Why Isn’t Gold Acting Like a Safe Haven—Yet? War, Liquidity Stress, and the Fracturing of the Bullion System (Part I)

 

Nations have scoured the earth for gold in order to control others only to find that gold has controlled their own fate. The gold at the end of the rainbow is ultimate happiness, but the gold at the bottom of the mine emerges from hell. Gold has inspired some of humanity's greatest achievements and provoked some of its worst crimes. When we use gold to symbolize eternity, it elevates people to greater dignity—royalty, religion, formality; when gold is regarded as life everlasting, it drives people to death—Peter L. Bernstein 

In this issue

Why Isn’t Gold Acting Like a Safe Haven—Yet? War, Liquidity Stress, and the Fracturing of the Bullion System (Part I)

I. The Muted Signal

II. Two Gold Markets

III. The Clearing Infrastructure

IV. When Logistics Stress Becomes Financial Stress

V. The Collateral Squeeze

VI. The Dollar as Lightning Rod

VII. Fragmentation, Not Failure

VIII. What the Quiet Is Actually Saying

VIIIA. Post Script: "There is No Haven" 

Why Isn’t Gold Acting Like a Safe Haven—Yet? War, Liquidity Stress, and the Fracturing of the Bullion System (Part I) 

Oil is surging, the dollar is rising—and gold isn’t responding. The explanation lies in liquidity stress, collateral dynamics, and the plumbing of the global bullion system.

I. The Muted Signal 

Long regarded as a safe haven, gold is expected to shine in times of crisis—particularly amid geopolitical shocks such as the escalating tensions surrounding the U.S.–Israel–Iran conflict.

Yet as instability deepens in the Middle East, a curious divergence has emerged. Oil prices have surged, and the U.S. dollar has strengthened, but gold has remained conspicuously subdued. 

For many observers, this raises an uncomfortable question: has gold lost its safe-haven status? 

The answer is almost certainly no. What we are witnessing instead is a familiar—but often misunderstood—dynamic in times of financial stress. Gold does not operate within a single, unified market responding to a single force. Rather, it exists at the intersection of multiple systems—monetary, financial, and physical—each reacting differently under pressure. 

To understand gold’s apparent silence today, one must move beyond the simplistic safe-haven narrative and examine the underlying mechanics of how crises actually unfold. 

II. Two Gold Markets 

Gold is not a single market. It is two markets operating simultaneously. 

The financial layer consists of futures traded on COMEX, forward contracts cleared through the London bullion system, and gold ETFs. Prices here move primarily in response to macro variables: the dollar, real interest rates, and shifts in global risk sentiment.

Figure 1

The resurgence in global gold ETF flows early in the year highlights the responsiveness of this financial layer to momentum, liquidity, and broader macroeconomic signals. (Figure 1, upper chart)

Unlike physical markets, positioning here can expand rapidly and at scale, without the need for underlying physical settlement, largely unconstrained by the frictions of moving and storing metal. Yet this flexibility stands in contrast to the more constrained and regionally fragmented nature of physical gold markets—a divergence that becomes evident when comparing pricing across Shanghai and London. 

The physical layer operates very differently. It consists of doré bars produced by mines, bullion refined in Switzerland, jewelry demand across Asia, and steady accumulation by central banks. This layer depends on transportation networks, refinery throughput, vault logistics, and customs clearance. 

Even at the level of demand, gold is not unified. As shown by the World Gold Council, demand is structurally divided across investment, jewelry, and industrial uses—each driven by distinct economic forces and time horizons. (Figure 1, lower graph) 

Figure 2

Rather than moving in lockstep, Shanghai and LBMA pricing in early 2026 oscillated between premium and discount. This back-and-forth reflects a market where arbitrage is active but not seamless—revealing, in practice, the dual structure of gold as both a financial asset and a physical commodity. (Figure 2) 

Under normal conditions, arbitrage keeps these two layers aligned. When physical premiums emerge in Asia or the Middle East, traders move gold to capture the spread, transmitting local signals back into global benchmarks. But when logistics slow or uncertainty rises, that alignment weakens. Physical markets may tighten even as financial benchmarks remain anchored to macro forces. 

III. The Clearing Infrastructure 

The global bullion system relies on a relatively concentrated infrastructure. 

London dominates price discovery through the clearing system associated with the London bullion market, while Switzerland refines a large share of the world’s doré into internationally tradable bars. Logistics hubs in the Gulf, in turn, connect African supply with major consumer markets in Asia. 

This network typically functions smoothly because gold flows continuously between these nodes. 

Figure 3

In effect, the bullion system operates as a hub-and-spoke network: Switzerland serves as a dominant refining center processing a substantial share of global supply, while London anchors pricing and clearing. This concentration enhances efficiency, but also creates critical points of vulnerability. 

When transport routes are disrupted or regional stability deteriorates, those vulnerabilities become visible. 

Geopolitical tensions in the Middle East have begun to complicate these flows. Even partial restrictions on cargo routes or airspace can slow the movement of metal between mining regions, refineries, and end markets. 

In a system where arbitrage depends on the physical movement of bullion, even modest friction does not simply delay flows—it weakens the transmission of price signals between markets. 

IV. When Logistics Stress Becomes Financial Stress 

Disruptions in the physical gold market rarely remain isolated. 

When the movement of metal becomes uncertain, arbitrage trades that normally link markets turn riskier. Traders who once relied on seamless transfer between regions suddenly face basis risk, as the cost and timing of moving bullion becomes unpredictable. 

Clearinghouses respond in the only way they can: by demanding additional collateral. Margin calls follow. 

To meet these calls, participants often liquidate the most liquid assets available—typically dollar-denominated instruments. 

