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Oct 02

LBMA 2010: Part II

Forget mining and
central banks. Here’s the single most important gold supply issue today…

SO IT WAS TOUGH yet
again to meet any gold "bears" at the London Bullion Market
Association’s annual conference last week, this year hosted in Berlin’s Hotel
Adlon.

The bullish arguments you know already no doubt. Low-to-zero
Western interest rates…plus a growing clamor to buy gold amongst Chinese
households (the Middle Kingdom’s demographics are more bullish still, as
Mitsubishi’s Matthew
Turner showed)…make a compelling case for rising gold investment demand,
even without the risk of government-bond defaults, rising inflation or
continued losses on "mainstream" financial assets.

The Berlin conference had plenty more to say on those
stories too, as we’ll see below (and as you can see on the slides now freely published
on the LBMA’s
website). But first, what of supply?

Well, all the gold ever produced in history came from a
mine, as Paul Burton of GFMS World Analyst
reminded the conference. But in the last decade, gold mining has failed so spectacularly
to meet the surge in demand, he could only question its "relevance" to
the market’s net outlook. Dollar gold prices quadrupled from
2000 to 2009, another speaker noted, yet annual mine output rose just 1%. And allowing
for the intervening slide in output, said Burton, gold mining output is now so
price inelastic, it took eight years of rising prices to produce any meaningful
blip in output (2009′s year-on-year increase of 7%).

Further output gains look unlikely, Burton went on, thanks
to the gold mining
sector’s "production lag" – both because of an "exploration
lag" (new investment only turned higher in 2003) and because new
discoveries of 1-million ounce deposits have collapsed regardless. The five
years to 2009 saw record-high levels of exploration spending, perhaps totaling
the previous 12 years added together (at least on BullionVault‘s skew-eyed reading of
Burton’s chart from the conference floor. See what you make of it on page 9 here). Yet
all told, GFMS’s best forecast is now for annual gold mining production to
decline by 13% between 2012 and 2019.

That other constant drip-drip of gold supply – the
"official sector" of central banks and outfits like the International
Monetary Fund (IMF) – also looks irrelevant for now, as Burton’s GFMS colleague
Philip Klapwijk
showed in his speech. European states are now holding, not selling their
reserves, but emerging markets (for now) remain mere ankle-biters compared to
the weight of private investment or jewelry demand each year. So net-net, said
the GFMS chairman, central bank activity looks "neutral", despite the
bullish picture for emerging-market demand he also laid out. More notably, and
"something we haven’t seen before", private-sector investment
holdings now outweigh central-bank gold reserves overall. Making investor
sentiment a key plank of any longer-term forecast.

Even without the end of central-bank sales, however, or the
failure of mine output to rise, "The single most important gold supply
issue is scrap," as John Reade of Paulson Europe said in his conference
summary. Re-selling unwanted jewelry "has gone mainstream" noted Jeffrey Rhodes,
CEO of INTL Commodities DMCC, becoming "socially acceptable" in a way
that using pawnbrokers to raise cash never was. Throw in gold coins, dental
bridges, bonding wire from microchips and any other supply "not from a
primary [ie mining] source", and scrap gold matched more than one fifth of
global gold mine output last year, up from just 7% a decade ago. Turkey has
overtaken India as the No.1 source of scrap gold supplies (217 tonnes in 2009,
equal to almost a tenth of world mining supply), but the most dramatic change
has come in the developed West, where "sophisticated electronic assay
equipment has seen the captain’s ball at your local golf club replaced with
gold buying parties," as Rhodes said.

Since 2005 alone, US scrap supply has more than doubled
according to data from GFMS Gold Survey, taking United States’ re-sales from fifth
to second position worldwide in 2009 with 124 tonnes. Italy’s re-sale market
moved from seventh to sixth with a tripling to 78 tonnes of scrap, and the UK
& Ireland have leapt 1505% from virtually nothing a decade ago to nearly 60
tonnes in 2009, bagging the world No.6 slot in the first-half of this year.
Throw in Germany and France, and four European nations make the top 10 scrap
supply nations by growth since 2000. In the first six months of this year,
scrap supplies from each of the US, Italy and UK & Ireland had all outpaced
India (the former No.1, remember), enabling scrap to become the "only
credible counter to investment buying." But should these massive supplies
of scrap in fact be overwhelming investment pressure on prices?

Since "investment buyers and scrap sellers are driven
by the same motivation of price expectations" as Rhodes reminded the LBMA
conference, this price-elastic source of supply could threaten "a perfect
storm of selling once sentiment changes," he believes. But first, that
would require higher prices again, because (for now) even scrap-gold merchants
have turned bullish, he reported, capping flows to refineries in anticipation
of stronger gains ahead. And second (and more critically given the source of
the last few years’ real jump in scrap supplies), "Is the drawer
empty?" as Paulson Europe’s John Reade
wondered in his quick-fire recap before the conference adjourned.

Cash-strapped households, remember, can only sell their
unwanted gold bracelets once. How high would prices need to go before more
cherished pieces could be sent to the smelters? Apply the same question to
private gold investments in fact (ETF holdings have proven notably
"sticky", if not yet as "long-term means forever" as gold
coins), and you get to the nub of the "bubble or boom?" debate.
Because at some point, according to pretty much every speaker, the circumstances
now boosting global investment demand will recede – and with them, therefore,
the gold price will fall back as well. As we’ve already seen (in Part I),
the bubblicious frenzy needed to mark the top of spike remains plainly absent.
Leaving only the circumstances behind this current boom to consider.

"The current bull market has much deeper roots than the
credit crisis," the LBMA was reminded by former Blackrock head of natural
resources Graham
Birch (now a farmer). Pointing to gold’s nadir of 1999, "continuous
disinvestment" was needed to keep prices down, and when Europe’s big
central banks agreed to cap their sales that September, it marked the start of
this rise. Roll on 11 years and 350%, however, and "Just because gold’s a
safe haven doesn’t mean it’s a cheap safe haven," Birch warned Berlin.
Which raises the question of cost and utility for new buyers today.

"I think people long gold should not be concerned
reading this slide," said John Reade in his summary, pointing to slide 14
of William White’s opening
keynote speech. Chairman of the OECD’s Economic & Development Review
Committee, White had prefaced his 20 minutes of gloom-and-doom (salted with
uncertainty, fear and doubt) by saying that the OECD itself would certainly
disagree with everything he was about to say. Reade reminded the delegates that
White’s copyrighted sales-line should be "Scaring investors since
2003," as he accurately picked the shape of the bubble well ahead of
schedule, and hasn’t been proven wrong yet.

"Investors should be positioning for ‘tail
events’," White concluded. "But which ones?" Somewhere between
deflation, slow growth, de-coupling of Asia from the West, or a lurch into
rapid hyperinflation or a new series of bubbles fed by ultra-loose monetary
policy, "Is there room for gold in a world like this?" asked the former
Bank for International Settlements forecaster.

"The answer has got to be yes. But quite what
role…well, that’s for you to decide!"

A handful of private investors have begun to make that
decision, as Wolfgang
Wrzesniok-Rossbach of the Heraeus refinery showed in detail. But the real
weight of money – the institutional mandates caring for your insurance and
pension savings – has scarcely bothered to buy gold ’til now, a point made at
length by both Shayne McGuire and Graham Birch on Monday morning. Across in
Asia, "People don’t need convincing on gold," said David Gornall of
Natixis, noting that 81% of global "bar hoarding" demand comes from
Asia, with buying amongst the "traditional buy-side countries" such
as India and Thailand – as well as the fast-growing world No.2 for gold demand,
China – continuing to grow despite record-high gold prices.
Even there, "the emergence of retail physical gold investors has resulted
in structural changes in distribution, product and buying behavior," as
Sunil Kashyap, managing director of Bank of Nova Scotia-ScotiaMocatta
explained. Yet all told (and absent the "bubble" idea which the
conference demolished time and again), what looks like a new paradigm might in
fact mean more a return to old patterns – globally – of gold buying and
hoarding…with a little "mobilization" thrown in by the scrap market
when times get tough.

India and Turkey, after all, have long been both top buyers
and scrap suppliers to the international gold market. Rising investment demand
here in the "rich West" (which, to repeat, remains well off a
"bubble" today) represents a simpler, unleveraged way of retaining
your savings than most Western households have grown used to. But gold was a
core chunk of private wealth holdings not so long ago, back before the
debt-fuelled boom we’ve enjoyed since WWII began – a boom which must now end
with "rebalancing" between the world’s debtors and creditors, as George Magnus of
UBS made plain Monday morning. The kind of dislocation required won’t be much
fun for either, which again looks good for gold demand, if not necessarily
prices.

All told today – and seeing the world’s fastest-growing
economies continue to buy and hold ever more gold as their wealth increases –
maybe US and European savers are only just getting back to the future. Either
way, that "bubble in gold" doesn’t exist. Not by a long way just yet.

