of well-educated, skilled, developed and developing peoples, made so by years of being agents of production for a dollar empire, now champing at the bit to capitalize on pent up domestic demand.

Yet nothing is guaranteed, and some things can take a lot longer than even the experts on the inside believe. I think the extent to which the dollar has survived has been underestimated, again in this time. Not whether it will eventually wilt into the marginalization, but when. By the tone of things (at least those made public) since WAG2, those wanting to see a break from a dollar-centric world financial system, are getting antsy. In the line of thinking discussed here, and held by several at the forum, the freeing up of the gold price is integral to a shift in the world monetary frame, and that this is just as much an act of political will as the current leashing of the gold price. The distinct thing to note, as Belgian mentioned earlier (and as has been stated hundreds of times here), is that the general lilliputian public stands to benefit by gold ownership, as gold is freed from monetary association, whereas gold ownership is frustrated in the current setting where gold is suppressed to keep the currency numeraire appear strong and stable.

Those wishing to benefit by a freed up gold price, cannot passively wait for fundamentals to play out, as the dynamics of today's financially hyper-engineered world, within a seemingly impregnable dollar fortress, make irrationality almost rational. Life through the looking glass may be fine for a children's story, or a rich source of allegory for the temporal and fickle ways of men, but will not sustain itself in the long run. As in FOA's river, the sometimes contradictory movement and activity at any given point is ultimately always overwhelmed by the overall coursing of the timeless river endlessly to the sea.

miner49er (11/5/05; 12:27:35MT - usagold.com msg#: 137601)
Ned @ 137586
Hello Ned.. maybe I can provide my response by working backward from your question list. Some of my thoughts on the rationale behind Fed IR action are in an earlier post (#135872 on 9/11). With that as a backdrop, I think very much in the forefront of their thinking was that raising rates initially would work towards slowing down the mortgage lending frenzy. But as the long end did not respond to the short end target increases, the Fed found itself approaching a flattened yield curve. And, if the long end still does not move enough to curtail lending, would the Fed force an inversion? I maintain they won't, as this would risk chaos in the derivatives markets. (I'm sure there are problems enough already -- in fact, any short-end / long-end arbitrage or spread trading is already having problems with the narrowing spreads, and is requiring greater amounts of leverage to get the same "high.").

Actually, that in itself is one way in which the dollar strengthens -- where non-dollar speculators playing for instance a spread off the short-end against something that isn't moving like it should (like the long end), require greater amounts of dollars to make the same trade, or if the trade is actually souring, and they can't get out of it just like that, they are forced to pony up additional margin, which also requires the purchase of dollars.

So, don't be misled by dollar strengthening as if it happens just like the Econ 101 textbook says. The illustration in the text book shows Country A expanding, leading to over-spending and growing deficits, and Country B running surpluses selling to Country A. This reaches critical mass, where A's currency is cheapened to the point that it stops buying so much from B, and B's is so strong, it starts spending its surpluses and outruns its own capacity and starts buying more from Country A, and begins running deficits, at the same time bidding up A's currency against its own, until the scales tip and the cycle repeats. Ok for a survey course, but woefully lacking the consideration of the plethora of complex dependencies, both directly economic, and indirectly political that make up reality.

Actually it does kind of fit the reality here, as this country's major export products are its financial products. We are uncompetitive in producing sneakers and ovens because of domestic structural elements (labor, regulatory costs, etc.). But we are structurally poised to produce one helluva financial deal for you. So, if you blur the accounting for a moment to view current account items with the capital account, we actually have been running a solid surplus over the past years. Not good accounting procedure, but for illustration purposes (and in practical fact, this is how many look at it), we have been a net exporter when adding intangible financial "products" with real goods and services. Remember, when people point out the monumental amount of dollars overseas, this is somewhat inaccurate, as most of these dollars have already come back here and "imported" dollar-denominated securities, which is what they are holding. Were that not the case, we would have reached the critical mass point mentioned above long ago, and before reaching such mind-boggling numbers. The world of derivatives has only served to further extend this paradigm, and by their leverage fostering design, amplified it exponentially.