What begins as a logistical friction in the physical market thus propagates into the financial system, triggering a collateral-driven tightening that can ripple across broader markets. 

Disruptions in the physical market do not remain isolated. 

V. The Collateral Squeeze 

Gold occupies a unique position in global finance. It is simultaneously a commodity, a reserve asset, and a form of high-quality collateral used across derivatives, repo agreements, and bullion banking. During periods of market stress, this collateral role can temporarily dominate its safe-haven function. 

Three mechanisms typically drive this dynamic: 

• Forced liquidation. Institutions facing margin calls sell the most liquid assets available. Gold is often among the first assets sold—not because confidence in it has vanished, but because it can quickly raise cash. 
• Haircut widening. When volatility rises, clearinghouses increase the discount applied to gold posted as collateral. Positions that were previously adequately margined can suddenly require additional coverage, forcing further liquidation 
• Tightening in the gold lending market. Bullion banks regularly lend gold through swaps and leases. Under stress, these channels can constrict as counterparties become more cautious. 

A current illustration of these dynamics comes from Dubai. Recent reports show that shipments of gold have been delayed due to regional logistical bottlenecks, rising insurance premiums, and higher financing costs amid Middle East tensions. 

Physical gold that is stuck or delayed can be sold locally—often at a discount—to meet liquidity needs even while global confidence in gold remains intact. This episode demonstrates how frictions in the physical market can amplify financial pressures, turning bullion into a source of immediate cash rather than a stable safe-haven. 

These collateral-driven dynamics are not unprecedented. Similar patterns emerged during the global financial crisis, the European sovereign debt crisis, and the market dislocations of 2020. In each case, gold initially weakened during the liquidity phase of the shock before later reasserting its safe-haven role. 

Financial instability theorist Hyman Minsky argued that crises often begin with a scramble for liquidity, forcing investors to sell even high-quality assets to meet obligations. Gold’s early weakness during crises—including today’s Dubai example—fits squarely within this pattern. 

VI. The Dollar as Lightning Rod 

A common explanation for gold’s weakness is that investors fled into U.S. Treasuries, strengthening the dollar.

Figure 4

The broader market picture suggests something different. Bond markets have not been rallying strongly. To the contrary, yields across many sovereign markets have risen as investors reassess inflation risk and fiscal sustainability following the oil shock. (Figure 4, upper image) 

The dollar’s strength reflects another mechanism. The global financial system is largely funded in dollars. (Figure 4, lower diagram) 

When volatility rises and leveraged positions unwind, institutions need dollars to meet margin calls and settle obligations. 

Capital flows into the dollar not necessarily because it is safe, but because it is required. The dollar therefore acts less like a haven and more like a lightning rod for global liquidity stress. 

Recent market behavior reinforces this dynamic. Episodes of rising dollar demand have coincided with sharp declines in gold prices and tightening cross-currency funding conditions—an indication that global markets are paying a premium to access dollars. 

These moves suggest that what appears to be gold weakness is in fact a symptom of a broader liquidity squeeze, in which institutions sell liquid assets to obtain dollars needed to meet obligations. 

Figure 5 

Historical patterns support this interpretation. Gold has often declined during the initial phase of major financial stress events, including the global financial crisis and the pandemic shock, before rallying as liquidity conditions stabilize. (Figure 5) 

Even gold can be temporarily liquidated in this environment, illustrating how financial liquidity dynamics can dominate its intrinsic safe-haven appeal. 

VII. Fragmentation, Not Failure

Figure 6 

Another structural trend may be shaping gold’s muted response. 

Central banks continue to accumulate gold, extending a multi-year pattern of reserve diversification, although the pace of purchases has moderated in recent months. (Figure 6) 

This suggests that while the strategic bid for gold remains intact, accumulation is becoming more measured—less urgent, more sensitive to price and liquidity conditions. 

At the same time, new trading corridors have gradually developed outside the traditional Western clearing system. Asian markets frequently trade at premiums to London, while regional demand and policy dynamics increasingly influence the movement and pricing of physical gold. 

Taken together, these developments point to a gradual shift toward a more multipolar bullion market. Disruptions to established logistics routes may accelerate this transition, encouraging alternative trading channels and settlement infrastructure. 

This signal that the architecture of the gold market is evolving—away from a single, tightly integrated system toward a more fragmented landscape, where multiple hubs and pathways shape pricing, flows, and accumulation decisions. 

While the trajectory of central bank gold policy remains uncertain under current conditions, a stronger dollar and rising fiscal demands—whether from defense spending or domestic support—may incentivize some central banks to mobilize gold reserves for liquidity. 

Yet these same conditions—intensifying geopolitical fragmentation and rising monetary risk—may reinforce the opposite impulse: to accumulate gold as insurance, as a hedge against currency volatility, or as part of a broader strategy of reserve diversification away from the dollar. 

This tension reflects a deeper uncertainty. Whether central banks become net sources of liquidity or continue as structural buyers will depend on how the current crisis evolves—whether it remains a liquidity event or transitions into a broader monetary regime shift. 

VIII. What the Quiet Is Actually Saying 

Gold’s muted reaction to current geopolitical tensions is not a failure of its safe-haven role. It is a signal—just not the one most investors are looking for. 

What we are observing is the early phase of a crisis in which liquidity demand, dollar funding pressures, and market microstructure dominate price formation. In this phase, assets are not repriced based on long-term risk, but on immediate funding needs. 

History suggests that these phases do not persist indefinitely. Energy shocks, financial stress, and monetary instability tend to unfold sequentially, not simultaneously. 