The safest gold at the lowest prices – start with a free gram of Zurich bullion right now at BullionVault…

Sep 30

LBMA 2010: Back to the Future

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"Gold: Bubble or boom?" is a big concern for the world’s professional gold industry…

The BIG MONEY flows from the biggest trends, of course, writes Adrian Ash at BullionVault, just returned from the London Bullion Market Association’s 2010 Conference in Berlin.

But even the brightest people, and with the best of intentions, can struggle to see today what hindsight will say you could have banked on.

By the summer of 1922, for instance, you needed 100 of Germany’s paper Marks to buy one Gold Coin Mark, against which they were supposed to be equal. Yet the German Chancellor "would [still] accept no connection between the printing of money and its depreciation," notes Adam Ferguson in When Money Dies (London, 1975)…even as the Weimar Republic’s hyperinflation pushed Berlin food prices well over 50% higher inside one month.

Indeed, "the opinion that the flood of paper is the real origin of the depreciation [in its purchasing power] is not only wrong but dangerously wrong," said the Vossische Zeitung newspaper. So by the time the worthless currency was abandoned 14 months later, it took one trillion paper Marks to buy one golden equivalent, and German banks "turned the Marks over to junk dealers by the ton" for recycling as scrap paper.

Who could’ve guessed?

Now, fast forward almost a century. Today the value of money (like its price versus gold) is at issue once more, and missing the big trend – inflation or deflation, commodities boom or depression – is a big worry for anyone serious about defending their savings. Over the last decade, gold prices have scarcely looked back in their rise from $252 to $1313 per ounce today. US equities, in contrast, have gone precisely nowhere, while commodities have certainly rallied, but hard assets (outside gold and silver) remain off their pre-Lehman tops of 2008. Treasuries and cash-in-the-bank can barely keep up with inflation, meantime, despite the official "core" US measure slipping below 1% per year. Housing looks like the "double-dip recession" cast in concrete.

Edging above $1300 this week, therefore, it’s little wonder that "Gold: Bubble or boom?" was the big theme (both on-stage and off) at this year’s London Bullion Market Association conference, held in Berlin. Besides dealing silver and the platinum-group metals, the LBMA’s membership is the world’s wholesale gold market – the refiners, assayers, vault operators, dealers, financiers and analysts who help move the metal from mine-head to retail production, whether jewelry manufacturers, dental suppliers, chip fabricators or Gold Coin mints. Very much centered in London (where the Association’s biggest bullion-bank members settle some $20 billion of gold trading between themselves each day), this odd little corner of the financial market well remembers the time before today’s current rally…a miserable two-decade run of falling gold prices, falling demand, and falling returns for the market’s suppliers. And no one wants to be late in seeing that the wind’s changed direction.

"When I started in precious metals in the early ’80s," said one head of metals trading to the 500+ delegates on Tuesday morning, "I understood that private clients would hold around 3% of their wealth in Gold Bars and coin…But over the next 20 years, those reserves were really liquidated, down to pretty much zero by 2000."

He’s just added to his own personal gold holdings, he said, buying Gold Bars first cast in 1980 for bank-teller sales to clients in the north-east of England. Yet the vast bulk of attendees – whilst bullish in their average $1450 price forecast for Sept. 2011, and with 60% believing gold would "perform well" even if deflation hit – are a long way from fully invested. A question thrown to the floor showed 74% of the bullion-market professionals meeting in Berlin keep between 0% and 10% of their own private wealth in precious metals. So either they’re shills who lack the courage of their convictions, or they prefer to separate where they keep their savings from where they earn their income, or gold has yet to capture the real investment dollar of even those people closest to it.

More broadly, current gold investment accounts for barely 0.5% of investable wealth worldwide, as Shayne McGuire of the Texas teachers’ pension fund (and now author of two books urging Americans to Buy Gold Now) showed on Monday, down from 3% in 1980 and far below the 5% of 1968 or 20% allocation gold received prior to the mid 1930s.

Thanks to the massive growth of other investment choices, "Gold has never played a smaller part in the global financial system than today," McGuire concluded, and while further gains aren’t guaranteed by the "weight of money argument" (as Philip Klapwijk of GFMS called it) the relative lack of investor hoarding hardly smacks of gold’s being a bubble. And while the Western world’s biggest central banks hold huge quantities of the stuff, the world’s biggest foreign exchange holders are all "underweight gold by any measure" (Philip Klapwijk again), with a growing desire at least to address their "overweight Dollars" position.

Indeed, "off-market" sales of Gold Bullion by European and even perhaps – one day in the far future – the US governments "may [in time] facilitate a transfer of bullion from West to East" the GFMS chairman said, reminding delegates of the gold transferred from the US to Europe to settle America’s balance of payments debts in the late 1950s and early ’60s. Meantime emerging economies continue to Buying Gold both "to diversify" their large US-Dollar holdings, and also as "catastrophe insurance", and private investors have similarly seen "the world’s markets flooded with cheap money," said Germany refinery Heraeus’s head of sales, Wolfgang Wrzesniok-Rossbach. His detailed (and best-in-show) presentation on Gold Bars, coins and other retail-investment products Monday afternoon noted the surge in European physical demand during the Greek deficit crisis of early 2010.

One driver is psychological, Wrzesniok-Rossbach said. Because "here in Germany, there is a great desire for security. We are the most over-insured people in the world." More historically, however, German households are asking "Haven’t we seen this before, in 1923…?"

Already scared by two stock-market crashes and a global property crash in the last decade alone, "There’s an entire generation of [Western] investors who may not want to trust governments or mainstream financial products," agreed Natixis bank’s head of precious metals (and LBMA vice-chairman) David Gornall on Tuesday morning. At several points during the global financial crisis, "The US Mint has been right at the limit of immediate physical supply," he noted, but that frenzy has since died down – even as the gold price has continued to rise. Together, that’s created a very un-bubblicious atmosphere on the trading floor.

"When the Gold Price broke new all-time highs [in early Sept.]," reported Steve Branton-Speak of Goldman Sachs, "volatility [in daily prices, measured on a rolling one-month basis] was at a 5-year low. When it then went through $1300, traders just shrugged and said ‘So, did you watch the game last night?’

"Compare that to the frenzy of gold trading we got when Bear Stearns and then Lehman Brothers failed," Branton-Speak continued, a point confirmed by both Gerry Schubert of ABN Amro (who restated the "lack of frantic activity or volume") and several of the traders I spoke to between presentations (and also in the bar of course).

"What looks like a massive boom in demand is actually very small…relatively insignificant," confirmed Jeremy East of Standard Chartered Bank, but gold keeps making headlines because it "punches above its weight in terms of significance."

Asked whether gold is now a bubble, East opted instead for "new paradigm – which is in fact a return to the old paradigm." Concurring with Shayne McGuire’s presentation on pension-fund holdings, Standard Chartered’s head of metals sees gold investment holdings only now starting to recover from the wipe-out caused by two decades of strong interest rates and economic growth between 1980 and 2000. This view, of gold not so much soaring to untold heights as simply returning to its former position as a key asset class ("Back to the future" as one oddly aggressive guy put it to me in the smoking lounge) might seem to downplay its gains. But consider why gold’s not always valued, said Graham Birch, former head of natural resources at Blackrock:

"You don’t need gold when…

Inflation is dead
Governments are benign
Taxes are low
Currencies are solid
Markets are booming…"

In other words, said Birch, "Nobody wants gold if market returns are high and don’t seem risky." Whereas today?

Part II to follow…

Tagged with: ABN Amro • Adam Ferguson • Adrian Ash • America • author • Back to the Future • bank • Bear Stearns • Berlin • BlackRock • bullion-bank members • cash-in-the-bank • catastrophe insurance • Chancellor • David Gornall • dental suppliers • driver • Europe • financial products • food prices • Germany • Gerry Schubert • GFMS • GFMS chairman • goldman sachs • Graham Birch • head of metals • head of natural resources • head of precious metals • head of sales • Jeremy East • jewelry manufacturers • Lehman • Lehman Brothers • London • London Bullion Market Association • metal • mine-head • Philip Klapwijk • printing • retail-investment products • Shayne McGuire • Standard Chartered • Standard Chartered Bank • Steve Branton-Speak • Texas • the Vossische Zeitung • United Kingdom • United States • USD • vault operators • vice-chairman • Wolfgang Wrzesniok-Rossbach

Sep 30

Why Did Gold Prices Rise?

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Gold Prices turned higher a decade ago, and haven’t stopped since. Why…?

HINDSIGHT is always a satisfying exercise, because you have all the facts, you know what happened eventually and you simply have to find the reasoning now established by history, writes Julian Phillips in his Gold Forecaster.

Forecasters can be thus judged efficiently as to whether they were right or wrong only in the light of history after the event. Whereas forecasting at the time is an entirely different matter, because you have no facts from the future. What you do have is the past and the present. Now you have to extrapolate these forward to construct tomorrow’s picture.

Forecasting requires giving each present fact its due portion in that future and its correct weighting together with a good dash of insight. Hopefully you will do the job well and be correct. This may sound simple but it isn’t. To help you look forward we look at the last decade in the gold market.

