By the way, last year at the Agora Wealth Symposium in Vancouver, one of our colleagues took the stage to point out that your editor was complete moron. In this particular case, it was for being bullish on gold

He said that gold hadn’t done much adjusted for inflation since 1980. What’s more, he said that it’s worth less—adjusted for inflation—than it was twenty years ago. How, he speculated, could anyone take the advice to buy gold seriously when it had performed so abysmally?

Well here are the facts. The gold price bottomed in October of 2000 at $263.80. At that time, the S&P 500 traded at 1,379. Since then, the S&P 500 has fallen by 31% (closing yesterday at 942.43) while the gold price is up 262% to $956.

We’ve asked Kris Sayce to bring this small fact to the attention of our colleague when he attends this year’s Vancouver show next month. The theme of this year’s show is “Ten Years of Reckoning,” Symposium Promo celebrating the tenth anniversary of the Daily Reckoning. Kris will be spearheading the Australian delegation. More details on that later this month.

In any event, it seems pretty obvious, that for the last ten years anyway, selling stocks and buying gold would have been a good trade/strategy. Stocks ended an 18-year bull market in 2000 and gold ended a 20-year bear market. One asset class was at a cyclical low. The other was at a cyclical high. In fact, you might even say that one was at a generational low and the other was at a generational high.

Gold is no longer as low as it once was. But it’s still not as high as we expect it to go before it starts to look foolish. Meanwhile, today’s government bond market looks an awful lot like the stock market circa 2000. You’re seeing a generational high in bonds. It’s another version of the “high-low” strategy.

This time around, though, we would add energy stocks to the mix, along with gold. Crude oil climbed to an eight-month high over $70 on Tuesday. Bloomberg says the weakness in the U.S. dollar is, “bolstering the appeal of energy as an alternative investment.” Sell bonds, buy energy. Pretty simple.

There is probably some truth to the fact that oil’s latest move is driven by investment demand more than, say, demand growth in the real economy. But investors ARE looking for ways to profit from U.S. dollar weakness. Oil is liquid and popular. In the long-run, it’s the smaller-than-expected oil supply growth that will drive the market.

One thing Kris will probably be making clear to U.S. dollar-based investors is just how relatively attractive Australia’s position is in the developed world. “Even as Australia’s challenges increase, it will still be the envy of the developed world,” writes William Pesek at Bloomberg. “Even in its worst moments… Australia is among the least unsightly economies anywhere,” he adds rather optimistically. We’ll see about that.

Finally, we meant to write a bit about other possibilities in China today. That is, we were going to explore collapse scenarios (financial, political, and societal). But we did not realize it would be ambitious to try that in a few hundred words. So look for something more considered later this week in the essay spot.

Regards,
Dan Denning
Daily Reckoning Australia

June 11, 2009

Last Decade: Buy Gold. This Decade: Buy Energy. was originally featured on Whiskey and Gunpowder

If the market says that oil is worth $147 one day and $100 the next, that does not mean the first number was wrong. Nor does it mean the second number is right for tomorrow. The value of a barrel of oil is whatever the market says it is.

The market exists to discover value.

If you could do it with a pen and paper, you would not need the market. Speculators merely try to anticipate changes in values — over time. And charts are like a window into their message, or story, if you will…they are not a crystal ball.

But before I look at any position, the first thing I do is look at the chart in order to determine what the market is telling me about an asset or commodity, the economy or even monetary policy…

Technical “Chalk Marks” Suggest Deflation as Fed Policy Outcome

Maybe it is early, but the chart says the Dow could be ripe for a break to new bear market lows. That should be bullish for gold if it prompts the central bank into action.

For the past year, declines in the stock market have spurred gold higher on just this expectation, as was the case back in the last Dow bear (2001-02). When that happens, it undermines the dollar — and confidence in the central bank’s policy, making it less effective. It limits the Fed’s ability to cope.

For this reason, the Federal Reserve had deliberately chosen not to expand the money supply, which had been growing in the low single digits (year-over-year percent) for over a year, despite implementing massive rate cuts. It was a deliberately “sterilized” policy — in Bernanke’s own words — aimed at lowering inflation expectations without undermining the boom. It was aimed at shedding his moniker, “Helicopter” Ben. That was a tough balancing act — impossible, probably — and he was bound to get it wrong.

Trouble is, the market was betting that the risk was to deflation.

That is, we saw asset and commodity prices under continued pressure and technically significant chart moves in the dollar and gold suggesting that the market is anticipating this policy to err on the side of deflation, rather than inflation…not that the Fed wants any errors. In fact, the dollar’s move this week potentially reversed a 3-year downtrend.

At least, the bearish trend is neutralized…even if the U.S. dollar index were to drop back to 72 now, we could not call it bearish until it put in a lower low; the bulls might just be setting up a double bottom. Our readers know that I have been looking for a bottom in the foreign exchange value of the dollar for almost a year now. I don’t know how these trends will work themselves out over the next three-six months, but the case could be made for a bear market rally in the U.S. dollar index that extends back to the 90-95 level over the next year or two, before we get to the final chapter in its demise as the reserve currency.

Don’t forget, with respect to the U.S. dollar index, we are talking about its value relative to other funny money. That’s why I have argued that gold would advance despite it. So far, it has not.

Although there is no deflation yet, those footprints suggest the market is starting to think about it.

There’s Good Reason to Disagree with the Market

I think the odds are very low that you will see deflation — outside of a short-term aberration. This is because banks can create money, and there is nothing restricting them from creating all they want.

There is no gold standard today.

Governments got rid of the gold standard so they could inflate without restriction.

Moreover, the central bank has only increased its control of the financial sector over the decades. If we ever had a real deflation (in the monetary aggregates), it would have to be deliberated. That is why the odds are low.

According to the True Money Supply, an Austrian School monetary aggregate, the Fed is currently no tighter than it was in the late ‘60s or mid-‘70s, or even 2000, for that matter.

It is not the 1980, 1990 or 1994 Fed, which was committed to disinflation — and had the public behind it. Nor is it as easy as Greenspan’s post-1996 or post-2001 Fed.

Still, the Fed’s policy could produce a deflation scare if it overshoots in its aim against expectations and allows some deflation in money and credit by some unforeseen accident…or moral hazard.

Such a scenario would probably make the chart right about $695, and boost the dollar.  And this could happen even if we are ultimately right about gold going to $3,000, or higher. It would be temporary, no doubt, Ben would quickly sport his helicopter hat in response.

But there is reason to doubt even a deflation scare.

I am skeptical that the Bernanke Fed will stick to its guns on the money supply for the following reasons:

1. The Fed’s current policy is already net bearish for the “boom” — That is, without money supply growth the “boom” will continue to falter.
2. The political mandate for a tight Fed is weak — In the current economic condition without a forced hand, the Fed will increase money supply.
3. The economy is in no shape for a tightening — At this point the economy is used to cheap money and a tightening of the money supply would cause a “bust” cycle.

However, as long as the Fed can bluff and withstand from increasing the money supply the gold chart will probably be right. If the bulls cannot hold the Aug. 15 low at about $774 on the front-month Comex contract or recover the $850 handle anytime soon, we’re going to $695, plus or minus, over the next few months.

This risk will dissipate if the bulls can recover $850, especially on a strong dollar. In fact, we have to look back only to 2005 for an example of this bullish scenario. I have already remarked on the similarities in this correction to 2004.

