Predictions in the Gold Market

Since 2002 we have argued in these pages that: (1) the world's developed economies were floating on an historic sea of credit which was mimicking an economic boom; (2) the credit bubble would burst; (3) the result would not be a deflationary bust because central bank policy would be to expand the money supply and weaken currencies rather than allow a pandemic of defaults; and (4) financial assets and fiat currencies would suffer a crippling loss of confidence, making gold the best performing asset of the next decade or more.  

We were early, but gold rewarded us while we waited.  Our first three predictions came to pass by early 2009 but we were surprised by the resilience of the financial system (or is it blind inertia?). Confidence in the dollar remains a cornerstone of the system, faith in a US economic recovery has persisted, Treasuries remain the safe haven of choice and the Federal Reserve's balance sheet has stabilized after a massive run up in 2008-11. Gold has therefore responded with a nearly one year long correction which, we believe, is about to end with a bang.

The world economy is now clearly slowing down and recessions appear to be imminent in the developed economies. If this oncoming recession was due to deleveraging ...the necessary corrective for a world smothered in debt...the slowdown would at least have some benefit. But overall debt levels have continued to rise despite all the talk about austerity in Europe and a higher savings rate in the U.S. Fiscal discipline is as elusive as ever, with fiscal cliffs looming not only in America but also throughout Europe, as tax revenues fall faster than spending reductions.

The central banks of Japan, Britain and Switzerland have voted for inflation of the money supply to weaken their currencies and promote 'growth', especially exports. China has long been on this same path with its dollar peg. We now expect to see the Federal Reserve and the European Central Bank (ECB) jump into the fray with both feet, unleashing a tidal wave of new, unsterilized money creation. The argument now being advanced for such a move is that it is a growth strategy, based on the wrong theory that more money stimulates the economy, enabling it to outgrow the debt burden. Also, governments will likely be blamed for making the money printing necessary because they did not exercise fiscal discipline. However, we believe the real motive will be to avoid default on sovereign and secured corporate debt, thereby saving the banking and financial system one more time by propping up the nominal value of next-to-worthless assets. As we have long predicted, decisions are being made in favor of inflation, negative real interest rates (financial repression) and rampant speculation - decisions that are opposed to default, deflation and the real value of savings.

Clear Messages

On August 1, 2012, the Federal Reserve's Open Market Committee reported on its latest monetary policy deliberations and, at first glance, the FOMC appeared to have done nothing new other than further downgrade the U.S. economy. However, there was a key difference in how the FOMC ended its statement.

Back in June, the FOMC statement read:

The Committee is prepared to take further action as appropriate to promote a stronger economic recovery and sustained improvement in labor market conditions in a context of price stability.

The August 1 statement read:

The Committee will closely monitor incoming information on economic and financial developments and will provide additional accommodation as needed to promote a stronger economic recovery and sustained improvement in labor market conditions in a context of price stability.

In our view, this language of "will provide" strongly implies future action. In short, this seems to us to be a promise to take action, perhaps as soon as the FOMC's September meeting, if the economy and labour market do not improve significantly. We expect more, unsterilized Quantitative Easing (QE).

We have been treated to a great many silly statements about plans to address the credit crisis in Europe. They have all turned out to be lacking in reality for one key reason...Germany did not agree. The ECB's statement of August 2, 2012 is different because this time Germany does agree. Agree to what?

• The ECB has a mandate to undertake QE. The ECB is able to buy sovereign debt under its existing mandate in order to repair the monetary policy transmission mechanism.
• The sovereign whose debt is to be purchased must first enter into an agreement with the European Stability Mechanism (ESM, successor to the EFSF) requiring measures to reduce deficits.

The ECB's statement of August 2 said in part: "The Governing Council extensively discussed the policy options to address the severe malfunctioning in the price formation process in the bond markets of euro area countries. Exceptionally high risk premia are observed in government bond prices in several countries and financial fragmentation hinders the effective working of monetary policy. Risk premia that are related to fears of the reversibility of the euro are unacceptable, and they need to be addressed in a fundamental manner. The euro is irreversible.

"The adherence of governments to their commitments and the fulfillment by the EFSF/ESM of their role are necessary conditions. The Governing Council, within its mandate to maintain price stability over the medium term and in observance of its independence in determining monetary policy, may undertake outright open market operations of a size adequate to reach its objective. In this context, the concerns of private investors about seniority will be addressed. Furthermore, the Governing Council may consider undertaking further non-standard monetary policy measures according to what is required to repair monetary policy transmission. Over the coming weeks, we will design the appropriate modalities for such policy measures."