Take the Gold Price. From 1985 despite all the good pointers to higher prices, few foresaw the vigor of the attack by the world’s monetary authorities on gold and yet that was the prime influence on the Gold Price.

When 1999 came most believed the all the world’s central banks were keen to sell all the gold they had to get this barbarous relic out of their vaults. Then came the "Washington Agreement". On the surface looked as though it followed the line of thought that central banks would continue to be unrestrained sellers. Britain appeared to confirm that picture as it sold half its reserves at the lowest price seen since then. This point in time and price is affectionately known as the "Brown Bottom" of gold, after the then-Chancellor of the Exchequer, Gordon Brown. What seemed an innocuous agreement simply limited the volume of sales per annum to 400 tonnes from all the signatories put together.

What was understood only later was that this cap on sales removed the fear of unlimited sales. The signatories felt that this limitation would protect gold producers from seeing a lower Gold Price and deter future gold production. But significantly, this limitation on "Official" supplies went further than this, it reassured the market that not only was the Gold Price underpinned but "Official" supplies were capped. The intention of the Agreement was to hold the market steady at those prices.

A further look at the demand / supply numbers showed that if demand rose, total supply would not increase. Traders demonstrated this when they went long and took the Gold Price from just over $300 to $390 and then took it back down again to $326. This was enough to scare the Gold Mining companies that had hedged their future gold sales. They soon realized how quickly the hedges they had could become very unprofitable as the Gold Price rose. Suddenly gold miners themselves saw that the Gold Price would fall no further so there was no point in continuing to hold them.

De-hedging started and the miners went to the market to buy back their hedges. This allowed them to make money as the Gold Price rose. Cutting these hedged positions realized profits there and removed potential losses. This was done in such high volumes, right through to 2010, that it accounted for almost the entire amount of gold sold by the signatories to the Washington Agreement and its successor, the Central Bank Gold Agreement – around 400 tonnes per annum.

So supply was limited to newly mined gold, which could not rise quickly for the easily mined deposits had gone. It takes around 5 years from the discovery of gold in the ground to taking that gold out of the ground and to market.

Over the years the Gold Price slowly rose on the back of the traditional demand such as India and the jewelry trade. Then came the accelerant, the gold Exchange Traded Fund (conceived by the World Gold Council’s James Burton). This allowed various types of funds to Buy Gold via the shares of the ETF, which bought gold with the proceeds of the sale of these shares, and thus directly impacted the Gold Price, while avoiding the corporate risks attendant on mining companies. Funds such as these had not been allowed to hold bullion itself, until then. These were brand new investors bringing a new type of gold demand to the market from the States. Until then traditional investors in gold bought bullion direct from the London gold market, had the costs and difficulties in storing bullion, which precluded other types of investors from being in the market. So great was the impact of this new demand that these funds in total now hold more than the central banks of Switzerland and China do.

Nevertheless the market was still focused on traditional demand as being the mainstay of the gold market and controlling the Gold Price. They still do today. It is a commonly held belief that investment demand will vanish as quickly as it came. Then we will see the Gold Price turn back to India and jewelry demand at prices well below today’s price.

But investment demand extended from primarily US fund demand to a much wider type of investment demand. The reason was because of an underestimated fundamental that most commentators ignored and rejected. As in 1999 the precipitant turned out to be the European central banks. The second European central bank gold agreement saw the ceiling of 500 tonnes hit only once or twice during its 5 year life.

In the last years of the agreement the sales started to drop quickly. In the last year of the agreement the sales tailed off steadily in the first and second quarter of that year until in the last quarter hardly any gold was sold by them whatsoever. In the first year of the Third Agreement, sales have been close to zero (with 6.2 tonnes sold for coinage – not in the spirit of the agreement). What should we learn from this? The sales had done their job of supporting the advent of the Euro on the world’s foreign exchanges, obviating the need for further sales. The first clause of all the Agreements stated that "gold would remain an important reserve asset". Gold would remain in the firm grip of central banks from then onwards in Europe. In itself it reassured investors that when the dark days arrived gold would have a use in the monetary world.

Now came another shot in the arm for gold. Asian central banks and Russia started to Buy Gold and seriously. The implication was that gold would have a use in times of monetary stress. In itself this meant little, but once the US Dollar started to weaken against the Euro, confidence in the world’s leading reserve currency began to falter. Currency values had become vulnerable to falling. Gold rose when currencies fell and the safety of ones wealth came under pressure.

For eighteen months gold had difficulties in rising beyond $1,200 for a variety of reasons. But then the transition of gold from a ‘commodity’, an industrial metal, a piece of non-corroding decorative jewelry, to an investment people with money buy, came about.

The falling Dollar, the various Sovereign debt crises, future currency crises, deflation, potential inflation or even hyperinflation appeared on the horizon, each persuading investors that gold was a good place to keep hold of one’s wealth. The days of monetary stress have arrived.

From now on gold’s evolution will be the most vigorous of its several stages of development. We are on the edge of a whole new way of looking at gold and its relevance in the global economy.

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Tagged with: bank • Britain • Central Bank Gold • Chancellor of the Exchequer • China • Europe • European Central Bank • Exchange Traded Fund • Gordon Brown • India • industrial metal • James Burton • Julian Phillips • London • physical metal • Russia • Switzerland • United States • USD • World Gold Council

Sep 30

Mine’s Bigger Than Yours

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Currency wars over who’s got the most money to burn are fuelling the Gold Price rally…

AS THE Gold Price moves through yet another major milestone – $1300 per ounce – some heavy hitters in the marketplace are beginning to wonder if the yellow metal’s rally is getting a bit too frothy, or even worse, writes Gary Dorsch, editor of the Global Money Trends newsletter.

Is a speculative bubble brewing – and one which might ultimately deflate under its own weight, leading to a sharp correction? On Sept 15th, famed hedge fund trader George Soros said that Gold Prices might continue to rise, but warned that that gold is the "ultimate bubble"…

"Gold is the only actual bull market currently. It just made a new high yesterday. In the present circumstances that may continue. I call gold the ultimate bubble, which means it might go higher. But it’s certainly not safe and it’s not going to last forever."

Soros has been bullish on gold in a big way, and as of June 30th, the Soros fund held 5.24 million shares of the SPDR Gold Trust GLD, a stake worth about $650 million today.

Soros’s fund also held equity holdings in Gold Mining corporations, plus other minerals, worth almost $250 million.

Over the past two months, there’s been a global stampede into precious metals, with investors of many different stripes, and from many countries, scurrying to Buy Gold and silver in both the physical market and through exchange traded funds.

The World Gold Council reported that the demand for gold worldwide surged 36% in the second quarter of 2010, swelling to 1,050 tonnes. The Greek debt crisis, instability in Irish and Portuguese bonds, and expectations the Fed would unleash "Quantitative Easing" (aka QEII) – flooding the world with a new tidal wave of freshly printed US Dollars – has supported the historic bull run. Europe accounted for more than 35% of the retail purchases of Gold Coins during the second quarter.

The latest surge in gold and Silver Prices was sparked in July, following comments from Fed officials signaling that QEII could be around the corner. On July 22nd, Fed chief Ben "Bubbles" Bernanke reassured congressional lawmakers the central bank is prepared to print more Dollars if the US jobless rate continues to hover around 10%.

"We are ready and will act if the economy does not continue to improve, if we don’t see the kind of improvements in the labor market that we are hoping for and expecting. Unemployment is the most important problem that we have right now. What we can do is make financial conditions as supportive of growth as we can and we certainly are doing that…"

On August 19th, St Louis Fed chief James Bullard was more explicit, signaling his backing for further monetization of the US government’s debt.

"Should economic developments suggest increased disinflation risk, purchases of Treasury securities in excess of those required to keep the size of the balance sheet constant may be warranted. Any additional Treasury buying should be undertaken in a measured, deliberate manner, commensurate with the magnitude of the deflation threat."

The Fed’s propaganda artists are operating behind a veil of "smoke-and mirrors", trying to instill the fear of consumer-price deflation amongst bondholders in order to justify another big round of stealth monetization of the US government’s debt.

The Fed’s first go-around with QE, totaling $1.75 trillion, combined with the Bank of England’s £200bn QE-scheme and the Bank of Japan’s ¥21 trillion QE-scheme, fueled a powerful rally in key commodity markets in 2009, lifting the Dow Jones Commodity Index (DJCI) from deep in negative territory, and onto the positive side, thus warding off the threat of deflation in the global economy.

However, since the Fed completed its 12-month buying spree in Treasury bonds and mortgage-backed bonds in March 2010, the year-over-year rate of increase in both the DJCI and the US Producer Price Index have petered out. Last November, the DJCI was hanging around the 135-level, just a shade below the 138.40-level that prevails today. If the DJCI stays stagnant or turns lower in the months ahead, it could knock the US-PPI into negative territory by year’s end, signaling the onset of another bout of deflationary pressures, and triggering a second round of the Fed’s QE.

Thus, on Sept 1st, Philadelphia Fed chief Charles Plosser said the Fed would embark upon further monetary easing if faced with a dangerous downward price spiral.