The 2004 correction in the gold sector was the one that occurred ahead of the Fed’s last tightening. Six months after the tightening started, the U.S. dollar began to advance. It advanced all year in 2005.

Likewise, I expect that the gold market will shrug off the deflation scare and recover soon here, as well, ultimately undermining the dollar advance. That is right: The U.S. dollar is the dependent variable, not gold.

It is correct to say that the U.S. dollar is gaining ground on the heels of gold’s correction; it is incorrect to say that gold is weak because the dollar is strong. Gold is weak because the Fed is targeting it.

But the Fed is bluffing with a bad hand.

Regards,
Ed Bugos
October 14, 2008

The Market Versus the Fed’s Money Supply was originally featured on Whiskey and Gunpowder

Also, as August rolled on, gold fell from a price over $900 to under $800 per ounce. And oil tumbled from a price point near $145 to under $100 per barrel. This is quite a drop. And a lot of observers credit the drop to the strengthening dollar. So what’s going on?

Usually, a currency strengthens when there is some sort of good news about the underlying economy. But is this the case for the U.S. and the dollar?

The banking crisis is still with us, as is the ongoing housing meltdown. And many insiders say that there are still more tough innings in this game. So where is the good news?

Indeed, Kenneth Rogoff, an economics professor at Harvard and the former chief economist of the International Monetary Fund, recently predicted that there is still more bad news to come from the worldwide credit crunch and financial turmoil. According to Rogoff, “The U.S. is not out of the woods. I think the financial crisis is at the halfway point, perhaps. I would even go further to say the worst is to come.”

Rogoff added an ominous prediction, stating, “We’re not just going to see mid-sized banks go under in the next few months. We’re going to see a whopper. We’re going to see a big one — one of the big investment banks or big banks.”

Looks like he turned out to be right on the money.

So if the U.S. financial system is in such a precarious state, is the rise in value of the dollar really justified? Will it be good for the U.S. economy to have a major bank failure? Or on the other hand, will it be good for the economy if the U.S. government has to step in to bail out a large bank? It all seems like a “lose-lose” proposition.

Another well-respected commentator, Richard Russell, who has published Dow Theory Letters since 1958, believes that we are on the eve of world deflation.

According to Russell, the big problem facing the world economy is not inflation, but deflation:

“From what I see, the markets are telling us to prepare for hard times, and a global spate of the worst deflation to be seen in generations. This is why gold has been sinking, this is why stocks have been falling — big money, sophisticated money, is cashing out, raising cash, preparing for world deflation.”

According to Russell, “Smart money is selling into the stock market, day after day.” People and institutions are raising cash. When deflation rules, this will usher in a strong dollar.

Russell offers an illustration for why people are raising cash:

“Look, if you have $5 million and you are receiving only 2% in interest on your money, that’s only an income of $100,000 on your $5 million. Big money realizes that in a deflation, you need a mountain of cash to keep up your lifestyle.”

So Russell anticipates an era of deflation, accompanied by low interest rates. Hence the need to raise cash to support an income stream over time.

Then again, what if the markets are anticipating an increase in interest rates over the medium to long term? Could this be prompting a rise in the value of the dollar? Think of how much new “money” is floating around out in the world due to just the recent creation of credit as the Fed has bailed out insolvent banks and investment houses.

Where has all that newly created money gone? It’s lurking out there, somewhere in this world. And that new money could show up at any moment, bidding up the prices of whatever happens to be the “big thing” on any given day. Thus, while Richard Russell thinks we are on the eve of deflation, we are also confronting the specter of inflation.

The last historical experience the world market has had with high inflation rates and stagnant growth was back in the late 1970s and early 1980s. To combat inflation, then-Fed Chairman Paul Volcker increased interest rates to double-digit levels. High interest rates hit the economy like a ton of bricks, but that was the idea. High interest rates broke the back of inflation for a generation.

You have to look back even further, to the 1930s and the time of the Great Depression, to find the last long-term era of deflation. What do you see? The price of gold and gold mining shares actually increased during the 1930s.

The key to the rising price for gold in the 1930s was the effort by President Franklin D. Roosevelt to raise the nominal price of gold from $20 to $35 per ounce. It was still — in many respects — a gold standard world back then. But in raising the gold price, FDR also indirectly spurred the market capitalization of much of the mining industry.

One thing to keep in mind is this. We know a few things about inflation, both practically and from economic theory. We don’t know nearly as much about deflation. If deflation shows up at the door, will anyone really know what to do about it?

So this prompts the question. Where are prices for precious metals headed? If we encounter deflation, will we just retrace the run-up of the past six years or so? Will we see gold back at $300 per ounce, and silver at $3 per ounce? I doubt it.

I think that we will look back at the summer of 2008 as a time when precious metals had a correction after a relatively quick move upward. To put it in terms of technical analysis, the prices “outran their support.” It’s like the tanks of Gen. George Patton outrunning the fuel trucks in the closing days of World War II. Patton had to stop advancing, while the trucks caught up.

When the dollar strengthened in mid-2008 — for a variety of reasons — it prompted a pullback in prices for precious metals and the related mining shares. If you are cautious, you will hold cash and sit it out. If you are bold, you’ll look for bargains and buy shares.

Long term, I don’t think you will get hurt by buying into share price weakness. Over the long term, precious metals and the mining shares should still continue to rise in a market in which dollars are getting cheaper and things of real value are becoming scarcer.

Regards,
Byron W. King
September 30, 2008

Inflation and Deflation was originally featured on Whiskey and Gunpowder

“Four charts, one metal, and the whole world wrapped up in trying to price risk and reward in a fast-shrinking currency…”

YOU CAN LINK THE HISTORIC SURGE in gold prices starting mid-August 2007 to many apparently disparate things.

Pick the right link and you might be able to tell whether it’s worth you buying or holding gold today.

One such link is the price of money, as decided by the U.S. Federal Reserve. Gold’s stellar 58 percent gain in the seven months starting Aug. 18 began with the Fed’s first change to U.S. interest rates in 18 months.

Last August’s 0.25 percent cut to the Fed’s “discount rate” — the interest rate it charges commercial banks to borrow short-term funds — was the Fed’s first interest rate cut since July 2003. By the end of March 2008, it became a 3.0 percent cut to the bank’s key fed funds target.

And gold’s initial jump turned into a pole vault…

The real cost of borrowing dollars — or, rather, the real returns paid to anyone saving money today — clearly impacts the demand for investment gold.

You can measure this real rate of interest quite simply. Just subtract the rate of consumer price inflation (CPI) from the fed funds interest rate, as in the chart above.

Then compare this changing value to the price of gold and you’ll see that when the real returns paid to cash sink below zero, investors and savers tend to pay more — or demand more — for gold.

That’s what investors and savers did in the 1970s. It’s what they then did NOT do again until real U.S. interest rates sank toward and below zero during the first six years of this decade.

Why choose gold when real interest rates sink? Because if central bankers, driven by a fear of “deflation” in asset prices and consumer spending, try to stop the public from hoarding cash, then people will seek out reliable stores of value instead, led by hard assets.

Unlike real estate, however, gold bullion remains a highly liquid, easily priced asset that can store huge quantities of wealth in a very small space.