So, what's the problem then, if all the financial products serve as just another item for export? Lots in the long run, but most preeminent is simply the fact that they are "virtual" entities. They represent contractual arrangements of ownership or creditorship, which depend on non-market, non-economic variables of social stability, and faith in the compass of the rule of law. I see Belgian touched on the attributes of stability and trust below, as well. Since the exported products sitting in accounts all over the world depend on a lasting measure of predictable behavior, and are reliant upon humans far removed from the actual security itself, and mostly unconscious of its very existence, there is a tall order to fill to demonstrate to the holders that their little digital entry representing stake or creditor status, will return to the owner what he/she expected. I import a camcorder, and if the exporting nation falls off the planet at sunrise, it doesn't affect the product, as I have it in hand. I "import" a bond or equity share from somewhere, and I have to rely on people and situations I have no control over, and really know nothing about for its performance (hence its value).

Now, why is the Fed raising rates? Yes, they talk a bit about inflation, and if energy prices stay high, they will become systemic as higher costs push up prices of "core" inflationary items, but that is not all there is to it. I think they actually fear a deflationary trend, if the current monetary framework persists, due to overinvestment and overcapacity; or a terrible stagflationary phase of asset contraction, and price increases, if the monetary game shifts to another arena. The former is wrong thinking I believe, because the setting for this assertion assumes an obsolete global paradigm. In it, developing countries export to developed countries, in turn getting the developed countries' "hard currency" with which they can buy advanced technology, products and services from the developed countries to further develop their own infrastructure, and oil with dollars, since oil preferred dollars in those days. The end result is the the developing countries end up developed, and everything harmonizes to equilibrium, whatever that is. This was the way it was all supposed to work.

The chief problem with this is that it requires a great loosening up of restrictions on capital movement. Otherwise, foreign investors won't take the risks. By that same token however, foreign investors also bail out on a moment's notice. Thus to keep foreign money, which is looking for quick hit returns, the incentive is there to only keep building infrastructure that supports a known and working gameplan -- i.e., to keep exporting products to the so-called developed countries. And in this world there are lots more than just Countries A and B. So B is in competition with C, D, E, and so on. All having cut costs to the bone to keep ahead of the other, they "race to the bottom" further by cheapening their currency to shave even more pennies off their export prices. How do they cheapen their currencies? By holding the imported currency instead of selling it back on the Forex, which would put unwanted upward pressure on their own currency. And instead of holding stacks of digital dollars, they use the dollars to import dollar securities, producing the capital surpluses described above. And, to make matters worse, as the exporting companies sell the dollars they earn back into their local banking system, they get their country's currency in their pockets, introducing inflation domestically, and with a currency unit that is predetermined to be cheapened for the overall "good."

This is why there is such a rift in places like China, where certain regions (those targeting exports) are in a hyper-boom, while most of the billion+ souls therein languish in miserable poverty. If China were to pronounce an effort to use their export surpluses to build the nation's general infrastructure, and promote local capital markets, to help stimulate demand internally, while a good policy, it would drive the "hot" speculative money right out the doors. Hot money doesn't want to wait 10 years for its return, especially when the governments of the target countries of their investment have an unproven track record in property rights and ownership. Speculative money wants quick returns, and the ability to bail instantly if the tide turns, and it prefers tried and true bets to make it all happen. So massive overinvestment in this paradigm is why many say we are due for a contraction. And were this the old war, I would agree.

Again, enter the derivatives component. Why hasn't this massive overcapacity brought about a shift and contraction already? 1) derivatives allow the off-loading of risk into a general dispersion throughout the globe, which permits direct investors to keep milking the cow for all its worth, and 2) the capacity for obtaining leverage cheaply enough to make the same bets, even with smaller returns, is still lucrative when you can make that bet yet again thousands of times because of the funds you can procure.

So, if I am the finance sector, and I am fat and lazy from working a good deal to its death, I don't want change. Even if the natural economic pressure were to let the dollar weaken, and allow some inflation back into the local economy to bid up wages, and produce some natural pricing power domestically, the financial sector pressures the fallible human beings in government to keep the currency strong, as it looks to protect its own narrow interests. And while manufacturing constituents want a somewhat weaker currency to make exports competitive, the game is decided on who lobbies, pressures, and buys off the decision makers best. And in the real world the banking/finance industry will always trump anyone else. Always have and always will.