If current tensions deepen into broader economic and financial disruption, the forces suppressing gold today may reverse. The same mechanisms driving liquidity demand—margin calls, collateral tightening, and dollar scarcity—often give way to monetary easing and balance sheet expansion. 

It is typically at that point—not during the initial scramble for liquidity—that gold reasserts its role. 

The signal is not absent. It is delayed. 

Gold is not failing as a safe haven—it is being temporarily subordinated to the needs of a dollar-based financial system under stress 

VIIIA. Post Script: "There is No Haven" 

Recent market behavior reinforces this interpretation. In the past week, the dollar, gold, U.S. Treasuries, bitcoin, and oil have all weakened simultaneously. 

In normal circumstances, at least one of these assets would function as a refuge. When all of them decline together, the signal is different: markets are not seeking safety—they are seeking liquidity. 

In other words, the system is still in the scramble-for-cash phase of adjustment or at times like this, markets behave as if no haven exists at all.

 

Quote of the Day: The Myth of Deleveraging

Doug Noland of the Credit Bubble Bulletin at the Prudentbear.com spectacularly demolishes the popular notion that the US has been deleveraging by delving into the nitty gritty of US systemic financing [bold mine]

The three Trillion-plus contraction in FSCMD did reduce Total System Market Debt – in the process seemingly improving debt-to-GDP ratios.  It is not, however, indicative of true system deleveraging and surely doesn’t reflect an improvement in our nation’s overall Credit standing.  Far from it.  From a Macro Credit Analysis perspective, the decline in FSCMD is instead reflective of fundamental changes in both the type of debt now fueling the boom and the corresponding nature of system risk intermediation.

First of all, mortgage debt is about to wrap up its fourth straight year of post-Bubble contraction.  Problem loan charge-offs have played a significant role, as have individuals using lower debt service costs (and near-zero returns on savings!) to speed the repayment of outstanding mortgages.  And, importantly, the decline in home values and the steep drop in transaction volumes have reduced demand for new mortgage debt – hence the need to intermediate mortgage Credit.  That said, the biggest factor behind the drop in FSCMD has been the activist Federal Reserve.

The Fed’s balance sheet is separate from the Financial Sector.  Federal Reserve Assets ended 2007 at $951bn.  Fed holdings ended Q2 2012 at $2.882 TN, up $1.931 TN, or 203%, in 18 quarters.  The Fed essentially transferred $2 TN of Financial Sector liabilities to a secure new home on its balance sheet.  Some may refer to this as “deleveraging,” but I won’t.

Importantly, the Fed’s moves to collapse interest rates and monetize debt (in conjunction with mortgage assistance programs) incited a major wave of mortgage refinancing.  And through the refi process, large quantities of private-label mortgages (previously included in FSCMD as ABS) were essentially transformed into sparkling new GSE-backed mortgage securities – and many then conveniently found their way onto the Federal Reserve’s rapidly inflating balance sheet.  This provided critical liquidity that allowed highly-leveraged Wall Street proprietary trading desks, hedge funds and banks to de-risk/de-leverage.  This bailout accommodated deleveraging for the financial speculators, yet for the real economy the boom in Non-Financial debt ran unabated. 

As noted above, Total Non-Financial Market debt ended this year’s second quarter at $38.924 TN and 249% of GDP – both all-time records.  Garnering all the focus from the deleveraging crowd, Total Household Debt has indeed declined since 2008 – having dropped $787bn, or 5.8%, to $12.896 TN.  At the same time, Federal debt has increased $4.689 TN to $11.050 TN. Non-Financial Corporate debt increased $434bn since ’08 to end Q2 2012 at a record $11.990 TN.  State & Local debt has expanded $101bn since ’08, ending Q2 at about $3.0 TN.   The data is the data - and Deleveraging is a Myth.

A 100% increase in Federal debt and 200% growth in the Federal Reserve’s balance sheet are surely not indicative of system de-leveraging.  Such extraordinary Credit developments do, however, have profound effects throughout the markets and real economy. The ongoing Credit expansion has inflated incomes, spending, corporate earnings and securities prices, in the process sustaining for now the U.S. economy’s Bubble structure.  And I would argue strongly that the data support the thesis that our system remains dominated by Bubble Dynamics. 

Also keep in mind that, in contrast to risky mortgage debt, federal debt requires little intermediation.  The marketplace absolutely loves it just the way it is, conspicuous warts and all.  For now, at least, it is “money” and shares money’s dangerous attribute of enjoying virtually insatiable demand.  The only alchemy necessary is to keep those electronic “printing presses” running 24/7.  It is, after all, the massive inflation of federal debt that is inflating incomes, cash-flows and profits, equities and fixed-income securities prices, and government tax receipts and expenditures – in the process validating the “moneyness” of the ever-expanding level of system debt (Ponzi Finance).

To validate Mr. Noland’s point, here are some charts from the US Flow of Funds for the period ended September 28, 2012 (courtesy of Dr. Ed Yardeni’s Blog)

Total US Debt as % of GDP

Non financial debt broken down into domestic sectors as % of GDP

Transformation of US debts from the household to Federal Debt and…

…and the US Federal Reserve’s balance sheet. (also from Dr. Ed Yardeni’s Blog on Central Banks and QE)

And the Fed balance sheet assets has increasingly been concentrated on US Treasuries.

Systemic deleveraging has indeed been nonexistent.

Quote of the Day: Real Deleveraging

No stock market commentary for today.