"If we do need to act, if fears of deflation were to become real, then we would need every ounce of credibility we can muster to convince markets we are not going to let deflation happen…

"I would certainly entertain the solution if I feared deflation, and if I feared that expectations were coming unglued in that direction – then we would have to take actions," he warned.

Interestingly enough, amid all this gloomy talk by Fed officials about the bogeyman of deflation, the demand for precious metals – traditional hedges against inflation and currency devaluations – is booming.

Why? Traders realize that the Fed’s magic elixir for fighting the scourge of deflation is more money printing – otherwise known as the nuclear QE-scheme. US bond dealers, who trade directly with the Fed, aren’t questioning whether QEII is on the table, but are rather taking bets on the size of the next tranche, with estimates ranging between $300 billion and $1 trillion.

Speculation that the Fed would unleash QEII soon has already spearheaded a new round of currency wars across the globe. Central bankers in Brazil, China, Chile, Japan, Russia, South Korea and Thailand have all stepped up their interventions, by injecting large sums of paper into the currency markets, while trying to prevent a precipitous decline in the value of the US Dollar versus their own currencies.

The amount of foreign currency reserves stashed away in the coffers of the Bank of Korea have climbed by $76 billion since April 2009, to a record high of $286 billion – and becoming the world’s sixth-largest after China, Japan, Russia, Taiwan and India. The BoK’s currency reserves are an indicator of the approximate size of its interventions in the foreign-exchange market, utilized to artificially hold down the value of the Korean Won vs. the US Dollar.

The value of the US Dollar is critical to Seoul, since Beijing pegs the Chinese Yuan to the US Dollar, and China is the biggest customer for Korean exporters. Thus, the BoK aims to protect its exporters in both the Chinese and US markets. However, the BoK hasn’t been able to turn the bearish tide against the US Dollar. It’s been overwhelmed by the ideas that the Fed would unleash nuclear QEII. Now the BoK can only try to stem the bleeding – engineering an orderly retreat for the greenback.

The Bank of Korea would of course be much wealthier if it had judged the Gold Price more correctly. The BoK holds only 14 tonnes of Gold Bullion, equivalent to just 0.03% of its total reserves. On Dec 9th, 2009, the BoK’s FX-chief, Lee Eung Baek argued:

"There’s an illusion in gold. Out of more than 200 nations, how many have bought Gold Bullion? Like other central banks, we have been increasing the types of currency reserves outside the Dollar. Gold offers little value, with no cash returns. Since India and Russia with large reserves bought gold, there’s speculation that Korea might buy it too. But we are not classified in the same category. There’s a slim chance that we will Buy Gold from the IMF…"

This was when the yellow metal was changing hands at $1226 an ounce, almost $100 below today’s price.

On Sept 16th, Tokyo’s financial warlords also intervened in world currency markets to drive down the exchange rate of the Yen.

The Bank of Japan sold an estimated ¥2 trillion ($23 billion) to buy up US Dollars. The first such intervention by Japan in more than six years, this was also the biggest ever one-day currency action, and breached a tacit agreement among the Group-of-Seven industrial powers (G7) to avoid unilateral currency interventions.

But Japan had threatened such action for more than six weeks, after the value of the US Dollar declined by 10% from May to a 15-year low of ¥83. The Japanese Yen also climbed sharply in relation to the Euro and the Chinese Yuan…meaning that Japan’s multinationals, listed on the Nikkei 225 index – and heavily dependent on exports – were suffering. The Dollar’s value had declined far below their average break-even point of ¥93, and threatens their ability to compete in selling goods abroad.

Japan’s foray into the currency markets triggered a short squeeze on over-zealous US Dollar bears, and lifted the Dollar as high as ¥86 in short order. However, the Dollar’s one-day rally quickly stalled, as speculators began to bet that the size of the Fed’s QEII would exceed the size of the Bank of Japan’s devaluation schemes. Earlier, the Bank of Japan boosted the size of excess Yen sitting in deposits held by Japanese banks to ¥30 trillion ($350 billion), in an effort to put a floor under the Dollar at ¥84.

Despite the massive size of the Bank of Japan’s injections of Yen into the local banking system, it hasn’t been able to turn the US Dollar’s bearish tide.

That’s because currency traders expect the Fed’s next round of QEII to trump the size of the Bank of Japan’s interventions. Also, US Treasury yields could resume falling further than comparable Japanese bond yields, thus narrowing the US Dollar’s interest-rate advantage over the Yen. In the current round of competitive currency devaluations, the Fed holds the trump card over the Bank of Japan.

Most interesting, Japanese 10-year bond yields are flirting with the psychological 1% level, despite the ballooning of the size of Japan’s public debt, now at ¥909 trillion ($10.5 trillion). Japan’s bond yields are falling, even though its debt-to-GDP ratio is about 180%, which on the surface is worse than 115% for Greece. Yet although public attention tends to focus on Japan’s gross debt, which has soared to ¥909 trillion, the government also owns about ¥700 trillion in assets.

That ¥700 trillion in assets includes roughly ¥180 trillion in real assets, such as public office buildings, and ¥520 trillion in financial assets, including stakes in special corporations. The government can sell these assets and use the proceeds to pay down debt. Thus, Japan’s net debt is about ¥200 trillion, or about 40% of its nominal GDP, which is over ¥500 trillion per year. Perhaps, this is why Beijing hasn’t been afraid to buy ¥1.7 trillion of Japanese government bonds in the first seven months of 2010.

Still, at yields of 1% or less for 10-year Japanese bonds, the only buyers would be short-term gamblers, or those who are convinced that Japan’s economy would be snared in the deflation trap for year’s to come.

Buying JGB’s at yields of 1% or less could lead to large losses over the longer-term. Thus, the more sensible investment for Japanese investors is to Buy Gold against the Japanese Yen. Priced in Tokyo’s money, gold has more than doubled over the past five years, and served as a good hedge against the Bank of Japan’s printing schemes.

Already, the Bank of Japan is monetizing half of Tokyo’s annual budget deficit of ¥44 trillion this fiscal year, and there’s pressure on the central bank to buy more government bonds to weaken the Yen. Although some traders might view the Bank of Japan’s bond-buying operations as a buy signal for JGBs, investors in Tokyo gold have profited more handsomely. Tokyo gold has been tracking the size of Japan’s outstanding debt, since Tokyo’s ruling elite prefer to pressure the central bank to monetize its debts, rather than sell-off state owned assets to finance budget shortfalls.

Gold’s not just tracking Tokyo’s monetary problems, either…

Bank Rossii, Russia’s central bank, manages the Ruble against a basket of Dollars and Euros to limit currency swings that may hurt it exporters. In August, Bank Rossii bought $1.1 billion and €136 million, trying to keep the Ruble within a floating range against the Euro-Dollar’s basket.

This summer’s agricultural drought, the worst in decades, has already shrunk Russia’s trade surplus to $8.3 billion in August, or 29% less than a year ago, and has slowed its economy’s growth rate to 2.4%, with 60% of the fall attributed to the agricultural sector. Thus, Bank Rossi is liable to start increasing the supply of Rubles in the money markets to limit further damage from adverse exchange rates moves to its economy.

The Kremlin earns most of its foreign currency from the sale of Urals blend crude oil, natural gas, and other natural resources, such as timber, platinum, and nickel. Along with rebounding energy and metals markets, Russia’s FX reserves have been replenished to around $478 billion today, from as low as $380 billion in March 2009. Moscow is keen to diversify some of its FX stash into gold, and last May, added 1.1 million ounces equaling 16% of monthly global mining output.

Overall, the Russian central bank bought gold at an average rate of 250,000 ounces per month for the past three years, and now holds an estimated 23.6 million ounces. As of the first quarter of 2010, Saudi Arabia said it had more than doubled its gold holdings from 143 tonnes in Q1 2008 to 323 tonnes this spring, for an average increase of 241,000 ounces a month, or about the same as Russia’s purchases.

Thus, gold traders will keep a close eye on the FX reserves of these two key oil producers.

Brazil has also ramped-up its intervention efforts in the foreign currency markets, buying US Dollars twice each day in order to prevent the greenback from falling below its latest defense line at 1.70 Reals.

Largely due to its super strong currency, Brazil’s trade surplus fell 44% to $7.9 billion in the first half of 2010, down from $13.9 billion a year ago, as imports grew nearly twice as fast as its exports. Four years ago, the Bank of Brazil (BoB) tried to prevent the US Dollar from falling below 2.10 Reals, but failed in its $100 billion intervention effort.

Currently, the BoB is trying to draw a red-line in the sand for the US Dollar at 1.70 Reals, but Brazil’s high short term interest rates, offered at 10.75%, are simply too irresistible to yield hungry investors from around the globe. Foreign inflows of cash into Brazil in the first ten-days of September alone was $2.14 billion. As a result of its relentless intervention efforts, trade surpluses, and foreign direct investment, Brazil’s FX stash has grown to $250 billion, and it’s the fifth largest lender to the US Treasury.