So, we have stretched the current paradigm so far beyond the breaking point that there really is no turning back. It doesn't matter about the "sensible" policies this or that group comes up with. It can't be reversed at this point. There is no such thing as bringing back a "little inflation" or "slowing things down a bit." Within our self-contained world, we will argue about various things like this, various monetary and fiscal tools to employ, e.g., mortgage interest deduction caps, and blah-blah.. but none of it will work at this point because the system is so far deteriorated. Maybe they were good ideas once upon a time. But now -- all too little, too late. Removing a superficial malignant tumor, may have been the best course of action for the cancer patient 6 mos. ago, but having left it to fester, it has so spread througout that cutting off the tumor now means nothing.

Only an absolute paradigm shift (and I know I use the word paradigm a lot, and people for some reason got a bad taste of this word through overuse some years back, but it is exactly what it is -- a paradigm shift). Only an absolute shift in the monetary paradigm will be able to approach fixing this (and not without bumps and pain for many along the way). All the mountains of debt and encumbrances that exist today cannot be made whole within the current framework. There is no safe haven in the current setting. Hard assets are illiquid generally, and only sophisticated niche players make money on them. What asset is globally established and recognized, liquid, tried and true, lasting, scarce enough, simple enough that anyone can understand it, and so far undervalued today that it could fill the void?

Gold. And, what framework will allow gold to find its true market value? A framework that does not foster the overwhelming use of instruments that artificially inflate its supply, and hence keep its price down by providing cheap substitutes. The current framework touts the monetary currency as successful when it is as good as gold. It relies hence on successfully keeping a lid on the price of gold in terms of itself. It benefits by the expansion of the gold supply, however it may be achieved, as this keeps demand satisfied, the price down, and makes the currency appear stronger by comparison.

In a genuinely productively expanding economy, gold will find downward pressure, as people choose to sell a non-producing asset to buy assets producing a return worth the risk. But, when the economic situation has stretched so far beyond this, we wonder why gold is relatively stale, why people do not fear the negative effects of over-expansion, with its bad loans, faltering companies, and the subsequent negatives upon the economy. But understand that the powerful interests that have such huge stakes in the pricing currency, don't want gold to appreciate as it points out the failure of the currency to be as good as gold. Again, with financial wizardry, the paradigm here has extended itself far beyond what most believed possible, and have lulled many into a very false sense of security.

What is needed is a framework that decouples the association with gold as a reference to the currency's value. This does not mean the issuing institution does not value gold, indeed it should keep gold as the ultimate asset in reserve, and to demonstrate its value (esteeming) of gold, should let gold be priced according to the market and mark its books accordingly. The currency will stand on the basis of the issuer's management practices, of which having a healthy reserve of gold is a simply one component, not the be all and end all reason. And, not as a convertible backing, but simply a demonstration of wealth and power -- components necessary to add integrity to a currency, which is and always will be, just a fiat digit or piece of paper. But to use the currency on a large scale, requires faith and trust among the users that the issuing institution will remain stable. So, hand in hand with a good reserve of unencumbered wealth, goes an intangible form of wealth. Clearly stated and adhered to objectives build the intangible wealth of integrity and reliability and promote the currency's stability, so the currency users can plan accordingly, as they denominate contracts and do commerce in terms of the currency unit.

And this is the framework that the world is moving towards, as the world increasingly recognizes its asset base is built chiefly on a currency so over-extended, whose value is tenuously in the hands of its external creditors, and so leveraged, and so lost in a monstrous labyrinth of obscure derivatization that makes any kind of benchmarking impossible. So many holes in the dike to plug, and always springing new ones. How many fingers does the Fed have left?

The confusion you perceive in interest rate movements, and the signals the Fed is sending, isn't you. They can't make any real strong pronouncements one way or the other, because any movement one way or the other outside a narrow band will exacerbate some extreme condition to a breaking point (spring another hole in the dike). They have to sort of mumble stuff and keep people guessing, but sound authoritative enough to maintain a semblance of being in charge. Even the Administration does the same mumbling act. For instance, it tries to get dollar depreciation vis-a-vis yuan appreciation, and throws bones to the manufacturing constituency on occasion about weakening the dollar, or restricting imports. But, at the same time mutters "strong dollar" just loud enough for the finance and banking constituency to hear it, and then hedges the whole thing with "let the dollar find its appropriate value in the free markets." Blah-blah-blah...

Anyway Ned, I hope I hit on some of what you asked... Later, miner

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