And gold, as the action since August’s first Fed cut reminds us, has acted as a reliable store of wealth for more than 5,000 years. In times of monetary destruction, or so history says, it’s human nature to seek an escape from fast-shrinking currencies:

Another important connection — also related to the Fed’s new rate-cutting cycle — sits in the currency markets.

In particular, look at the euro/dollar exchange rate. Because as the dollar sank versus the euro in the back half of 2007, daily movements in the U.S. dollar gold price were more strongly linked to the euro than they were to crude oil, the broad commodity markets, and even the price of silver — gold’s poor cousin in the precious metals market.

This “correlation coefficient” would stand at zero if gold’s daily movements bore no relationship whatsoever to the euro. It would be negative if gold rose when the euro slipped back (as happened to oil in the fall, albeit marginally, as the chart shows above). The correlation would stand at 1.00 if they always moved together in lock step.

And as of last month, gold and the euro were more tightly connected (with a correlation of 0.62) than gold and crude oil (0.45) or gold and the broad Goldman Sachs Commodities Index (0.29).

What does this tell us? First, the gold price is behaving much more like a currency than it is acting like a raw material. This is unsurprising given what little use gold has as anything other than a store of value.

Barely 15 percent of last year’s total gold fabrication worldwide ended up in either electronics as gold bonding wire, coating for space shuttle windows, or in people’s teeth as dental fillings. But that lack of apparent practical use — which actually grew by 49 tonnes from 1998, to total 411 tonnes in 2007 — doesn’t mean gold is useless.

You’d hardly say the European single currency holds zero value, correct? But you try fueling a jet engine or building a highway with euros today and no end of bloggers and financial hacks will step up to say your failed experiment just proves that it’s useless.

That’s why smart institutions such as the Royal Bank of Canada trade gold alongside the euro on their currency desks, rather than handing it to their commodity teams. If you think the long-term decline of the dollar is only set to grow worse, you might want to consider joining them:

As you can see, the gold price in euros has risen by more than 160 percent from its lows of 1999, even as the European currency has surged against the dollar.

The upshot? Don’t be misled by that strengthening correlation between gold and the euro. You would still have better rewarded a bearish view of the greenback in gold than in the European single currency or any other major world money. And while the euro has risen 48 percent against the dollar since March 2003, gold outpaced that gain by a further 97 percent on top.

But just before you open a new Internet window and type “Buy gold” into Google today, hang fire for a moment. Because yes, the dollar’s 12 percent loss versus the euro has somehow created a 28 percent gain for European gold investors since last August. And yes, again, the Fed’s new rate-cutting campaign still has no firm end — let alone a reverse — in sight.

But if everything’s lined up for a fresh surge in world gold prices, why did the market pull back so sharply in the middle of March? Plunging 15 percent from its new all-time record above $1,030 per ounce, the gold market now stands some $100 lower. The euro, in contrast, has risen since then. So too has the oil price.

The latest cut to Fed interest rates lopped another 0.75 percent off the gross returns paid to dollars, as well. So why the big swoon?

“This sharp reversal in price cannot be explained by a stronger U.S. dollar,” notes the team at Virtual Metals in London, writing in the April edition of Metals Monthly on behalf of Fortis Bank. “Gold’s decline measured in euros has been larger than in dollars.

“Nor can [the drop] be explained by a reduction in inflationary expectations, as this hasn’t happened,” they go on. “Instead, it seems to be narrowly based on improving sentiment in the credit markets…”

This chart “shows a close relationship since October 2007 between the gold price and the benchmark Markit CDX investment grade index, which measures the risk of credit-swap defaults,” explain Matt Turner, Gary Mead, and Jessica Cross at Virtual Metals.

In plain English, the Markit CDX measures the cost of buying insurance against nonpayment by 100 big corporate borrowers in the United States. And “As the Bear Stearns panic subsided, the index fell sharply, and so did gold.”

Meaning? Gold didn’t only surge on the Fed’s rate-cutting frenzy to mid-March. It also gained as institutional investors ran for cover amid the world-banking crisis — a crisis yet to end.

No one’s to create at will, gold is also no one’s liability — not if it’s owned outright, rather than as a mere credit on a gold dealer’s ledger. Incredibly, London professionals have told BullionVault that around 97 percent of the world’s gold dealing takes place on this kind of “unallocated” basis, attaching a real risk of default to the vast bulk of day-to-day gold trading.

Perhaps that concern explains why, alongside gold futures and exchange-traded gold trust funds, the latest GFMS analysis notes “healthy growth” in physical gold bullion investments, “mainly in allocated accounts.”

This market in late 2007 “was dominated by institutional and high-net worth investors,” the group’s Gold Survey 2008 goes on. “Many of the latter bought gold as a safe haven, soon after the subprime credit crisis erupted.”

Demand from smaller retail investors, in contrast, “grew over the year (and notably in the last couple of months), but its contribution to total investment remained marginal overall.”

In short, the mass of private investors and savers still have yet to buy gold, or even consider it. So if you were concerned that gold might be reaching some kind of bubble, you might want to consider the absence of “last fools” to date.

You might also want to note that, so far, the threat of U.S. corporations defaulting on their debt obligations has been more imagined than real. Just what happens to the price of insuring corporate risk — and the resulting dash into gold — when debt defaults really do start to turn higher?

Regards,
Adrian Ash
BullionVault
April 16, 2008

The Case for Gold was originally featured on Whiskey and Gunpowder

As the quarter unfolded, it became clear that the world’s credit system was drifting aimlessly, like a ship sailing with no wind. A lot of business that should have gotten done just did not happen, for lack of funding. Funding went away because risk aversion kicked in with a vengeance, and for a very real reason.

The last 12 months or so have been a time of re-pricing risk — and this occurred on a global scale. But the re-pricing was not orderly. The U.S. dollar was steadily drifting downward in value, and prices for most things were readjusting just on this monetary basis alone. Add to this some severe industrial disruptions, from power shortages in South Africa to floods in Australia to economy-stopping winter weather in China.

Closer to home, the downward re-pricing of risk rapidly became a collapse as flaws in the U.S. rating agency process bobbed to the surface. With so much distressed commercial paper floating around, many people were paranoid about risk. It was like the old game of “hot potato,” except nobody could pass their potatoes onto the next guy down the line.

For example, in one major presentation, I heard General Electric CEO Jeff Immelt spend a large part of his discussion defending GE’s “triple-A credit rating.” Normally, Immelt would be up there slapping the pointer against the screen and bragging about all the great products that GE makes and sells. Instead, he was busy trying to “prove a negative,” that GE does not hold bad paper in its money operations. But Immelt believed he had to defend GE’s stock price by dispelling fears of a rating markdown.

And through it all, the resulting stock market gyrations were a reflection of investor confusion about the future. Are we at the end of something good? Are we at the beginning of something bad? Is this the beginning of the end? Or is it only the end of the beginning? Really, what comes next? Will credit markets liquefy? Or will they stay dried out? Can we do business? Or should we hold tight and sit on the cash?

New York Times columnist Paul Krugman recently told Fortune “Large parts of the financial system will have to be reinvented.” And there’s no argument from me on that one. But so much of the financial system is broken that the question is where to even start.

The Flipping Industry

It is apparent that much of the old way of doing business — particularly in the realm of lending money — was rotten to the core. In my view, it begins with the dollar itself. The dollar has been steadily deteriorating in value for decades, so inflationary expectations are part of the worldwide consciousness. That is, just because of the long-term decline in the value of the dollar, most people expect most things to go up in price most of the time.