On Sept 15th, Brazil’s Finance chief Guido Mantega vowed to defend the country’s exporters, joining other governments worldwide that seek to weaken their currencies as a way of speeding up an economic recovery.

"We will not sit on the sidelines watching the game, while other countries weaken their currencies at the expense of Brazil. We’re going to take appropriate measures to stop the real from appreciating," he declared in Rio de Janeiro.

Under conditions of slowing growth in the US economy, there’s been an eruption of currency wars worldwide, with an increasing number of governments seeking to secure their share of export markets through outright intervention in the currency markets.

At the heart of the problem, US Senate Banking Committee chairman Christopher Dodd declared China a currency manipulator last week, and said its "economic and trade policies present roadblocks to our recovery." He accused Beijing of stealing intellectual property, violating international trade agreements and dumping goods. Since then, the US Dollar tumbled 1.2% to 6.7035 Yuan.

US Treasury chief Tim Geithner suggested that China should raise the Yuan’s exchange rate by at least 20% and issued a thinly veiled threat, noting that "China has a very substantial economic stake in access to the US market." Meaning, the biggest beneficiary of the growing currency trade wars is the precious metals – silver and Gold Investment – now basking in the growing supply of freshly printed paper currency worldwide.

The prospect of QEII by the Fed is prompting other central bankers to counter with currency devaluations of their own. Yes, some central banks such as Banco de Chile, the Bank of Australia, and the Bank of India are going the opposite way – lifting their interest rates, and their currencies have become magnets for foreign capital. But the Fed has concluded that the only expedient weapon in its arsenal to speed-up the US economy is to inject another tidal wave of US Dollars into the banking system, while aiming to artificially inflate the US stock market higher, and thus, create the illusion of greater wealth and better times ahead.

However, when seen through the lens of gold, or in "hard money" terms, the Dow-to-Gold ratio is still trapped near its lows of Q2 2009, highlighting the notion that the US-economic recovery has been mostly limited to Wall Street and US multinationals. Meanwhile, the divide between rich and poor in the US is getting wider. The Dow Industrials’ 3,800-point rally from the low of March 2009 was a monetary illusion, and Gold Bullion is still best way to preserve wealth.

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Tagged with: Banco de Chile • bank • Bank of Australia • Bank of Brazil • Bank of England • Bank of India • Bank of Japan • Bank of Korea • Bank Rossii • Beijing • Ben "Bubbles" Bernanke • Brazil • BRL • Chairman • Charles Plosser • chief • Chile • China • Christopher Dodd • CNY • crude oil • currency traders • Dow 30 • Dow Jones Commodity • editor • editor of the newsletter • Energy • EUR • Europe • famed hedge fund trader • Federal government • Finance chief • G7 • Gary Dorsch • GBP • George Soros • gold bullion • greece • Guido Mantega • India • International Monetary Fund • James Bullard • Japan • Japanese government • Korea • Lee Eung Baek • local banking system • location • London • May • money printing • monthly global mining output • Moscow • natural gas • Nikkei 225 • oil producers • Philadelphia Fed • printing schemes • queen • retail purchases • Rio de Janeiro • Russia • Russia's central bank • Russian central bank • Saudi Arabia • Seoul • South Korea • Taiwan • Thailand • Tim Geithner • Tokyo • United States • Urals • US • US Dollar • US government • US Producer • US Producer Price • US Senate Banking Committee • US Treasury • USD • World Gold Council • yellow metal

Sep 23

"Contained" Inflation

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What’s in a word from the Fed…?

IT IS TOO BAD that the media fails to make use of an accessible resource, writes private investor and author Fred Sheehan from North Weymouth, Massachusetts, in Bill Bonner’s Daily Reckoning.

Itself.

Newspapers and financial TV are generally content to report what is being said today with no reference to the past. There seems to be no memory. A recent instance is Federal Reserve chairman Ben Bernanke’s opinion that inflation is not a concern. In a sane world, his opinion would not matter much. But we live in a more nonsensical atmosphere in which abstractions substitute for reality.

The Fed chairman’s inflation prediction is thought to reflect whether the Federal Reserve’s Open Market Committee (FOMC) will raise the fed funds rate from zero. It is not, then, Bernanke’s opinion about inflation that stirs imaginations (very limited imaginations, to be sure), but the train-of-thought that the global yield curve is a consequence of his purported wisdom. If the Fed Chairman’s public view changes, the residence of several trillion Dollars will also change: carry trades, institutional asset mixes, and potential reallocations from stocks into money markets are examples of financial securities that are shipped from asset class to asset class according to the Fed chairman’s price-change gazetteer.

The real world today is repeating a pattern of a couple of years back. Prices are rising everywhere. This was also true when Bernanke became chairman of the Fed, in February 2006. Shortages, bottlenecks, black markets and prices were increasing when Bernanke became chairman. They continued to do so into late 2008. These conditions then retreated but are charging upward again.

To cut to the finale, a search through the files shows that Ben Bernanke was neither concerned nor understood the 2006 to 2008 inflation. It is certain, reading the evidence, that once again he will ignore (or remain malignantly ignorant, as the case may be) inflation until long after rice riots outside California supermarkets are a feature on the evening news.

To those unaccustomed to Fed-foolery, there is a motive for the chairman to day-dream through an inflationary swindle. The Federal Reserve wants to print money at will. An admitted problem with inflation would make it difficult to keep pumping money into the market.

Two conclusions can be drawn with near-certainty: the FOMC will not raise its zero-percent fed funds rate as long as Ben Bernanke remains Federal Reserve chairman. (A trivial 0.25% or 0.50% increase is possible.) Prices of things, particularly of commodities, will keep rising. This is an area to make money.

The Prosecutor’s Brief

In 2006, Bernanke had the excuse of being new to the job, without his predecessor’s experience at judging how every comment would be interpreted and analyzed. In the end, his inexperience with the media was not a disadvantage. (Discussed in the past tense, all of this is just as true today.) He talked in circles, made little sense, but criticism of the Federal Reserve Chairman’s remarks was confined to vocabulary. He could have bellowed his discontinuities of thought, of logic, of basic economics through the public address system before a full house at Yankee Stadium and the financial media would have remained deferential. An instance was his inflation commentary. An abbreviated sequence of Bernankeism follows.

Chairman Bernanke discussed inflation before the Joint Economic Committee on April 27, 2006. He sent written responses to the committee following his testimony. In this take-home exam, the new Fed chairman pronounced "inflation is overstated" and expectations are "well contained." His contentions were controversial, not for the obvious reason that crude oil prices had risen 50% since the beginning of 2005. Such comparisons between what is real and what Bernanke recites do not interest the media. Again, his economics are illogical. This was the real story, but was not discussed.

Instead, the press and financial TV grew aggressively neurotic when the Federal Reserve issued a statement, on May 10, that inflationary expectations are "contained". The media was consumed with the distinction from "well contained" in Bernanke’s April 27, 2006, statement.

On June 5, Bernanke, speaking at the IMF, admitted inflation, not inflationary expectations, was a problem. Again this distinction in vocabulary was front page news. Barely discussed were announcements in the same week that mergers and acquisitions for the year had already passed the record level of 2000 ($1.4 trillion), private equity in Europe was "loading companies with a record amount of debt," and home mortgage debt in the US was increasing at a 12.2% pace (when the national income was rising at a 3% rate).

On June 15, 2006, Bernanke spoke about expectations (not inflation, as he had on June 5). He believed expectations remained within historic ranges, which seemed to be consistent with his May 10 statement, but he was chastised for "giving mixed signals," maybe because he discussed expectations rather than inflation, though this was not clear, and who cared other than the panting, breaking-news media and the trading desks that might unwind billion-Dollar arbitrage positions in reaction to the media’s portrayal of the Fed chairman’s word choice?

On November 28, 2006, he told the National Italian American Foundation that inflation expectations were "contained." He repeated this assessment on many other occasions. The chairman may have thought his personal contentment would sooth the masses. Whatever the case, Simple Ben applied the formula to any topic that popped into his head. On March 28th, 2007: "At this juncture … the impact on the broader economy and financial markets of the problems in the subprime markets seems likely to be contained."

In his November 2006, address to the National Italian American Foundation, Bernanke talked in clichés that had lost all meaning. He would "continue to monitor the incoming data closely." The FOMC is "prepared to take action to address inflation if developments warrant." The chairman, at best, made glancing references to what he was monitoring, when the FOMC would take action, and what form the action might take.

Seven months later, in July 2007, Bernanke finally gave a speech devoted to the Federal Reserve’s measurement of inflation: "First, how should the central bank best monitor the public’s inflation expectations?" Bernanke’s description of the Fed’s methods could not be refuted, since there was nothing to refute: "The Board staff employs a variety of formal models, both structural and purely statistical, in its forecasting efforts. However, the forecasts of inflation (and of other key macroeconomic variables) that are provided to the Federal Open Market Committee are developed through an eclectic process that combines model-based projections, anecdotal and other ‘extra-model’ information, and professional judgment. In short, for all the advances that have been made in modeling and statistical analysis, practical forecasting continues to involve art as well as science." This means nothing. Dan Quayle was ransacked for misspelling "potato," yet the media adored Bernanke for sounding like an idiot savant.

