The Collapse of the Historic Credit Bubble

As we have argued for many years, the world economy has been in the grip of an historic credit bubble. This bubble is now collapsing faster than we could have imagined, thanks in large part to the erratic policies of the U.S. Treasury and Federal Reserve who saved a number of institutions from bankruptcies before inexplicably losing their nerve on Lehman Bros., much to the detriment of confidence in the world financial system. Deleveraging of the private sector is now proceeding at a rapid pace in parallel with an unprecedented acceleration in the growth of public sector leverage.

How has gold performed in this extraordinary environment? On the one hand, it has outperformed commodities and it is up for the year against most major currencies. But, on the other hand, it has disappointed many of us in the gold sector who had anticipated and planned for a financial and economic environment similar to the one we are now in.

Why is the gold price not higher? In our view, there are three main reasons, each of them short-term in nature -- forced liquidation, a strong US dollar and growing fears of deflation.

Liquidation of massive holdings in commodities (including gold) by hedge funds and commodity funds which began in July of this year is continuing although it is probably nearing its end. These speculators used immense leverage to bet on inflation, financed by short positions in the preferred funding currencies -- the U.S. dollar and the Japanese yen. As these positions moved against them, forced selling began which fueled more of the same. Credit contraction for the speculators led to margin calls. The evidence is in the open interest for gold on COMEX which is down over 40% from the highs and now back to levels of two years ago when the inflation trade became popular. The gold price will ultimately benefit as the excess leverage is run out of the system but the short term impact has been very negative.

Second, the U.S. dollar screamed upward from July through October, primarily the result, in our view, of an historic short squeeze. Because of its depth of market, low interest rates and downward price trend, the U.S. dollar was borrowed and sold to finance speculations in developing markets and commodities. As these trades unwound, the dollar was bought aggressively. The trend reversal was strengthened by a flight into dollars by investors fearing a collapse of the global banking system and the ravages of deflation. These investors bought the hugely-liquid short end of the U.S. treasury market. Essentially, the dollar replaced gold as a safe-haven investment.

Finally, many investors now fear that we are entering a deflationary period when cash will outperform other investments. In part, this thinking reflects the widespread confusion that equates asset deflation and debt default with monetary deflation. Falling asset prices do not reduce the money supply nor does debt default. It is true that deleveraging in the form of debt repayment does reduce money supply if the lenders involved do not re-lend. But we at Seabridge have an abiding faith in the ability of central banks to re-inflate the money supply and expand credit in a fiat monetary system. Once inflation expectations are reignited, investors will be forced out of treasuries and cash.

The efforts of the Federal Reserve and other central banks could not be clearer. While they talk about deflation, they are engaged in inflating the monetary base at extraordinary and unprecedented rates using a bewildering array of indirect and direct lending programs. The balance sheet of the Federal Reserve grew to US$500 billion from 1913 (when the Federal Reserve was created) to 1997, a period of 84 years. The second increment of US$500 billion was added to the Federal Reserve balance sheet from 1997 to September 1, 2008, a period of 11 years. The third US$500 billion increment was added in September of this year and the fourth US$500 billion was tacked on in October. The Federal Reserve balance sheet now totals more than two trillion dollars which equates to the adjusted monetary base for the United States. Less than ten percent of the Fed’s balance sheet now consists of U.S. treasuries compared to the historic average of nearly 95%. This deterioration in the quality of the Fed’s balance sheet will weaken the U.S. dollar over time.

Much of this increase in the Fed’s balance sheet has been injected as bank reserves. Will the banking system lend this money into the economy? We are convinced that the profit potential will prove irresistible, likely beginning with the purchase of quality corporate debt which is now paying historically high spreads above treasuries. This will move cash into the economy. We also expect that the Federal Reserve will be forced to purchase treasury debt with newly created dollars because the U.S. Treasury will not be able to sell enough debt to other investors to finance all of its bailouts and because the Fed is nearly out of treasuries itself having swapped them for junk debt from the banking sector. Monetizing treasury debt will rightly be perceived as highly inflationary.

Some economists assume that the Federal Reserve will attempt to recover the excess liquidity it has created as soon as it is not needed. We do not see how this will be possible anytime soon given the weakness in the financial system and the overall economy. We believe that it is the intention of the Federal Reserve and other central banks to prevent massive defaults and catastrophic unemployment by inflating the money supply. We are confident they will succeed and that inflation will be evident as soon as next spring. As inflation takes hold, private deleveraging will slow and possibly reverse as speculators try to find offsets to the declining value of money. In our view, the first asset to benefit from perceptions of inflation will be gold and the common equity of those companies that hold it.

Report to Shareholders (excerpt)

November 13, 2008