So is it any wonder that people developed a “speculation expectation”? This fed into an entitlement mentality, as well, that tainted every rung of the credit ladder. A lot of people wanted to buy and flip, whether it was houses or stocks or commodities. So other people lent to people to enable buying and flipping. Flipping became a dominant, if not defining, element of the financial “industry,” of sorts.

The Money Was Just Too Good

But what an industry! For example, in the past five years, many people just plain lied through their teeth on everything from credit card applications to mortgage applications to the lending documents for multibillion-dollar takeovers. It was pure and brazen fraud in many instances, verging on burglary in plain sight. The next level up the food chain — the brokers and loan officers — often just looked the other way and rubber-stamped the papers. “Hey, not my problem.”

This kind of bad buck-passing went all the way to the top of some firms, many with familiar names. There in the ethereal reaches of the nice office buildings in Irvine, Calif., and Fort Lauderdale, Fla. — let alone Wall Street — the chief executives knew, or should have known, how risky the portfolios were becoming.

But these corporate worthies let it happen. The pressure to “make the numbers” was too much. The money was just too good. The bonuses were too sweet. And besides, there is always the old excuse that “Everybody does it this way.” Yet it was not for nothing that the ancients defined greed as a deadly sin. At each step of the ladder of financial deceit, people just let it slide. They should have known better, and maybe they did know better.

Now looking ahead, we have a hell of a rocky road before us. And can we as a society really “regulate” our way out of that situation? Or is there a systemic problem with deeper roots? Really, what do the Furies have in store for us?

Until we meet again…
Byron King
April 8, 2008

2008 First Quarter was originally featured on Whiskey and Gunpowder

“Living in a credit era, we cannot go back to a currency era without massive upheavals.”

— Robert L. Smitley, Popular Financial Delusions (1933)

WHY DON’T WE JUST DO AWAY WITH all the different currencies of the world and settle on one single money to buy, sell, invest and light our cigars with?

Because as it is, the Babel we live in — where 143 different kinds of currency either change hands or act as a way of measuring prices around the globe — keeps finding itself in no end of trouble.

“The rupee rose on [Feb. 1],” reports Livemint, The Wall Street Journal’s Mumbai offering, “as investors bought the Indian unit for its higher yields after a hefty interest rate cut by the U.S. Federal Reserve.

“But concerns weighed that the Indian central bank would intervene against the local unit, as it is widely suspected of doing in recent months.”

“There was some suspected intervention against the Singapore dollar at 1.427,” a currency trader in the tiny Asian state told Reuters in January, “so I guess players are wary.” Across the Pacific, meanwhile, the Argentine peso has lost more than 10% of its value against the U.S. dollar over the last four years thanks to “continued central bank intervention,” says the newswire elsewhere.

And as the world’s stock markets tumbled last month, the central banks of the Philippines, Malaysia and Turkey are also rumored to have stepped into the open market, dumping their own currencies and buying the U.S. dollar in a bid to support it and thus keep their export economies cheap for foreign customers.

Put another way, as Benn Steil of the Council on Foreign Relations said at a recent meeting (or so The Washington Post reports), “The United States is exporting inflation worldwide” by forcing these sovereign nations to print up mountains of their own currency with which to buy the ailing greenback.

Countries like China and the Middle Eastern petro-kingdoms peg their currencies to the dollar — the world’s No.1 reserve currency, and still top dog after all these years. So they “thus [peg themselves] to U.S. monetary policy” too.

And U.S. monetary policy, quite clearly, is inflationary right now. That makes monetary policy inflationary everywhere from Abu Dhabi to Beijing. Even those of us lucky enough to sit outside the “dollar zone” can expect rates to slide in tandem.

Slashing almost a third off the cost of borrowing dollars inside eight days — and then offering to lend U.S. banks $60 billion in 28-day loans every two weeks — makes for quite the game of “follow the leader,” don’t you think?

Ah, but over in the dozy spires of pan-global political daydreams, abolishing sovereign currencies and anointing one single money in their place would smooth the wheels of commerce and boost world GDP overnight. Apparently.

“Annual transaction costs of $400 billion [would] be eliminated,” reckons Morrison Bonpasse, editor of The Single Global Currency (2007 edition), published by Munich University. “Global currency imbalances will [also] be eliminated,” he adds, along with “all balance of payments problems…currency crises…currency speculation…and the need for foreign exchange reserves (with a current annual opportunity cost of approximately $470 billion).”

Indeed, “Worldwide interest rates will be lower than the current average due to the elimination of currency risk” — and you’ve just got to love cheaper money!

So what’s not to like? “National currencies and global markets simply do not mix,” wrote Benn Steil in the policy wonk’s favorite glossy, Foreign Affairs, last May.

“Together, they make a deadly brew of currency crises and geopolitical tension and create ready pretexts for damaging protectionism. In order to globalize safely, countries should abandon monetary nationalism and abolish unwanted currencies, the source of much of today’s instability.”

Instability being a bad thing — the kind of thing that knocks the S&P lower by 7% inside one month, for instance — it should be abolished, right? The beautiful stability of Western Europe’s economies just goes to show how remarkable a single currency could prove:

“Spanish and Italian manufacturers are clearly struggling in the head winds of weaker global growth, the strong euro, high oil prices and eroding demand in domestic markets,” said Jacques Cailloux, economist at the Royal Bank of Scotland in London, to Dow Jones Newswires Feb. 1 after the eurozone’s Purchasing Managers’ Index for January showed a slight rise overall.

“Against this, French and German manufacturers continue to do well, at least for the time being, but German producers have failed to fully make up the pace lost last autumn.”

Why the disparity? According to most Spanish, Italian, Portuguese and Greek politicians, the cost of borrowing euros is too high. According to the latest inflation data for the 14-nation currency zone, however, it’s still way too low.

“Annual inflation in the eurozone jumped to a new high of 3.2% in January, the European Union’s statistics bureau Eurostat estimated on Friday,” reports the China Daily.

“The figure, including new eurozone members Malta and Cyprus for the first time, was the highest since the single currency was introduced to world markets as an accounting currency in 1999. It rose from 3.1% in the previous two months and stayed well above the 2% ceiling preferred by the European Central Bank (ECB) for the fifth consecutive month.”

Spain’s minister of finance, Pedro Solbes, said Jan. 24 that “there’s significant debate” inside the European Central Bank about whether or not to cut interest rates as the global slowdown looms over Europe. But then again, he faces re-election in March — and no one seemed to mind too much about interest rates being too low during the Spanish real estate bubble that began bursting last year.

Property prices nearly tripled in Spain between 1997-2007, thanks to a wave of British expats in search of a perma-tan and the sudden collapse in borrowing costs that preceded the birth of the euro in 1999. Mortgage rates went from 11% in 1995 to below 6% and then 5% as the single currency delivered the hope of German-style monetary policy and interest rates.

Across the sea in Ireland, house prices trebled in just seven short years after the introduction of the euro. But not even a peak of just 4% in the eurozone’s cost of money could keep the bubble inflating forever.

Now “Spanish banks are issuing mortgage securities and asset-backed bonds on a massive scale to park at the European Central Bank,” reports the London Telegraph, “using them as collateral to raise money at favorable rates from the official credit window in Frankfurt.