He went on to ask critical questions (e.g.: "Do we need new measures of expectations or new surveys?"). There were no answers. Bernanke described some of the inputs to the Fed’s models, but then crushed hopes of those who were trying to understand how the Fed measures expectations: "[T]he model specifications employed differ considerably in their details, including how lagged inflation enters the equation, how resource utilization is measured, and whether a survey-based measure of inflation expectations is included. In principle, formal econometric tests could determine how much weight should be put on the forecast of each model, but in practice the data do not permit sharp inferences…." In the end, he confirmed what Fed skeptics already believed – the Federal Reserve is a Works Project Administration for failed statisticians: "Because of these considerations, as I have already noted, the staff’s inflation forecasts inevitably reflect a substantial degree of expert judgment and the use of information not captured by the models."

Others disagreed. In April 2007, Harry Landis, 107 years old, a World War I veteran, was interviewed by the St. Petersburg (Florida) Times: Landis had "lived through the invention of airplanes, televisions, interstate highways and cell phones. But the biggest change? ‘Money has decreased in value,’ he said. ‘There is so much more of it.’"

Not according to Simple Ben. On July 10, 2007, Bernanke addressed current inflation, then dismissed it: "The steep run-up in oil prices in recent years has not triggered either high inflation or recession, in large part because consumers and businesses expect price increases to remain tame." Three days before Bernanke spoke, Lehman Brothers (R.I.P.) released its food ingredients cost index for the first 6 months of 2007. It had risen 14.9%.

The value of stuff was rising against Dollars and against paper assets in general. Detachment of prices from previous levels leads to poverty, desperation, and crime.

California suffered a copper crime wave. Irrigation systems were stripped from farms; their replacement had cost $2 billion in 2006, a 400% increase from 2005. Value investors "pulled plaques off cemetery plots, raided air-conditioning systems in schools, yanked catalytic converters from cars." The copper in a penny was worth more than one cent; the Treasury Department decided melting pennies for the copper was a crime with a sentence of up to five years in jail. In Britain, Monopoly, the board game, cut costs by replacing paper money with a calculator. In the United States, those who lacked formal education knew best: Twenty-two percent with a high school education or less named the economy as the country’s worst problem, compared to eight percent with college degrees. Through history, inflation first attacked the lower classes and not stopped until it consumed the upper classes. This time looks no different.

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Tagged with: bank • Ben Bernanke • Bernanke • Bill Bonner • Britain • California • cell phones • cent • Chairman • crude oil prices • Dan Quayle • Department of the Treasury • Europe • Federal Open Market Committee • Federal Reserve's Open Market Committee • financial media • food ingredients • Fred Sheehan • Harry Landis • International Monetary Fund • Joint Economic Committee • Lehman Brothers • Massachusetts • model • National Italian American Foundation • North Weymouth • Oil prices • private investor and author • Prosecutor • St. Petersburg (Florida) Times • United States • US Federal Reserve • USD • Works Project Administration • Yankee Stadium

Sep 23

Banking on Moral Hazard

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Keep bailing out the banks, and you’ll keep encouraging reckless banking…

LEGISLATORS in Western countries are in the process of rewriting financial sector regulations, and most commentators encourage the politicians in this mission, writes Jamie Whyte for the Cobden Centre.

Yet few politicians or commentators pause to ask themselves why such regulations are required in the first place – that is, why market mechanisms alone do not properly constrain banks’ risk taking.

The answer is that government guarantees of bank deposits greatly reduce the "risk premium" that banks must pay on their debt capital. Retail deposits (i.e. deposits under some threshold) enjoy the explicit guarantee of the government regardless of the bank’s credit worthiness. Only bank creditors who are not guaranteed by the government (e.g. large commercial depositors and other "wholesale" liability holders) will demand higher interest rates when banks take more risk. And even they will do so only to the extent that they doubt the government will cover their losses should their debtor bank fail.

The history of bank bailouts – especially for the "too big to fail" institutions – vindicates the view that debt holders will be made whole, and therefore justifies the low levels of "bailout doubt" observable in the prices wholesale bank creditors charge banks. Since 1988, 28 of the world’s largest 100 financial institutions (as measured by assets) have failed. This equates to a 1.3% annual probability of default, which should equate to a BB credit rating. In fact, the top 100 banks have enjoyed an average credit rating of A+, which equates to a 0.05% annual probability of default. This apparent anomaly is easily explained by the fact that in only two of these 28 cases of bank failure (Lehman Brothers and Washington Mutual) did the national government allow creditors to suffer losses.

These explicit and implicit government guarantees of bank creditors effectively subsidize bank risk-taking. They remove the normal market discipline on risk-taking: namely, the premium that creditors charge for risk. Given this subsidy, banks can extend their risk taking, and the revenues that come with it, well beyond the point where an unsubsidized risk premium would have stopped them.

Excessive bank risk taking is simply another example of the general principle that subsidies create excess supply. And, as usual, to avoid a wasteful misallocation of resources, governments must then try to rein in the overproduction created by their subsidies. In agriculture, this is typically attempted by imposing production quotas or "caps" on the crops for which the government guarantees above-market prices. In banking, the standard cap used is on leverage. Banks are legally required to fund no less than a specified percentage of their assets with equity capital rather than debt. Since the advent of the Basel Accord on Banking Supervision in 1988, this minimum capital requirement has been expressed as a percentage of "risk weighted" assets.

This approach, of trying to regulate away the excess risk taking encouraged by debt-holder guarantees, failed catastrophically in the crisis of 2007-08. The standard response of policy makers and advisers has been that the approach is right in principle and that the catastrophe was caused by nothing but faulty execution. The regulations need only be corrected. Unlike the Basel 1 and Basel 2 accords, whose measures of bank risk taking were hopelessly inadequate, the post-crisis Basel 3 regulations will get things right.

This is difficult to believe. Bankers will seek out activities whose risks are overlooked or mispriced by the new regulatory regime. In other words, they will continue to engage in the "regulatory arbitrage" that occurred on a massive scale under the Basel 1 and Basel 2 regimes. It is mere wishful thinking to believe that it will not also occur under Basel 3.

"More active supervision" is the mantra that encourages many to indulge in this childish optimism. No matter how "active", supervisors cannot be expected to win this game of cat and mouse. For the mice have too many advantages. They are more numerous, mostly smarter, better informed and, given the complexity of modern financial products and the global scope of the financial markets, they have a near limitless supply of nooks and crannies in which to hide their risks. What’s more, bankers are far better incentivised to win the game than government employees are.

This inevitable regulatory arbitrage is disastrous, not simply because it prevents regulations from having their intended effect of reducing aggregate bank sector risk-taking, but because it distorts the allocation of capital in the economy. Debt capital is allocated not to those uses that deliver the best return on risk; it goes to the uses that deliver the best return on the bank equity capital required by the government’s rules. In short, bank capital rules undermine the market mechanism that ensures resources go to their most valuable use.

Nor will the politicization of lending be restricted to such unintended effects. The government’s role in deciding the cost of lending to various classes of borrowers (through the risk-weightings and other rules) provides a strong incentive to lobby government officials for preferential treatment. The borrowers who seek discounts, the banks who serve them and the politicians who wish to be seen as the champions of these groups all have an incentive to distort the framework and thereby add to the misallocation of capital. Such shenanigans have already been incorporated into the 2010 Dodd-Frank Bill, which requires banks to hold 5% of loan securitizations on their own books, except when the securitized loans are "qualified mortgages" (which are yet to be specified).

The perverse result of tighter risk regulation will be more risk, as bankers seek ever more ingenious ways of evading the rules, and lower economic growth, as the rules distort the allocation of capital in the economy.

Government guarantees of bank debt-holders and risk regulations are a package deal; the former demands the latter. But the package is calamitous. The regulations cannot do their intended job of eliminating the "moral hazard" created by the guarantees, and the failed attempt merely perverts capital allocation. The guarantees are the problem. The solution is to eliminate them and the attendant regulations that prevent market participants from pricing bank risks properly.

Buying gold today…?

Tagged with: aggregate bank sector risk-taking • bank • bank bailouts • bank capital rules • bank creditors • bank deposits • bank equity capital • bank failure • bank risk taking • bank risks • banking • debtor bank fail • Excessive bank risk taking • execution • financial products • Frank Bill • Jamie Whyte • Lehman Brothers • national government • reckless banking • Retail deposits • Washington Mutual

Sep 23

Betting on Inflation? Buy Gold

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Buy gold to back Bill Gross’ $8.1 billion bet on US inflation…

"Bill Gross’s PIMCO made an $8.1 billion wager," Bloomberg news reported last week, says Dr.Steve Sjuggerud in his Daily Wealth email.

Bill’s bet is simple: He’s betting inflation will return to the US in the next 10 years. And he’s willing to risk billions on the idea.