Here is a brilliant objective analysis of the current bubble conditions from Doug Noland of the Credit Bubble Bulletin at the PrudentBear.com (bold emphasis mine)

Our economic structure certainly enjoys unmatched capacity to absorb Credit excess without engendering traditional consumer price inflation.  Yet there is indeed a huge problem that no one seems to want to recognize:  Our system also has an unprecedented capacity to expand Credit that is backed by little in the way of wealth-creating capacity.  Our government literally injects Trillions into the economy – Credit that inflates incomes and sustains consumption and elevates asset prices.  The downside of this economic miracle is that, at the end of the day, there’s little left to show for the whole exercise except for an ever-expanding mountain of suspect financial claims.  Moreover, market values of these claims are sustained only by the unrelenting expansion of additional claims/Credit concurrent with increasingly radical monetary management.  This is Minsky’s “Ponzi Finance” at a systemic level.

A real deleveraging would see the economy and financial markets weaned off of rampant Credit growth.  Non-financial Credit growth averaged about $700bn annually during the nineties.  This inflated to about $2.4 TN at the Mortgage Finance Bubble pinnacle in 2007.  As I noted above, we’re currently running at an annualized Credit growth rate of nearly $2.0 TN.  This is posing great unappreciated risk to system stability.

A real deleveraging would see price levels (and market-based incentives) adjust throughout the economy in a manner that would spur business investment – in the process incentivizing sound investment-based lending and resulting job growth.  Real deleveraging would see a shift in the economic structure from Credit-fueled consumption to savings and productive investment.  Real deleveraging would give rise to our endemic trade deficits shifting to surplus.  Real deleveraging would see a meaningful reduction in non-productive debt.  Real deleveraging would see market prices dictated by fundamentals rather than governmental intervention, manipulation and inflationism.

The “raging” debate is whether recent elevated unemployment is a “cyclical” or “structural” phenomenon.  Academic “white papers” not required.  After all, find a system that doubles mortgage Credit in about six years and then proceeds to double federal debt in four - and you'll no doubt locate a deeply maladjusted economic structure.  Such gross financial imbalance ensures economic imbalance.  And, importantly, the longer such imbalances are accommodated/incentivized by loose fiscal and monetary policies the deeper the structural impairment.  Throw massive fiscal stimulus and monetize Trillions and such a structure will surely demonstrate historic deficiencies and fragilities.

Deleveraging – the process of unwinding the economic damage wrought from years of excess - will be a quite arduous economic process; one that will commence at some unknown date in the future.  Oh, I guess I failed to mention that total (financial and non-financial) Credit ended Q2 at a record $55.031 TN, or 353% of GDP.  And Rest of World holdings of our financial assets ended the quarter at a record $19.100 TN, a $3.860 TN increase from the end of 2008.

Deleveraging, which has been the mainstream tautology, has been promoted by cherry-picking evidences in support of this view.

Yet while it may be true that some sectors have been enduring salutary deleveraging, the big picture reveals that systemic debt has been intensifying not only in the US but on a global scale most of which has been borne by the governments.

And much like austerity, deleveraging has been a maligned and distorted term and uttered like an incantation which has been used to justify more government interventions. 

All these only adds up to have a compounding effect on systemic fragility. 

Contagion Risk: Watch for China’s Catastrophic Deleveraging

Dee Woo at the Business Insider has an insightful analysis on why we should continue to keep vigil on China’s banking and financial system. (bold emphasis mine)

China’s policy makers have been caught in a dangerous bind.

1. The frustrated and aggressive central bank

If one wants to know how bad the health of China's economy has gone, look no further than the PBOC's composure, which seems rather frustrated and aggressive as of late. On 5th July, the central bank cut benchmark interest rates for the 2nd time in less than a month. This happened right after the fact that in December 2011, PBOC cut the reserve requirement ratio(RRR) by a 50 bp to 21%, it followed up with another 50 bp in February and another 50 bp in May to 20% currently.

On top of all the rate cuts, PBOC also made its biggest injection of funds into the money market in nearly six months. The PBOC injected a net 225 billion yuan ($34.5 billion) through the reverse-repurchase operations(repo) on last Tuesday and Friday, following a combined injection of 291 billion yuan in the previous four weeks.

2. The systematic short-circuit of debt financing's in order

So why PBOC is in such an urge to open the floodgate of liquidity? This economist will spare you the boredom of looking at the diagrams of China's economic misery: HSBC PMI, etc, since you can find those eye candies everywhere else on the web. Let me cut to the chase: However high it aims, PBOC's action in practice merely work as the band aid to the bleeding economy. But it won't be able to fix it. The central bank's aggressive pro-liquidity maneuvers at best serve to sustain the over-leveraged economy and avoid the systematic short-circuit of debt financing. Now allow me to divulge:

The main drivers of China's debt financing,China's state-owned banks, are starving for cash. According to Citigroup estimates, in 2011 seven of the biggest Chinese banks raised 323.8 billion renminbi ($51.4 billion) of new fund. Several financial firms are expected to raise another $17.7 billion in the next few months, with China’s fifth-biggest lender, the Bank of Communications, accounting for $9 billion. The unprecedented lending binge encouraged by the central government,increasingly rigorous requirement of regulatory capital and excruciating maintenance of excessive dividend payouts have rendered the most-profitable banks in the world--Chinese banks--in a rather precarious position.

GaveKal's data will illustrate this is no exaggeration: In 2010, China’s five biggest banks — the Big Four plus the Bank of Communications — paid more than 144 billion yuan in dividends while raising more than 199 billion yuan on the capital markets. The ballooning balance sheet caused by the loan frenzy and strict capital requirement make China's banks' cash-craving burning at both ends:this march, China’s big four— Industrial and Commercial Bank of China, the Bank of China, China Construction Bank and Agricultural Bank of China — have a combined 14 percent increase in total assets, to 51.3 trillion yuan, which is roughly the size of the German, French and British economies combined.