“The rating agency Moody’s said lenders had issued a record €53 billion [$78 billion] of mortgage- and asset-backed bonds in the fourth quarter of 2007, yet almost none of the securities have actually been placed on the open market. Most have been sent directly to the ECB for use in ‘repo’ operations.”

So for all its tough talk on inflation, the European Central Bank is still feeding the growth of credit and money supplies in Europe. Any wonder the broad M3 money supply is swelling at a three-decade record rate? Any surprise that consumer price inflation is surging beyond the ECB’s grasp?

And does anyone really imagine this isn’t a problem?

“Living in a credit era,” wrote Robert L. Smitley in his 1933 classic, Popular Financial Delusions, “we cannot go back to a currency era without massive upheavals. The cause of the great boom was credit expansion to an abnormal degree — the same cause as that for all booms under a credit system.”

The world’s central bankers know this all too well. Few of them, if any, believe a return to “cash only” possible, let alone desirable. So if the world’s consumers and investors choose to shut down the credit markets — both as borrowers and lenders — and pile into cash instead, then the world’s central banks will just have to destroy cash in the hope of forcing a flight back into credit.

How else would you characterize a cut of 125 basis points in the rewards paid on dollars inside eight days?

The panic starting last August — a panic that closed the West’s mortgage markets almost entirely — can be beaten by central banks buying mortgage-backed bonds themselves if need be. The stock market panic of January — a panic that knocked almost one-tenth off the value of equities worldwide — can be reversed by historic cuts to interest rates and a fresh flood of short-term loans to the banks.

Or so the central banks think. But the panic they’re then causing as a direct result — a panic revealed by the surging gold price since August — might prove worse than the flight into cash that they’re fighting:

A complete loss of faith in all official currency.

Might that lead to the one single money that daydreaming economists think can cure the world’s evils? Whatever comes when the dust settles, you can be sure the world won’t turn to using gold coins again.

Yes, Ben Bernanke’s depression theories might be disputed — and yes, his current credit inflation panic looks absurd. But history would seem to make clear that during the 1930s deflation those nations that abandoned the gold standard soonest turned the corner the fastest and began to recover.

The “barbarous relic” of tying the supply of money to a real quantity of gold bullion can’t make a comeback for as long as “deflation” and “depression” are still blamed on gold hoarders.

But that doesn’t mean you can’t hoard a little real wealth in the meantime. You might want to consider it if you’re losing your faith in government money.

Regards,
Adrian Ash
BullionVault
February 5, 2008

The Global Effect of the U.S. Dollar was originally featured on Whiskey and Gunpowder

WITH ALL EYES NOW SQUINTING at the fast-vanishing U.S. currency, it was only ever a question of “when” — not “if” — the bold and the beautiful would start rejecting the misshapen dollar.

The imperial greenback is just sooooo 20th century, darling!

“We don’t know what will happen to the dollar,” as Patricia Bundchen, sister and manager of Gisele, the statuesque and shapely Brazilian supermodel, puts it. “Contracts starting now are more attractive in euros.”

Not so fast, counters her agent at IMG Models in New York. “ Gisele does have contracts in dollars, [but] when she works in Europe, she gets paid in euros. When she works in the U.S., she gets paid in dollars…when she works in Brazil, she gets paid in reals.”

Whatever hair-pulling and hissing is going on among her people behind the catwalk, the former squeeze of Leonardo DiCaprio has now asked for euros, not dollars, in payment for promoting Dolce & Gabbana’s new perfume, The One.

Being based in Legnano, Italy, D&G no doubt had plenty of euros on hand. But Procter & Gamble? According to Veja — Brazil’s best-selling weekly magazine — Gisele has now demanded euros instead of dollars in her new contract to promote P&G’s Pantene shampoos and conditioners.

And who can blame her? In the year up to June, Gisele made an income worth $30 million to defend. If she kept that sum in dollars, then this Beauty would have already lost 8.3% of her money — in four short months — to the lumbering Beast…

Rejecting the dollar isn’t a new gambit for headline-hungry celebrities, of course.

The last time the U.S. dollar sank beneath the weight of low-yielding Treasury bonds, soaring oil prices and a looming recession, Bette Midler — the comedienne and singer — famously demanded that her $600,000 fee for a European tour in 1978 be paid in South African gold coins.

Smart move! Eighteen months later, that little mountain of Krugerrands would have been worth $2.1 million. But did Ms. Midler show more brains…if not beauty…than today’s ex-dollar superstar?

Gisele Bundchen actually seems keen to quit the U.S. altogether. (Maybe The Enquirer should tell her current beau, Tom Brady of the New England Patriots…) She cut the asking price of her New York penthouse just last weekend. Now her West Village apartment, with views of the Hudson thrown in for free, is on the market for $9.2 million — down from $10.9 million previously — according to the New York Post.

“In Tribeca,” the rag goes on, “Russian supermodel Natalia Vodianova has discounted her alluring 5,000-square-foot penthouse from $11 million to $9.9 million.”

Are the beautiful people turning bearish en masse on both the greenback and U.S. real estate? They might want to show the brains of Bette Midler…instead of the tanned midriff of Gisele…if so.

Since the dollar reached parity with the euro, for instance, exactly five years ago this week, gold priced in euros has risen by nearly 70%.

Yes, that pales next to the gold price in dollars…now more than 140% higher from this time in 2002.

And yes, “Gold is the most reliable performer as a hedge against dollar movements,” as Rhona O’Connell found in a research report for the World Gold Council last month. She compared the performance of various commodities — everything from zinc, cattle, heating oil and palladium to sugar — with the dollar’s changing fortunes on the currency market.

O’Connell’s yardstick for the U.S. dollar was an index of the world’s next five most important currencies. Gold bullion mirrored the changes in this dollar index more closely than any other physical commodity from January 2005-July 2007.

But gold is delivering much more than simply a dollar hedge. Given the political and economic barriers to raising interest rates anywhere in the world right now, you might wonder if it’s going to keep on giving, too.

Gold, so far in November, has also broken out against a whole series of other major currencies besides the U.S. dollar. Gold priced in euros just broke the top of May 2006, equal to 562 euros per ounce. The Japanese yen is trading at a 23-year low in terms of bullion. The Australian dollar — caught between being a “commodity currency” and a debt-fuelled Anglo-Saxon basket case — has just sunk to new record lows against gold.

And for British investors, gold has never been so valuable…

What to make of it? Here at BullionVault, we’ve been trying to figure out just what investors buying gold today can expect it to do for them.

Gold itself makes no promises, remember. Paying no yield or interest — and with little-to-no industrial usage, compared with silver or platinum — gold really doesn’t have very much to recommend it. Not besides the verdict of history.

The ultimate store of value and wealth for more than 3,000 years, gold is now drawing in a flood of investment cash from private individuals across the world. The proof? It’s moving fast against ALL of the world’s major currencies, not just the dollar.

We blame central bankers. And government wonks. And those investment banks that created a flood of “near money” assets at a record clip when they spied the mark of low-income homebuyers with no hope of ever repaying a mortgage.

“[Bank of England governor] Mervyn King’s effective guarantee of the liabilities of the British banking system is much more significant than declining South African gold production,” as John Hathaway of Tocqueville Asset Management puts it.

We’d add the Bernanke put, too…plus the Bank of Japan’s zero-rate madness…the Swiss National Bank’s sub-3% rates…and the eurozone’s basic political fault lines.