Bill Gross is known as the Bond King. He’s probably the most famous and successful bond-fund manager in history. He manages the PIMCO Total Return Fund – the world’s biggest bond fund, with a quarter-trillion Dollars in assets. It makes sense to pay attention to Bill’s bets…

Bill is betting on inflation. Actually, more specifically, Bill is betting that DEFLATION won’t happen.

Today, I’ll show you why Bill’s bet is a smart one. And I’ll show how to make your own bet on this idea. But first, let me explain what exactly Bill is up to…

The mechanics of Bill’s bet are a bit complicated. In short, he took the other side of a bet on deflation.

Bill received $70.5 million now… If deflation occurs over the next 10 years (if the consumer price index is lower in 2020 than it is today), Bill is on the hook for up to $8.1 billion. If deflation does NOT occur, he simply gets to keep the upfront $70.5 million.

"We think the possibility that the US goes 10 years with stagnant or falling prices is remote," a PIMCO portfolio manager told Bloomberg news.

Fears of deflation have increased dramatically this year. We’ve seen a huge shift in the mindset of the US consumer. We’ve gone from a "conspicuous consumption nation" to a nation of savers. Deflation is simply defined as "falling prices" – and the US consumer has surely seen that… Exhibit "A" is the price of their home.

But Bill has an ace in the hole for PIMCO’s anti-deflation bet… Ben Bernanke.

Bernanke is the chairman of the US Federal Reserve. He is a student of the Great Depression. And he is determined to prevent the destructive deflation we saw in the 1930s from happening again today.

In a now-infamous 2002 speech, he said:

"…The US government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many US Dollars as it wishes at essentially no cost… Under a paper-money system, a determined government can always generate higher spending and hence positive inflation…

"Prevention of deflation remains preferable to having to cure it. If we do fall into deflation, however, we can take comfort that the logic of the printing press example must assert itself, and sufficient injections of money will ultimately always reverse a deflation."

Bill Gross has made a career out of taking calculated risks. A bet on inflation, when Ben Bernanke is at the helm of the Fed, seems like a smart one. While the fears of deflation are high, the chances of sustained deflation are slim in a paper-money society.

If the Fed does "crank up the printing press," the simple investment you want to hold is gold. The Fed can print Dollars, but it can’t print gold.

Gold is particularly attractive today. Since the Fed has cut interest rates essentially to zero, gold is more attractive than money in the bank. You earn zero percent on your cash in the bank, and earn zero percent on your gold. You don’t give up any "opportunity cost" – you don’t give up any interest on your cash – by holding gold today.

If you believe Bernanke is telling the truth – and the US government will print money as needed to prevent deflation – you should hold at least some of your savings in gold instead of paper money. You’ll be on the same side of the bet as the Bond King.

Buy gold at the lowest prices, and store it in the world’s very safest vaults at Bullion Vault…

Tagged with: bank • Ben Bernanke • Bill Gross • bloomberg • bond-fund manager • Chairman • manager in history • PIMCO Total Return Fund • printing press • Steve Sjuggerud • United States • US Federal Reserve • US government • USD

Sep 23

Time Running Out for IMF Gold Sales

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The IMF has 88 tonnes of gold still to sell. Time’s running out for the central banks who want it…

SO THE CENTRAL BANK of Bangladesh bought 10 tonnes of Gold Bullion last week from the IMF, notes Julian Phillips at the GoldForecaster.

This leaves 88.3 tonnes still to sell. Who might buy it?

The 10 tonnes that Bangladesh bought cost them around $1260 an ounce. So price was not a determinant in the matter. This may surprise many, but it highlights something about why central banks in general are Buying Gold now.

The potential, not just for currency crises, but serious foreign exchange structural problems is huge. The international level of cooperation between nations is poor, as we are seeing in the US China faceoff over the Yuan exchange rate against the Dollar. That leaves us uncertain at the prospect of unstable currency markets, and this has vastly increased the attraction of Buying Gold as a reserve asset.

As such, the price paid for gold in foreign exchange reserves is hardly relevant. Because when that dark and rainy day comes when owning gold is what matters, its use in settling pressing foreign obligations will heavily outweigh what the gold cost. It’s having the gold to pay these obligations or guarantee foreign currency obligations that will matter then.

The International Monetary Fund (IMF) slated 403 tonnes for sale starting in summer 2009. It has since chosen to sell that gold in only two ways:

Selling direct to central banks, announcing each sale after its completion;
Selling the remaining gold on the open market, through the bullion banks, over time and in a manner that would not influence the price.

This second route has resulted in just a couple of tonnes being sold in one go, right up to 15 or more tonnes sold in any month.

Now, you may be surprised that China has not made a direct bid for the IMF’s gold, but there are good reasons why they have not bid. The Chinese central bank, the People’s Bank of China does not Buy Gold for its reserves direct from any market or auction. It uses an agency to do the buying. This agency can hold the gold for five years and then pass it to the People’s Bank. Only at that point does the central bank declare it has bought it.

This anonymity is very important to China. If it were known that China had a serious long-term commitment to Buying Gold there is no doubt that it would precipitate such a jump in the Gold Price that the market could destabilize and China not be able to access open market gold.

Because of these considerations of a direct and then announced approach by China to the IMF we doubt very much if China will now be a buyer. They will continue to buy in the open market anonymously.

If the IMF had been willing to sell direct to large institutions (such as China’s buying agency if they had been a buyer) the gold would have been sold to it and/or to other private funds and sovereign wealth funds very quickly after the initial announcement to sell gold had been made by the IMF In fact, there are many non-central bank institutions that want to approach the IMF to buy the gold, but the two selling routes are inviolate. This means that, with only 88.3 tonnes left to sell it the opportunity to Buy Gold in a large amount is slowly disappearing.

A potential buyer could have been India, who made the largest purchase of IMF gold at 200 tonnes last October. Just after India bought the 200 tonnes of gold from the IMF it stated that it may be a further buyer of this gold. Will they come in again, or will more Asian central banks come in for the first or second time? Well, both time and supply are running out for all central banks buyers.

As the buying has come from Asian countries who know and love gold, the most likely buyers will be from that part of the world, not from the developed world’s central banks. For the West to be buyers, may well be seen as undermining the paper currency world.

At the present rate of selling in the ‘open’ market the IMF will have completed selling in 6 months time. So the clock is ticking. That’s why we expect one or more announcements from the IMF on further sales to central banks soon. These will come anytime from now and over the next 6 months. We would not be surprised is the entire remaining amount goes in one fell swoop, soon. No-one can say who for sure will be buyers.

The IMF’s announcement that IMF gold sales are complete will be a trumpet signal to the market that supplies have narrowed. Then what?

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Tagged with: Bangladesh • bank • bank institutions • China • India • International Monetary Fund • Julian Phillips • People's Bank of China • THE CENTRAL BANK of Bangladesh • USD

Aug 20

What’s Driving Gold Right Now?

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It’s important to understand the underlying driving force for gold. Here is an interesting article that highlights this.

The key factors driving Gold Prices, plus those less-important elements…

RIGHT NOW, it appears that the Gold Price is being linked to the state of global economic growth or lack thereof, writes Julian Phillips of The Gold Forecaster.

Is it? Or are there other factors that contribute to the rise in the demand for gold? A look at the different types of demand gives us perspective on the real influences on the Gold Price.

Start with China’s contribution to the Gold Price, because this week saw an announcement that China is now the second largest economy in the world as well as being the world’s largest exporter. This is a landmark announcement as this country is headed fast to be the world’s largest economy with the world’s largest foreign exchange reserves.

As a nation, we do believe China is Buying Gold, eventually for their reserves, from local production as well as in the market. Additionally, the government and its institutions are encouraging the rapidly swelling numbers of newly enriched middle classes to Buy Gold. It is hard to give you an accurate number on this because such growth has never been seen before.

But there is a brake on the relationship of the growth of this class as regards gold. The Chinese are savers and because of their skepticism, recent experience of being poor and inexperience, they are not quick to change from the simplest of saving-account deposits to other investments. But overall they are happy with gold as an investment and are moving across to it, particularly as they understand the benefits of a rising price. Their obedience to government directives is helping the process. They have the lowest per capita holding of gold in Asia. We attribute this firstly to the long history of hardly any disposable per capita in the country. This is changing fast.

The demand is not seasonal except that it reaches a high point at the Chinese New Year, a time for people to celebrate and give presents. After New York closes, Asian demand kicks in at the start of their day pointing towards Indian, Indonesian, etc. demand, including that from China. Watching the market right through to before London opens, also gives on insight into demand from there.

Please note, this demand does not take note of the state of European or US economic growth. Most Chinese gold buyers are not aware of Western economics, but want financial security through savings in Yuan and gold.

Chinese demand is going to be large enough to be a major Gold Price driver in 2010 and 2011 and beyond.