Meanwhile, under a new set of rules, the country’s biggest banks will need to increase their capital levels to 11.5 percent of assets by the end of 2013.Their core Tier 1 capital ratio will need to be at least 9.5 percent. These requirements are more stringent than the rules that apply to American and European banks. Hereby, we shouldn't be surprised why the world's most profitable banks are in the dire need of cash. It has to be PBOC who comes to the rescue.

Diminishing returns of China’s inflationism…

According to the great Ray Dalio's principles, the credit-fueled China's economy is so over-leveraged that a great de-leveraging is going to be the only way out. The pyramid of debt/credit is cracking and will collapse since the conditions of underlying economic agents are deteriorating.There's no mount of monetary band aids that can alter that destiny.

According to Fitch’s data, the ratio of total financing/GDP in China rose from 124% at end‐2007 to 174% at end‐2010, and rose by another 5pp to 179% in 2011.In 2012 the growth of broad credit will slightly decelerate but still outpace GDP. Clearly China is not suffering a liquidity crisis but the diminishing economic return on credit. According to Fitch, in 2012, each CNY1 in new financing will yield ￥0.39 yuan in new GDP versus ￥0.73 yuan pre-crisis.Returns would have to rise above ￥0.5 yuan for domestic credit/GDP to stabilize at 2011’s 179%.

The dilemma is that business entities will need more and more credit to achieve the same economic result, therefore will be more and more leveraged, less and less able to service the debt, more and more prone to insolvency and bankruptcy. It will reach a turning point when the increasing number of insolvencies and bankruptcies initiate an accelerating downward spiral for underling assets prices and drive up the non-performing loan ratio for the banks.

And then the over-stretched banking system will implode. A full blown economic crisis will come in full force. The chain of reaction is clearly set in the motion now. The question is when we will reach that turning point. What PBOC has done is only adding fuel to the fire because it is unable to tackle the root causes of China's economic ills.

Again interventionism will require more interventionism. Yet interventionism via inflation is a policy that will not and cannot last. Has China reached that moment?

More, insufficient savings to tap for bank recapitalizations…

Let's examine the structural reasons that China's domestic demand will have its work cut out to refill the tank space of the economic growth left out by collapsing investment and export:

1st, Contrary to what many choose to believe, China's trade surplus is not caused by Chinese consumers' high saving rate, but has much to do with their deteriorating disposable incomes which far lag behind GDP growth and inflation. According to the All China Federation of Trade Unions (ACFTU), workers' wages/GDP ratio have gone down for 22 consecutive years since 1983. It goes without saying that the consumption/GDP ratio is shrinking all the while.

Meanwhile, Aggregate Savings Rate has increased by 51% from 36% in 1996 to 51% in 2007. Don't jump to your conclusion yet that Chinese consumers has been over-tightening their purse strings. The truth is far away from conventional perceptions: according to Development Research Center of the State Council's report, that increase is mainly driven by the government and corporations and not by the household. For the past 11 years, Household Saving Rate has only increased from 19% to 22%. Even India's Household Saving Rate of 24% is higher than China's right now.

All the while, government and corporations' saving rate has increased from 17% to 22%, which accounts for nearly 80% of the increase on Aggregate Savings Rate. For the past decade, Government's fiscal income is growing faster than GDP or Household Income. In 2009, the fiscal income was 687.71 billion yuan, and achieved an annual growth of 11.7% while GDP growth was 8.7%, Urban household disposable income growth was 8.8% and agriculture household disposable income growth was 8.2%. It is obvious that the state and corporations has taken too much out of national income and hence they continue to weaken the consumers rather than empower them.

All inflationism is deceptively about self-serving politics…

The biggest problem for China is the state, central enterprises and crony capitalists wield too much power over national economy, have too much monopoly power over wealth creation and income distribution, and much of the GDP growth and vested interest groups' economic progress are made on the expanse of average consumers stuck in deteriorating relative poverty. If these problems aren't solved, the faster the Chinese GDP growth, the less Chinese consumers will be able to support the over-capacity expansion, the more export momentum China will need to sustain its growth. This is a vicious circle of global imbalance. Even the revaluation of RMB can't break it.

Read the rest here

To recall the admonitions of the great Professor Ludwig von Mises against Keynesian policies…

The boom can last only as long as the credit expansion progresses at an ever-accelerated pace. The boom comes to an end as soon as additional quantities of fiduciary media are no longer thrown upon the loan market. But it could not last forever even if inflation and credit expansion were to go on endlessly. It would then encounter the barriers which prevent the boundless expansion of circulation credit. It would lead to the crack-up boom and the breakdown of the whole monetary system.

Will China's policymakers ease on bank capital regulations? Or will China's authorities opt to finance these through PBoC's money printing that increases the risk of hyperinflation? Or will China be forced to deleverage? Many questions that has yet to be answered.

Be careful out there.

Phisix and the Rotational Dynamics

It is a sobering fact that the prominence of central banks in this century has coincided with a general tendency towards more inflation, not less. [I]f the overriding objective is price stability, we did better with the nineteenth-century gold standard and passive central banks, with currency boards, or even with 'free banking.' The truly unique power of a central bank, after all, is the power to create money, and ultimately the power to create is the power to destroy.- Former US Federal Reserve chairman Paul Volcker

The Phisix fell 1.43% for the first time in four weeks. This comes after a turbocharged advance since the start of the year. Year to date, the local benchmark has been up 7.04% based on nominal Peso returns. But for foreign investors invested in the Phisix, the returns are higher. Since the Philippine Peso has materially gained (over 2%) from the same period, returns from local equity investments in US dollar terms is about 9+%.

Could this week’s decline presage a correction phase?