If you want to join Gisele, then buy euros. Thrown in for free, you’ll get the yawning gaps between Germany’s economy and the overspent, over-indebted economies of Italy, Greece, Spain, Ireland and Portugal.

If you don’t trust central bankers or government paper, on the other hand, then make like Bette Midler. Just don’t pay the extortionary dealing charges and insurance fees that buying a pile of Krugerrands will cost you.

Regards,
Adrian Ash

November 14, 2007

Beauty and the Beast? Gisele vs. Bette was originally featured on Whiskey and Gunpowder

The collapse of the “strong dollar policy” of that period formed one of the major premises of my case for gold at the time. However, by early 2005, as the currency reached my original target and began bouncing off its long-term lows, I recommended that clients no longer bet against the dollar, because I felt that the dollar would level off. Still, I wrote, gold prices were going to make their biggest move yet. As subsequent events proved, I had that one right.

Now, the gold story is this: The value of money is in danger of dropping precipitously again, and it is increasingly likely that the world monetary system will have another brush with hyperinflation akin to what occurred in the 1970s, except this time, worse.

The evidence supporting this thesis is devastating, yet this story is scarcely factored into gold values, let alone financial markets. That is, we have seen a rush to gold when the foreign exchange value of the U.S. dollar has crumbled, whenever some geopolitical boiling point has been reached, when other commodities have left the station, because the Chinese and Indian economies were heating up, and so on. But there has yet to be a significant enough deterioration of confidence in central banking institutions, or the quasi-fiat money they produce, to herald the kind of buying in which a person is “anxious to swap his money against ‘real’ goods, no matter whether he needs them or not, no matter how much money he has to pay for them,” according to Ludwig von Mises.

The evidence suggests we are headed there, but it also suggests that the most spectacular part of the bull market in gold must still lie ahead of us.

But the most interesting part about these “spectacular” moves in gold, where the market’s spotlight focuses entirely on the gold story (the greatest story never told), is the behavior of the currency markets.

What Most Investors Don’t Know About Gold and the U.S. Dollar

The biggest moves in the gold price occur when the foreign exchange value of the U.S. dollar is stable.

Did you get that? It may initially sound counterintuitive, but after reading this article, it shouldn’t.

Consider first the fact that the largest moves in gold’s free-trading history occurred in four brief periods each lasting two-three years: 1973-1975, 1978-1980, 1985-1987, and 2005-? We know that the first two of these occurred during bull markets in gold, the third one in a bear market rally, and the last one we believe to be a bull market move, which can hardly be considered arguable at this point. As a matter of fact, the two former periods and the last (current) one have something important in common — they saw the lowest (inverse) correlations with the currency. That is, they occurred when the U.S. dollar had reached some level of relative stability following a two-three year collapse in its foreign exchange rate.

Since we are still in the midst of the final period, I used the current gold and dollar price for the table, while measuring all the other periods from trough to peak.

But if we take the high in gold prices last year as our peak, the gain in gold was actually 70%, and the U.S. dollar lost just 2% in this period — instead of the 51% and 0% originally in the table — hence making it more substantial than the bear market rally of 1985-1987, when the U.S. dollar dropped more precipitously…and nothing yet suggests those trends have ended.

Since its 1971 fix, the price of gold is up some 1,750%, or 18.5-fold.

Everyone will notice the general inverse relationship between the dollar and the gold price that can be seen in the chart, but it is not a well-known fact that the gains in the price of gold that occurred in the top three bull market moves alone (shaded regions in the above data series), where exchange rates were most stable, explain nearly two-thirds of this whole move in gold prices — more than $400 of the gain from $35 to $650 — while the U.S. dollar’s foreign exchange rate fell less than 5% net.

If we apply the 1970s model to the current move that started in 2005, we would suggest that it could end in late 2007 with a run in gold prices to somewhere between $900-1,200, and the dollar might well be only a few points from where it is today when it all blows over. Both of the instances of dollar stability in the ’70s saw the most spectacular gains in the gold price, and by all counts, the same factors are at play today. Investors were surely just as surprised by it then as they will be today.

There are a lot of strong arguments for why the dollar should continue to new lows. For instance:

• It is no longer an intrinsically viable reserve currency
• China may buy fewer dollars
• The size of the U.S. trade deficit still suggests that it is cheaper to import goods than produce in U.S.
• The trend in interest rate differentials probably favors the foreign currencies in the medium term.

But these arguments may already be factored in the medium-term (three-18 months) currency outlook, and attention should perhaps be drawn to the overlooked bullish arguments favoring the U.S. dollar.

For some of these arguments have potency, yet are least considered.

Here are two very important arguments for this time horizon:

• Money supply inflation by international central banks has exceeded the Fed’s for four years
• Risk premiums have more upside adjustment in foreign currencies than in the U.S. dollar

Don’t worry if you don’t understand these things.

The main point of this article is to illustrate the historical precedent behind a potentially bullish gold price explosion, regardless of whether the U.S. dollar makes new lows or not.

The historical fact is that gold’s biggest moves occur when the U.S. dollar is relatively stable.

Now you know what few people do.

Regards,
Ed Bugos

August 27, 2007

What You Probably Didn’t Know About the U.S. Dollar and Gold was originally featured on Whiskey and Gunpowder

“The $100-a-barrel oil that Goldman Sachs Group Inc. said would prevail by 2009 may be only a few months away.

“Jeffrey Currie, a London-based commodity analyst at the world’s biggest securities firm, says $95 crude is likely this year unless OPEC unexpectedly increases production, and declining inventories are raising the chances for $100 oil. Jeff Rubin at CIBC World Markets predicts $100 a barrel as soon as next year…

“Higher prices will increase revenue for energy producers from Exxon Mobil Corp. to PetroChina Co., while eroding profit at airlines including EasyJet Plc and railroads such as Union Pacific Corp. The U.S. and other oil-importing nations risk accelerating inflation, while higher energy costs threaten to restrain growth.

“Benchmark crude oil futures ended last week at $75.57 a barrel on the New York Mercantile Exchange, up 51% since mid-January and twice the level of early 2003. A record number of options have been sold that give the buyer the right to buy crude oil at $100. The contracts, covering 50 million barrels, only pay off should oil go above the target price…

“A National Petroleum Council study led by former Exxon Mobil chairman Lee Raymond, released last week, predicted a growing gap between production and demand for oil and gas during the next two decades. As recently as 2005, Raymond said oil prices had probably peaked and dismissed the possibility that supply and demand could not be brought back into balance.

“‘There are questions about whether the oil industry can keep up with demand,’ U.S. Energy Secretary Samuel Bodman said last week, commenting on the Petroleum Council report.

“Gasoline pump prices averaging more than $3 a gallon across the U.S., the consumer of 25% of the world’s oil, haven’t dented sales. Deliveries of gasoline were a record 9.23 million barrels a day in the first half of this year, according to a July 18 report from the American Petroleum Institute in Washington.

“‘It appears that high prices are acceptable to the American consumer,’ said Robert Ebel, chairman of the energy program at the Center for Strategic and International Studies in Washington. ‘People want the house with a yard and white-picket fence so they are moving further and further out of the cities. They have to just get up earlier and drive further’…

“Oil prices could triple in three months, to more than $200 a barrel, given the right circumstances, according to Matthew Simmons, chairman of Simmons & Co., a Houston investment bank…

“A pullout from Iraq may be the event that pushes oil to $100 a barrel, according to Boone Pickens, the Dallas hedge fund manager who has joined Forbes magazine’s list of billionaires because of his bullish bets on energy prices. Pickens predicted a year ago that $100 oil would probably occur by now. Today he is looking for $80 within six months, and he says growing chaos in Iraq would be a bad sign. ‘That could run prices pretty high,’ he said.