Indian demand is also crucial. The monsoon this year (south of Pakistan) has been plentiful and expectations are that the harvest will be a good one. As 70% of gold purchases used to come from the agricultural sector, this time of the year is significant still. But as India urbanizes, the seasonality of gold buying there is lessening. Because the disposable income of Indians in the countryside is limited, the tonnage of actual gold purchased by them is falling. On the other hand, the numbers of the middle class is increasing and so is their disposable income.

To a growing extent this is making up the volumes that could be bought. The volume purchased per annum has been as high as 850 tonnes but can fall to 400 tonnes a year. The monsoon has had as much to do with that alongside rapidly rising prices. Please note that this difference is the same as de-hedging demand from the major Gold Mining companies was at its height.

Although India is growing at 8% per annum, the Indian middle classes are not growing as fast as China’s middle class. The main restraint on Indian gold buying is the fear that the Gold Price will fall after they have bought it. This year we do expect them to be more enthusiastic because the Gold Price has been stable over the last year and more at around $1,200.

They usually start to buy just before or after the beginning of September. That’s in two weeks time. Indian demand goes on through the year to May of next year.

Indian demand has been a major gold demand sources and is going to be a growing force, in line with Asian growth in 2010 and for years to come. As with China, western economic growth or lack thereof, does not affect Indian demand.

Developed world jewelry demand will also play a role. With the northern hemisphere and developed world holidays slowing down to early September, manufacturers of gold jewelry there start to gear up for the year end festivities. They Buy Gold for this time in September so that it can be in the shops in November or earlier. This has, in the past been the largest source of demand for gold.

Developed world demand relates directly to developed world levels of disposable income. These are not good this year, so we expect no increase in demand from that source. Disposable income has been well down since the start of the housing crisis, which began towards the end of 2007. We don’t expect them to rise for at least one year. But the buying that will take place will begin round about the beginning of September and last through to November before it slows to the steady flow up to May of next year.

If the Gold Price does not rise by much this demand will rise in significance, but we feel that it will again be sidelined by rising prices soon.

Industrial demand, in contrast, doesn’t matter so much for Gold Prices. Intel’s recent results and following comments showed us that electronics have now joined the category of ‘necessary’ items for households and businesses. As electronics are the main use for gold in industry, we do not expect there to be any significant drop in demand from industry. Overall, industrial demand is not seasonal, but such demand is not a major factor in the Gold Price.

As for demand from Central Banks, we are of the opinion that the turn in the market, by central banks from seller to buyers, overall is a trend that has barely begun. Russia, China, Saudi Arabia, the Philippines and no doubt to be joined by others in the future, are buyers of gold. Previous sellers have now taken a firm grip on their remaining holdings. Last year central bank buying equaled over 400 tonnes.

The monetary crises that lie ahead in the next year or two will, we believe, will incite much more buying by central banks as confidence in the monetary system continues to decline.

The International Monetary Fund’s sale falls out of this category, but is a supplier at the moment. Of its 413 tonnes there remains around 150 tonnes. We expect to see this absorbed completely within one year. Once this has gone prices will rise to the point where dishoarding begins, so providing the market with supply.

Again this demand is non-seasonal. However, it not only leads investment demand, it has the capacity to absorb all available supplies. Further, once its persistent visibility is accepted, it will incite considerably more institutional investment demand. Central bank demand these days is aimed at giving central banks liquidity when its nation faces international monetary credibility problems. We expect to see this demand rise in 2010 and 2011.

Finally, Gold Investment demand. Apart from the huge demand we have seen for the shares of gold Exchange Traded Funds enormous demand for physical gold bullion has been present in the market place. It is persistent and large. However, it will not chase prices. It is professional and aims at buying certain amounts at particular prices. It ranges from small wealthy individuals through to institutions to Sovereign Wealth funds. You need to know how all these demand forces come together and impact the Gold Price!

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Tagged with: Asia • bank • China • Chinese New Year • driver • electronics • Exchange-Traded Funds • gold mining • Gold Price • India • Intel • International Monetary Fund • Julian Phillips • Last year central bank • location • London • Major • New York • Pakistan • Russia • Saudi Arabia • the Philippines • United States • USD

Aug 19

Goldman’s Gold

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Interesting article on Goldman and Gold.

Goldman Sachs is bullish on Gold Prices. Reason to worry…?

If GOLDMAN SACHS is publicly bullish on gold, is that a good thing or bad thing for gold bulls? asks Dan Denning in his Daily Reckoning Australia.

Wall Street’s notorious trading house published a report on gold last week setting a price target of US$1300 in the next six months. The report cited several factors. But before we get into them, we’ll confess it made us a bit nervous. Whenever a broker is saying one thing, you have to wonder if they’re actually doing the opposite.

That said, Goldman did make a point that is true of an asset in a bull market: it requires corrections to shake out the speculators and weak hands from time to time. Following the June high north of $1250 the net speculative long positions declined. Traders took profits. And so did momentum players in the exchange traded funds market.

But then something happened that naysayers such as Michael Pascoe and Rory Robertson did not expect. The gold bubble did not pop. Because it’s not a bubble. The momentum players departed and the price found plenty of support. It’s now around US$1220.

Goldman says the big catalyst for a further move higher (other than its announcement leading to a stampede of money into gold short-term) is a repricing of US growth expectations for the rest of this year and all of next. Maybe it’s a fear trade, or just bearishness on US corporate profits when unemployment keeps rising.

Either way, about the only dubious chart we saw in the whole report is the one showing lower US real interest rates and the Gold Price (exhibit five). As those cool cats in statistics say, correlation is not causation. Its possible low rates give speculators fuel to play in the gold market. But it’s more likely, we reckon, that US rates are low because the bond market is pricing in a deflationary scenario.

So why would gold rise in a deflationary scenario? Good question! It brings us full circle to the argument fund-manager David Einhorn made when we announced his gold position: you Buy Gold when you think monetary and fiscal policy are bad (we’re paraphrasing). Whether it’s inflation or deflation matters less than the fact that something unconventional and bad is going down. Gold does well in that environment, what with it being real money and all.

Take a look at the Aussie Gold Price chart below. It shows you that gold is much closer to making a new high in US Dollar terms than it is in Aussie Dollar terms. For Aussie gold to match the greenback gain, you’d need a much stronger greenback or a much weaker Aussie. It’s worth noting that following the Fed’s announcement that it would sort of begin quantitative easing part two, the Aussie made the second-largest declines against the greenback, trailing only the dreaded Esperanto currency, the Euro…

As we have banged on about gold for years now, we won’t test your patience much longer. But last week’s news that the Aussie unemployment went rate up in July wouldn’t be Aussie Dollar bullish, would it?

Maybe the Aussie will get a boost when this miserable Federal election nonsense is over. When thinking about the election we recall the phrase, “Don’t vote! It only encourages them.” Of course voting in Australia is compulsory. But it might be a fine worth copping if you can say you weren’t an accessory to “the advanced auction of stolen goods,” as Mark Twain once put it.

Seriously. If anything is clear so far about the difference between the two major parties, it’s that both treat Australians as chattel. We are but tax slaves who exist to fund the government’s spending pleasures. And the Greens? More like the Reds!

But that’s all politics. Financial independence is the only real defense against this kind of relentless State encroachment from all sides. Get it. Keep it. Defend it. And whether you like it or not, more and more governments across the world are spending out of an empty pocket. They’re spending to give people money that’ve lost jobs as a result of the structural shift in the labor markets. That shift came from globalization. The money might keep people above water for awhile, but it’s no replacement for a real job making real things.

More and more spending is going to simply pay the interest on previously borrowed money. This is probably the most dangerous aspect of a credit bubble. You borrow and spend all that money and, and the end of the day, you have nothing to show for it…no bridges…no roads…no factories…no real increase in the capital stock. Just a lot of over-priced residential housing that suddenly isn’t in such short supply as you thought. And now Australia finds itself at an interesting crossroads.

Just a little debt didn’t seem like such a bad idea at the height of the global financial crisis. Both Australia’s major political parties now promise to pay it off quickly, with all the bounty from mineral and energy royalties. Both will increase spending too, but in different places, cutting other spending priorities.

But should the housing bubble pop sooner rather than later, and should Aussie banks find themselves last in the queue for global capital in another phase of the Great Correction, the temptation for more government borrowing will be nigh irresistible.

Why? Well, our stance against government debt may seem dogmatic. But if it is, it’s because the modern State always abuses the power to borrow. Always. Whether it’s to fund politically popular but economically unproductive projects, or whether it’ just a way of putting off tough choices about actually reducing government spending and, thus, the reach of the State into private life, it’s always easier to borrow and kick the can down the road.

Debt is the health of the State in the same way that liquor is the health of the alcoholic. The relationship is inherently destructive. But we reckon that in the face of so much unproductive debt (household and sovereign) the only politically palatable policy response will be to monetise that debt: pay it off or buy it from bank with new money. The deflationists can enjoy their moment in the sun while it lasts. But it won’t last for long at this rate.

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Tagged with: Australia • bank • broker • Dan Denning • David Einhorn • energy royalties • Federal government • Goldman • goldman sachs • manager • Mark Twain • Michael Pascoe • Rory Robertson • United States • USD

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