Rotational Dynamics in the PSE and the Cantillon Effects

The decline of the Phisix has not been reflected over the broad market as exhibited by the positive differentials of the advance-decline spread. This means more issues gained despite the natural corrective profit taking process seen on many of the Phisix component heavyweights.

And leading the market gainers has been the mining index which seems to have reasserted the leadership after a rather slow start. Also defying the profit taking mode has been the industrial sector.

From the start of the year, despite this week’s retrenchment, the property sector remains the best performer followed by the mining and the financial sectors.

This week’s market activities demonstrate what I have always called as the rotational process or dynamic. Sectors that has lagged outperforms the previously hot sectors which currently has been on a profit taking mode. Eventually the overall effect is to raise the price levels of nearly issue.

Here is what I previously wrote[1],

A prominent symptom of inflation is that prices are affected unevenly or relatively.

Eventually prices in general moves higher, but the degree and timing of price actions are not the same.

It’s the same in stock markets, which represents as one of the major absorbers of policy induced inflation.

Prices of some issues tend go up more and earlier than the others. At certain levels, the public’s attention tend to shift to the other issues which has lagged. This brings about a general rise in prices.

These are the spillover effects which I call the rotational process.

The mining sector has been narrowing the gap with the property sector and has surpassed service and financial sectors. The industrial sector which has been the tail end, has shrugged off the current profit taking process.

In the real economy, the effects of inflation has been similar, this known as the Cantillon Effect (named after the Mercantilist era Irish French economist Richard Cantillon) who brought about the concept of relative inflation or the disproportionate rise in prices among different goods in an economy[2]

The great Murray Rothbard dealt with the social and ethical considerations of Cantillon Effect or the relative effects of inflationism to an economy[3]

The new money works its way, step by step, throughout the economic system. As the new money spreads, it bids prices up--as we have seen, new money can only dilute the effectiveness of each dollar. But this dilution takes time and is therefore uneven; in the meantime, some people gain and other people lose. In short, the counterfeiters and their local retailers have found their incomes increased before any rise in the prices of the things they buy. But, on the other hand, people in remote areas of the economy, who have not yet received the new money, find their buying prices rising before their incomes. Retailers at the other end of the country, for example, will suffer losses. The first receivers of the new money gain most, and at the expense of the latest receivers.

Inflation, then, confers no general social benefit; instead, it redistributes the wealth in favor of the first-comers and at the expense of the laggards in the race. And inflation is, in effect, a race--to see who can get the new money earliest. The latecomers--the ones stuck with the loss--are often called the "fixed income groups." Ministers, teachers, people on salaries, lag notoriously behind other groups in acquiring the new money. Particular sufferers will be those depending on fixed money contracts--contracts made in the days before the inflationary rise in prices. Life insurance beneficiaries and annuitants, retired persons living off pensions, landlords with long term leases, bondholders and other creditors, those holding cash, all will bear the brunt of the inflation. They will be the ones who are "taxed."

The distributional impact of an inflation generated boom means the chief beneficiaries of inflation policies are the first recipients of new money who constitutes the political agents (politicians, bureaucrats), the politically privileged (welfare beneficiaries) or politically connected economic agents (war contractors, government suppliers, cronies and etc.). Where they spend their newly acquired money on will then serve as entry points to the diffusion of these new (inflation) monies to the economy.

The impact of current series of inflation policies works the same way too, they are meant to benefit, not the economy, but the insolvent banking and financial system of developed nations and their debt dependent welfare states teetering on the brink of collapse. And such policies have partly been engineered to buoy the financial markets (stock markets, bond markets and derivatives markets) because the balance sheets of their distressed banking system have been stuffed or loaded with an assorted mixture of these paper claims.

In the stock market, a similar pattern occurs, early receivers of circulation credit who invest on stock markets will benefit at the expense of the latecomers, usually the retail participants, where at the end of every boom, retail investors are left holding the proverbial empty bag.

As Austrian economist Fritz Machlup wrote,

the money which flows onto the stock exchange and is tied up in a series of operations, need not come directly from stock exchange credits (brokers' loans) but that any "inflationary” credit, no matter in what form it was created, may find its way onto the stock exchange[4]…

Extensive and lasting stock speculation by the general public thrives only on abundant credit[5].

So for as long as the interest rate environment can accommodate an expansion of inflationary or circulation credit, then stock markets are poised for an upside move.

Rotational Dynamics Abroad

The distributional and rotational dynamic can also be seen in the actions of ASEAN-4 bourses where Thailand’s SET has swiftly been closing on the lead of the Phisix on a year to date basis, while Indonesia and Malaysia has yet to get started.

Not only have the rotational effects been manifested in the region but also seem to be percolating around world.

Of the 71 bourses in my radar list, only about 18% have been in the red. The current environment has been the opposite of what we have seen in 2011.

And importantly, similar to the dynamics dynamics in the Philippine Stock Exchange, last year’s laggards have currently been outperforming.

About two weeks ago, the Philippine Phisix took the second spot[6] after Argentina among world’s top performing bourses. Apparently the relative effects of inflation has prompted for a strong recovery for the previous tailenders—such as the BRICs [Brazil, India, and Russia to the exclusion of China whose bourses have been closed for the week in celebration of the Year of Dragon] and developed economies as Germany and Hong Kong as well as a fusion of other nations from developed as Austria to the frontier markets Peru—to eclipse the gains of the Phisix and Argentina.

Central Banking Fueled Inflationary Boom

Financial markets have only been responding to what seems as synchronized efforts to deluge the world with liquidity in the hope that these efforts would lead to a structural economic recovery.

Unfortunately such short term oriented policies will only mask the problems by delaying the required adjustments and at worst, build or compound upon the current imbalances which would significantly increase systemic fragility which ultimately leads to a bubble bust.