“Goldman Sachs’s Currie also notes similarities to a year ago, with global inventories at about the same level and U.S. government data showing an increasing bet on higher prices.

“‘At face value, this market is strikingly similar to a year ago,’ Currie said. ‘What is different? Supply is down a million barrels a day, demand is up a million barrels a day. The market is in a deficit.’”

If Bush is dumb enough to invade Iran, $200 could come in a hurry. But the idea that oil surges on a U.S. pullback from Iraq is debatable. The sooner we leave Iraq, the sooner Iraq will recover (I might add, just as Vietnam did), and the less jet fuel we will be wasting on needless missions.

Could there be a short-term spike when we leave Iraq? Perhaps, but the long-term benefits of us getting the hell out will be enormous.

Gasoline Demand Is Inelastic

It’s not so much that “high prices are acceptable to the American consumer,” but that the demand for gasoline is relatively inelastic. Consider the plight of taxi drivers and the Chicago Tribune article “Pinched Taxi Drivers Hope to Fare Better by Organizing”:

“His fares for the last two days were dismal, and now halfway through the day, Khalid al Hag had only $20 in his pocket.

“At this rate, he figured he would have to dip into savings to make his $520 weekly payment to the cab company for use of the car.

“‘I’m going to have to work at least 12 or 14 hours today and still I won’t get by,’ he said, gulping down a meal so he could get back into his cab, which lately he has been driving seven days a week.

“Other cabbies — independents who have to pay out of their pockets for gasoline and other expenses and benefits — flitted through the restaurant with the same laments. At $3.46 for a gallon of regular gas, high fuel prices are swallowing their thin profit margins…

“The drivers’ distress is why [Prateek Sampat, head of a taxi worker organizing project] thinks an effort to organize many of Chicago’s nearly 11,000 cab drivers, including 2,500 who own their own cabs, will succeed. Similar efforts are ongoing across the country.

“The organizing efforts are more of a cry for rights and recognition waged largely on behalf of thousands of immigrants who have quietly slipped behind the steering wheels of most of the nation’s cabs.

“Why are cabbies the focus of organizing efforts? Taxis are today’s Ellis Island for many immigrants, statistics show. And cab driver is the first line of work in the U.S. for many without good language skills and without credentials to land easier, safer, and better-paying jobs…

“The last fare hike in Chicago was in 2005. Soon after that, Chicago ranked 18th out of 23 cities in the U.S. for the price of an average cab ride, according to an industry study that city officials said still is relevant.

“The organizers presented figures compiled from a handful of drivers, showing that the drivers were spending an average $44 a day on gas last month and were earning $6 an hour when all of their expenses were deducted.

“But Ald. Thomas Allen (38th), chairman of the Committee on Transportation and Public Way, said he doesn’t sense any support within the City Council or from city officials for a surcharge. ‘Gas prices have kind of settled,’ he added…

“‘Every day when I go home, I ask myself the same question, “When am I going to stop being a cab driver?” And every day I say I’m going find something better, but I can’t,’ grumbled Omar Shire, 29, a Somali refugee, who has been driving for the last three years in Chicago…

“‘I work 14 hours a day, seven days a week. That’s all I do,’ he said, his voice rising in anger, his eyes wide. The city does not limit how many hours cabbies can drive.”

Is there a real choice here? The bottom line is you have to drive and you have to eat. While one can cut back eating expenses by switching from steak to hot dogs, there is no cheaper substitute for gasoline.

Monthly Crude Trendline Still Intact

The weekly chart has had a few busted trendlines, but the monthly still looks great:

Those watching crude may also be watching the U.S. dollar index and the yen versus the dollar.

Let’s take a look.

U.S. Dollar Index

Yen vs. U.S. Dollar

Forex traders will note that the chart of the yen versus the dollar is inverse of normal trading pairs.

It’s now do-or-die for both the U.S. dollar index and the yen versus the U.S. dollar. Both currencies have been anemic lately, compared with anything else. The U.S. dollar is on the verge of collapse, and the yen is at lows compared with the British pound and the euro.

With trillions in carry trade bets riding on the outcome, the impact of a major breakdown in either currency could be very significant. Out and out disasters are most often in the direction of the prevailing trend. Here, two competing losers also are going head to head. Resolution should come soon. The U.S. dollar is going to eventually break hard but one must be on the lookout for a major headfake with all the stops in too obvious places.

Regards,
Mike Shedlock ~ “Mish”

July 24, 2007

Is $100 Oil Coming? $200, Anyone? was originally featured on Whiskey and Gunpowder

The answer comes from the San Francisco Fed in an article entitled, “Interest Rates, Carry Trades, and Exchange Rate Movements”:

“What is the carry trade?

“In the most common version of this strategy, an investor borrows a given amount in a low-interest-rate currency (the ‘funding’ currency), converts the funds into a high-interest-rate currency (the ‘target’ currency), and lends the resulting amount in the target currency at the higher interest rate…

“According to economic theory, an investment strategy based on exploiting differences in interest rates across countries should yield no predictable profits. Consider two countries, one with a high interest rate, and the other with a low interest rate. According to another equilibrium condition of international financial markets called the ‘uncovered interest parity,’ the difference in interest rates between the two countries simply reflects the rate at which investors expect the high-interest-rate currency to depreciate against the low-interest-rate currency. When this depreciation occurs, investors who borrowed a given amount in the low-interest rate currency and then lent it in the high-interest rate currency will find that their return is worth less. The uncovered interest parity condition implies, indeed, that investors should expect to receive no profits, as they should expect the return from lending in the high-interest-rate currency to be worth ultimately as much as the cost of borrowing in the low-interest-rate currency.

“In practice, however, investors in international financial markets do seem able to make profits through such strategies…

“Empirical evidence shows that currencies that are at a forward premium and that, correspondingly, have a low interest rate, actually tend, on average, to depreciate, not appreciate, as the theory of interest parity conditions predicts…Similarly, currencies that are at a forward discount and that, correspondingly, have a high interest rate, tend, on average, to appreciate, not depreciate. This anomaly, then, implies that an investor who enters a carry trade is quite likely to make predictable profits from two sources: the interest rate differential between two currencies and the appreciation of the high-interest rate currency that was originally bought at a forward discount.”

Referring back to the COT numbers on the yen from Part I…they might seem huge. After all, $13,212,986,904 bet on shorting yen futures sure looks like a big number, but in all likelihood is peanuts in the grand scheme of things. Expressed as $13.2 billion, it seems much smaller. Please consider Brad Setser’s excellent article, “A Trillion Dollars Gets My Attention, Whether It Comes From the PBoC or the Yen Carry Trade”:

“Tim Lee, of Pi Economics, reckons as much as $1 trillion may be staked on the yen carry trade. Were the yen ever to rise sharply (making the trade unprofitable), there could be hell to pay in the markets…

“I suspect Gillian Tett would be far better positioned to guess the actual size of the yen carry trade than most. Her excellent FT article spells out the various ways cheap yen have influenced global markets — and not just the obvious ones.