The meaning seems clear. The ECB intends to proceed with QE (termed "outright open market operations") and will do so by buying government bonds.  Not only that, other "non-standard measures" that have not yet been tried may be adopted as well, all in the name of "repairing monetary policy transmission"...getting the ECB back in the game of manipulating interest rates. Before the ECB intervenes, the countries concerned will have to ask the ESM for help. This in turn implies that the countries concerned will have to relinquish some of their fiscal sovereignty. The ESM is still to be ratified by the German parliament which is why this new program has not yet been implemented. Ratification has been scheduled for September, 2012.

On August 6, 2012 the Financial Times reported that "the European Central Bank is acting within its mandate when considering further government bond purchases, a spokesman for the German government said on Monday. 'The government has no doubts that everything the ECB does is within its mandate,' German government Spokesman Georg Streiter said during a press conference, adding that the government approves of the ECB's crisis actions."

Skeptics will declare that, German approval notwithstanding, we have heard this all before...we will believe the money-printing when it happens. Under the ECB's poorly reported (secretive?) Emergency Lending Assistance program (ELA), euros are already being printed off balance sheet by national central banks with the approval of the ECB, to support the poorest credit risks. According to figures compiled by Citigroup, Ireland has made constant use of this facility since 2008 with the Irish central bank printing between €40 and €60 billion since 2010. Most recently, Greece has also resorted to the ELA to the tune of about €55 billion...a completely different use of the facility than the one originally intended. In our view, there can be no mistaking the direction of the ECB.

This Is Going to Be Big

As already noted, the rationale being advanced for QE is to promote growth but we see the real motive as saving the financial system...the debt markets and the banks. The fulcrum is the sovereign debt market which must be defended at all costs if the financial system is to survive in something like its current form. So, how much are we talking about here? Hang on to your hats.

According to the PFG Group, a U.S.-based financial advisory, the 10 most indebted nations currently owe $31.3 trillion and "nearly 50% of the total outstanding debt of the world's top 10 debtor nations needs to be rolled over by the end of 2015." (see http://www.financialsense.com). Financial markets are currently focused on Spain and Italy but while Italy has a debt-to-GDP ratio of 120%, Japan takes the top spot with 208%; and while Italy currently has a budget deficit to GDP ratio of -3.9%, the US is far worse at -8.1%. As the chart below shows, this is a global problem.

More than US$ 15 trillion of sovereign debt has to be rolled over from 2012 through 2015, never mind the trillions of dollars in new borrowings required by sovereigns (deficits continue), banks and corporations. We believe there is simply too much debt maturing over the next couple of years for capital markets to absorb without pushing up rates and crowding out private investment. Commercial banks, especially those in Europe, are already loaded up with sovereign debt and need to reduce their leverage.  In our view, it is highly likely we will see QE on a global scale. Central banks will need to step up as buyers of last resort to help suppress interest rates and keep debt servicing costs low.

As serious as the roll-over problem is now, as indicated by the above chart, it grows worse by the day. Many sovereign issuers are aggressively reducing the average duration of their outstandings to bring down interest costs. Many of the roll-overs in this table will be for short terms, therefore needing to be rolled again in the near future. The ECB has also indicated that its planned bond purchases will focus on the short end of the curve.

Is There an End Game?

Not anytime soon. At some point, the consequences of money-printing will become evident and we believe it will come to an end, accompanied by an increased likelihood of serial defaults. Paper is only as good as the entity behind it making the promise. In this hyper-connected world, paper is only as good as the entities owing money to the entity making the promise. As we saw in 2008, the innovations of shadow banking and the derivatives system have intermeshed the balance sheets of companies to a never-before-seen extent.  One failure like Lehman Brothers can trigger a counter-party cascade that threatens the entire system.

In our view, gold will perform very well in a period of aggressive central bank balance sheet expansion. But as the one asset that backs itself and has no counter-party risk, gold may have its greatest value when the music stops. If you own debt-based assets at that point, you may be lucky enough to get a government bailout or a payout from a bankruptcy court.  But gold investors won't need either and gold companies will offer their shareholders the advantage of holding the world's most reliable asset on their behalf.