Four central banks cut interest rates this week[7] (Thailand, Israel, Angola and Albania) with India paring down on the reserve requirements—mandated minimum reserves held by commercial banks.

Most of the world’s major central banks have been enforcing an environment of negative real rates, where as I have earlier noted, global interest rates reached the lowest level since 2009[8].

Meanwhile the US Federal Reserve recently announced the extension of the incumbent zero interest policy (ZIRP) rates “at least through late 2014”[9] on economic growth and unemployment concerns.

Also US Federal Reserve Chair Ben Bernanke has again been signaling the prospects of the revival of Fed’s bond buying which he said is “an option that is certainly on the table”[10].

In reality, the Bernanke led US Federal Reserve has been using the economy as cover or as pretext to rationalize the funding of what has been the uncontrollable spending whims by US politicians, aside from providing support to the banking system (both the US and indirectly Europe), which serves as medium for government to access financing.

However it would seem that access to financing windows has been closing.

The US debt ceiling, without fanfare, had been raised anew[11], which accounts for the relentless increase in the spending appetite of the incumbent administration.

Next foreign financing of US debts are likely to shrink, perhaps not because of geopolitical issues but because economic developments could alter the current financing dynamics. For instance, Japan’s trade balance posted a deficit for the first time in 31 years[12] and that China’s trade surpluses have been steadily narrowing[13]. China has already been reducing its holding of US treasuries.

If the trade balance of the key traditional financers of the US turns into extended deficits, this would put a cap on funds from Japan and China. Unless other emerging markets will fill in their shoes, and with low domestic savings rate, the US government will be left with the US Federal Reserve as financier of last resort. Of course, the Fed may possibly work in cahoots with other central banks through the banking system to accomplish this.

This only translates to a growing dependency on the printing press for an increasingly debt reliant welfare-warfare based political economic system.

And importantly, monetization of debts would have to be supported by zero bound rates to keep the US treasury’s interest expenditures in check.

So the current debt and debt financing dynamics will imply for a deeper role of the US Federal Reserve. All of which will have implications to markets and the production aspects.

Yet Bernanke’s nuclear option (helicopter drop approach) has palpably become the conventional central bank policy doctrine for global central bankers, specifically for most of developed economies.

There is no better way to show of the unprecedented direction in central bank policymaking than from the aggregate expansion of, in terms of US dollar, the balance sheets of 8 nations (US, UK, ECB, Japan, Germany, France, China and Switzerland) in order to keep the current system afloat.

By such nonpareil actions, there would no meaningful comparisons in modern history (definitely not Japan circa 90s or the Great Depression)

Deflation as Political Agenda and the Fallacy of Money Neutrality

It is important to stress that the mainstream’s obsession with so-called deleveraging process, although part of this is true, operates in an analytical vacuum. For their analysis forgoes the political incentives of the central banks to forestall the markets from clearing. For allowing the markets to clear will translate to a collapse in the current redistribution based political system. Deflation, a market clearing process, is a natural consequence to the distortions brought upon by prior inflationary policies or the boom bust cycle.

The irony is that those who benefit from inflation (government and banks), will be the ones who will suffer from deflation.

As Professor Jörg Guido Hülsmann explains[14],

the true crux of deflation is that it does not hide the redistribution going hand in hand with changes in the quantity of money. It entails visible misery for many people, to the benefit of equally visible winners. This starkly contrasts with inflation, which creates anonymous winners at the expense of anonymous losers. Both deflation and inflation are, from the point of view we have so far espoused, zero-sum games. But inflation is a secret rip-off and thus the perfect vehicle for the exploitation of a population through its (false) elites, whereas deflation means open redistribution through bankruptcy according to the law.

Thus the shrill cry over deflation amounts to nothing more than a front for vested interest groups who insists on pushing forward the inflationism agenda. Yet despite years of ceaseless incantations about deflation, asset markets and economic activities have behaved far far far away from the scenarios deflationists have long been fretting about. To contrary the risks has been tilted towards higher rates of consumer inflation.

I would further add that another mental lapse afflicting mainstream analysts, who embrace the “we inhabit a deflation, deleveraging reality”[15] mentality is that their aggregatism based economic analysis sugar-coats what in reality signifies as largely heuristics or mental short cuts predicated on political beliefs or appeal to acquire readership or catering to the mainstream to get social acceptance.

They believe that money printing by central banks has neutral effects—which means changes in money supply would lead to a proportional and permanent increase in prices that has little bearing on real economic activity as signified by output, investment and employment.

In reality, prices are determined by subjective valuations of those conducting exchanges, given the particular money at hand, the goods or services being traded for and the specific timeframe from which trade is being consummated, thus changes in the supply of money will not affect prices proportionally.

Money is never neutral. Professor Thorsten Polleit explains[16],

What is more, money is a good like any other. It is subject to the law of diminishing marginal utility. This, in turn, implies that an increase in the stock of money will necessarily be accompanied by a drop in money's exchange value vis-à-vis other goods and services.

Against this backdrop it becomes obvious that a rise or fall of the money supply does not confer a social benefit: it merely lowers or raises the exchange value of the money unit. And a change in the money supply also implies redistributive effects; that is, a change in money stock is not, and can never be, neutral.

So even as central banks continue with their onslaught of adding bank reserves at a pace that has never happened in modern history, they believe that such actions will be engulfed by “deleveraging”.

And going back to the “policy trap” or path dependency of policymaking that has been tilted towards inflationism, as said above, the balance sheets of crisis affected financial and banking institutions greatly depends on artificially bloated price levels. And in order to maintain these levels would require continuous commitment to inflationary policies, which means compounding or pyramiding inflation on top of existing inflation. Inflation thus begets inflation.