“Just how large the carry trade is, nobody really knows… But whatever the precise number, what is clear is that carry trades have been fueling the dash into risky assets in the past couple of years.

“After all, with Japanese interest rates at rock bottom and the yen on a downward path, it has been frighteningly easy for any hedge fund to borrow in yen, invest in something yielding, say, 5% a year, apply a bit of leverage and — hey, presto — produce returns of 20%, or more. Conversely, if an investment bank wants to create a collateralized debt obligation but cannot sell the riskiest debt tranche, it can put this on its own books — funded by ultra-cheap yen. The yen has thus been tantamount to the ATM of the global credit world — spewing out (almost) free cash.

“There is nothing like borrowing in a depreciating currency to buy the equity tranche of a CDO in a world where there are virtually no defaults. No wonder investment banks have been so profitable.

“Of course, the biggest carry trader of them all is the Japanese government. It borrowed a lot of yen to buy something that yielded a bit under 5% a few years back…

“That trade has paid off. Big Time. The MoF borrowed in depreciating yen to buy appreciating dollars — and got a bit of carry in the process. And the MoF did it on a truly enormous scale.

“A private investor might even want to start to take some profits…

“Bottom line: A ton of people — the Japanese government and Japanese ‘real money,’ as well as the leveraged community — are short yen and long higher carry currencies at a time when the yen is very, very weak by most historical standards.”

In September 2006, MarketThoughts.com had an interesting article called “The Yen Carry Trade Revisited”:

“The second great yen carry trade began in the summer of 1995 and it did not end until October 1998 — when the yen ended its decline by rising 15% in a week…

“As for the current yen carry trade, there is little evidence to believe that much of the borrowed yen went into commodity speculation — as the decline of commodity prices in the last four months has generally not led to a higher yen. More likely, the typical profile of the latest yen carry trade participant is as follows:

“1. A speculator who borrows or shorts yen and use the money to invest in a higher-yielding asset (usually government bonds or CDs) in the U.S., U.K., or countries in the euro zone. The days of using this money to invest in higher-yielding countries in ‘peripheral’ developed countries like Iceland and New Zealand has definitely ended — given the crash in both of these currencies earlier this year.

“2. A Japanese investor (e.g., a pension fund, a life insurer, or an individual investor) who converts his money from yen to U.S. dollars (or the euro or the pound, etc.) in order to invest in Treasuries or overseas real estate. Note that this position is usually unhedged — which again puts further pressure on the yen.

“Quoting the IMF’s ‘Financial Stability Report’:

“‘The evidence that Japanese domestic investors conducted a form of the carry trade by seeking higher returns overseas is quite strong. Domestic institutions, such as life insurers, effectively engaged in the carry trade by purchasing foreign bonds to support yen-denominated liabilities, often on an unhedged basis. Net purchases of foreign bonds by life insurers totaled 848 billion yen ($7.4 billion) in 2005. Individual investors — particularly wealthier retired households — shifted a share of wealth away from bank deposits or other low-yielding yen investments, toward foreign bonds or investment trusts explicitly tied to foreign bonds (see the first figure). At its peak in late 2005, the money flowing into foreign bond funds exceeded 5 trillion yen over the trailing 12-month period, equivalent to about 1% of GDP’…

“Positioning on yen futures contracts also points to the existence of an offshore yen carry trade. Data from the Chicago Mercantile Exchange show noncommercial traders (predominantly financial players) moving from net long to net short yen positions in early 2005, and staying net short until the end of April 2006… [Mish Note: Speculators are hugely short yen futures again, as discussed above.]

“So the $64 trillion question is this: When will the yen carry trade end? On a purchasing power parity basis, the yen is undervalued against the U.S. dollar, but massively undervalued against the euro. That being said, things can always get more extreme before reversing — especially when it comes to the financial markets. Drawing a tentative uptrend line from the previous lows in the yen in early 1990, October 1998, and early 2002, one gets a target range of approximately US$0.78-0.82 (for every 100 yen) before we see the yen bottoming. But in all likelihood, it will need some kind of trigger. Just what is that trigger? I will discuss more about this as we approach the US$0.78-0.82 range and my preferred time frame (later this year), but for now, I am guessing lower-than-expected economic growth in Western Europe as the revision of the German VAT comes into play, starting Jan. 1, 2007. Historically, a goods and services tax has always meant a stronger-than-expected economic slowdown, and the German economy will be no different — despite the prevalent optimism among the German government at this point.”

So now we have Japanese life insurers speculating in the carry trade. Isn’t that special? One possible answer to the “$64 trillion question” (When will the yen carry trade end?) is that these things always seem to go on much longer and get more insane than any rational person deems likely. Such thinking suggests a possibility that the trendline break in the yen (as noted in Part I and repeated below) is a real one. Those following along carefully will note that is the opposite of what I suggested in Part I in reference to the COT data (i.e., an unwinding of the futures positions is dollar negative on balance).

Yen/U.S. Dollar (Monthly)

Fundamentals

• All fiat currencies eventually head to zero. The only difference is the length of time it takes to get there
• Gold has never gone to zero, and barring a Star Trek-like replication device or nanotechnology that can easily combine atoms to make elements, gold is not likely to head to zero, either
• In the meantime, the biggest factors that determine relative worth of currencies seem to be interest rate differentials, expansion of money and credit, and foreign direct investment. The much ballyhooed trade deficit is far down the list
• When it comes to the yen, the interest rate differential between Japan and the U.S. or Japan and Great Britain is substantial
• Japan is also sitting on a national debt of 150% of GDP. What that will do to interest payments if rates rise rapidly should be obvious. The implication is Japan may have to raise taxes substantially smack in the face of poor demographics (shrinking population). Japan has lots of reasons to resist hiking rates. That is yen negative
• Europe has demographic problems of its own. Europe also has a very rapid expansion of M3, but a much lower interest rate than the U.S’s. That is euro negative versus the U.S. dollar
• Great Britain has a housing bubble of its own and will undoubtedly burst at some point. This should put pressure on the pound, as expected rate hikes in the U.K. may not occur.

Everyone has a tendency to look at problems in the U.S. in isolation. As you can see, the issues are both many and complex. There are a lot more to currencies than the one-sided view often heard that “The U.S. dollar sucks.” This post is an attempt to look at things from as many angles as possible.

From a purely technical standpoint, I would have to suggest “Trust the trendline breaks on the charts.” From the standpoint that things almost always get crazier than anyone thinks, I am inclined to believe the yen is likely to sink further and then whipsaw massively. I suggested this quite some time ago and so far have been correct. From the explosive potential of the unwinding of the carry trade, one should be watching those charts carefully.

From a political standpoint, I am rather unimpressed with Paulson even as others seem to be going gaga just because he is “watching very, very carefully.” From the standpoint of the U.S. dollar in and of itself, things do not seem as bad on many standpoints as most seem to think, especially in relation to the Euro. Ultimately, however, the fate of the dollar may depend on the timing, magnitude, and swiftness of the unwinding of the carry trade, and from what level that unwinding occurs. Taking quick action should something go wrong with whatever you are doing (in whatever direction you are doing it) seems like the best advice at this juncture given that the situation is potentially explosive in both directions.

Regards,
Mike Shedlock ~ “Mish”

February 13, 2007

Focus on Currencies, Part II was originally featured on Whiskey and Gunpowder