Again Professor Machlup[17],

An inflated rate of investment can probably be maintained only with a steady or increasing rate of credit expansion. A set-back is likely to occur when credit expansion stops.

And anytime central banks’ desist or even slow the rate of these expansions, this would entail or usher in violent downside volatilities in the marketplace (including the Phisix). Thus “exit strategies” signify no less than political agitprops.

A noteworthy and relevant quote from James Bianco[18], (which includes the chart above)

Until a worldwide exit strategy can be articulated and understood, risk markets will rise and fall based on the perceptions and realities of central bank balance sheets. As long as this is perceived to be a good thing, like perpetually rising home prices were perceived to be a good thing, risk markets will rise.

When/If these central banks go too far, as was eventually the case with home prices, expanding balance sheets will no longer be looked upon in a positive light. Instead they will be viewed in the same light as CDOs backed by sub-prime mortgages were when home prices were falling. The heads of these central banks will no longer be put on a pedestal but looked upon as eight Alan Greenspans that caused a financial crisis.

So how does one know that “expanding balance sheets will no longer be looked upon in a positive light” considering that central banks can elude accounting rules? My reply would be to watch the interest rate price actions, currency movements and prices of precious metals along with oil and natural gas.

No Decoupling, a Redux

Any belief that the Phisix operates separately from the world would be utterly misguided.

2011 should be a noteworthy example.

The Phisix ended the year marginally up while the US S&P 500 was unchanged. Except for the first quarter where the S&P 500 and the Phisix diverged (green oval, where ironically the US moved higher as the Phisix retrenched), the rest of the year exhibits what seems as synchronized actions. Or that based on trend undulations, the motion of the Phisix appears to have been highly correlated with that of the S&P.

While correlation does not translate to causation, what has made the US and the Phisix surprisingly resilent relative to the world has been the loose money policies adapted by the US Federal Reserve. Money supply growth in the US has sharply accelerated during the latter half of the year despite the technical conclusion of QE 2.0.

Not only has such central bank actions partly offset and deferred on the potential adverse impact from the unfolding crisis in the Eurozone, aside from exposing internal weaknesses, monetary inflation has buoyed the US financial markets.

The deferment of recession risks magnified the negative real rates environment in the Philippines and the ASEAN financial markets which has prompted for the seemingly symmetrical moves and the outperformance relative to the world.

My point is that the notion where Philippine financial markets will or can decouple or behave independently from that of the US, or will not be affected by developments abroad, has been baseless, unfounded, in denial of reality and constitutes as wishful and reckless thinking that would be suicidal for any portfolio manager.

Final Thoughts and Some Prediction Confirmations

Bottom line:

Given the added empirical indications of an ongiong an inflationary boom, here and abroad, the current correction phase seen in the Phisix will likely represent a temporary event

The seemingly synchronized actions by global central bankers to lower rates allegedly to combat recession risks will magnify the negative real rate environment that should be supportive of the bullish trend in both the Phisix and the Philippine Peso and also for global markets.

The hunt for yield environment will be concatenated by the debasing policies of central banks of major economies which will likely spur international arbitrages or carry trades.

Before I conclude, I would like to show you some confirmations of my predictions

An inevitable confirmation of my assertion that the actions of central bankers represent as the main drivers of price trends and not chart patterns[19] can be seen in the above chart from stockcharts.com.

The price actions of the US S&P 500 segues from the bearish death cross, which now officially represents a failed chart pattern, that gives way to the bullish golden cross.

Above is another vital confirmation of my thesis against gold bears who claimed that December’s fall marked the end of the bull market[20]. Gold has broken out of the resistance level which most possibly heralds a continuation of the momentum that would affirm the bullmarket trend.

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[1] See Phisix: Why I Expect A Rotation Out of The Mining Sector, May 15, 2011

[2] Wikipedia.org Richard Cantillon Monetary theory

[3] Rothbard, Murray N. 2. The Economic Effects of Inflation III. Government Meddling With Money What Has Government Done to Our Money?

[4] Machlup Fritz The Stock Market, Credit And Capital Formation p.94 William Hodge And Company, Limited

[5] Ibid p. 289

[6] See Global Equity Markets: Philippine Phisix Grabs Second Spot, January 14, 2012

[7] centralbanknews.info, Monetary Policy Week in Review - 28 January 2012, Bank of Albania Cuts Interest Rate 25bps to 4.50%

[8] See Global Central Banks Ease the Most Since 2009, November 28, 2011

[9] Bloomberg.com Fed: Benchmark Rate Will Stay Low Until ’14, January 26, 2012

[10] Bloomberg.com Bernanke Makes Case for More Bond Buying, January 26, 2012

[11] See US Senate Approves Debt Ceiling Increase, January 27, 2012

[12] AFP Japan posts first annual trade deficit in 31 years, January 25, 2012, google.com

[13] Bloomberg.com Shrinking China Trade Surplus May Buttress Wen Rebuff of Pressure on Yuan, January 9, 2012

[14] Hülsmann Jörg Guido Deflation And Liberty, p.27

[15] Mauldin John, The Transparency Trap, January 29, 2012 Goldseek.com

[16] Polleit Thorsten The Fallacy of the (Super)Neutrality of Money, October 23, 2009 Mises.org

[17] Machlup Fritz op. cit, p 291

[18] Bianco James, Living In A QE World January 27, 2012 ritholz.com

[19] See How Reliable is the S&P’s ‘Death Cross’ Pattern? August 14, 2011

[20] See Is this the End of the Gold Bull Market? December 15, 2011