G20 to institutionalize Bank Bail-Ins?

As I have been saying and predicting here, governments have been in a mission creep to institutionalize "deposit haircuts ", which eventually culminates into a Cyprus style bail-IN. This has been part of the deepening of use of financial repression.

Negative deposit rates signify a slippery slope towards wealth confiscation as I recently noted: Negative rates will serve as a precursor to the widespread adaption of deposit confiscation via haircuts or wealth taxes especially when the global crisis emerges.

Analyst Russell Napier warns (published at the Zero Hedge which he calls “the day the money dies”) that the G-20 has reached an accord for member nations to standardize Bail INs by legislating a downgrade on the treatment of bank deposits. (bold mine)

The G20 announcement in Brisbane on November 16th will formalize a "bail in" for large-scale depositors raising the spectre that their deposits are, as many were in 1932, worth less than banknotes. It will be very clear that the value of bank deposits can fall in nominal terms.

On Sunday in Brisbane the G20 will announce that bank deposits are just part of commercial banks’ capital structure, and also that they are far from the most senior portion of that structure. With deposits then subjected to a decline in nominal value following a bank failure, it is self-evident that a bank deposit is no longer money in the way a banknote is. If a banknote cannot be subjected to a decline in nominal value, we need to ask whether banknotes can act as a superior store of value than bank deposits? If that is the case, will some investors prefer banknotes to bank deposits as a form of savings? Such a change in preference is known as a "bank run." 

Each country will introduce its own legislation to effect the ‘ bail-in’ agreed by the G20 this coming weekend. The consultation document from the UK’s Treasury lists the following bank creditors who will rank ABOVE depositors in a ‘failing’ financial institution: 

-Liabilities representing protected deposits (in the UK the government guarantee protects 100% of deposits up to the value of GBP85,000) any liability, so far as it is secured

-Liabilities that the bank has by virtue of holding client assets

-Liabilities arising with an original maturity of less than 7 days owed by the banks to a credit institution or investment firm

-Liabilities arising from participation in designated settlement systems

-Liabilities owed to central counterparties recognized by the European Securities and Markets Authorities… on OTC derivatives, central counterparties and trade depositaries

-Liabilities owed to an employee or former employee in relation to salary or other remuneration, except variable remuneration

-Liabilities owed to an employee or former employee in relation to rights under a pension scheme, except rights to discretionary benefits

-Liabilities owed to creditors arising from the provision to the bank of goods or service (other than financial services) that are critical to the daily functioning of its operations

The above list makes it clear that deposits larger than GBP85,000 will rank ahead of the bond holders of banks, but they will rank above little else. Importantly, both borrowings of the banks of less than 7 days maturity from other financial institutions and sums owed by banks in their role as counterparties to OTC derivatives will rank above large deposits. 

Large deposits at banks are no longer money, as this legislation will formally push them down through the capital structure to a position of material capital risk in any "failing" institution. In our last financial crisis, deposits were de facto guaranteed by the state, but from November 16th holders of large-scale deposits will be, both de facto and de jure, just another creditor squabbling over their share of the assets of a failed bank. 

Interestingly, HM Treasury uses the word ‘failing’ rather than "failed" in its consultation document and investors could find their large deposits frozen for a prolonged period in any "failing" institution while the courts unpick the capital structure and decide exactly where any losses should fall. 

If we have another Lehman Brothers collapse, large-scale depositors could find themselves in the courts for years before final adjudication on the scale of their losses could be established. During this period would this illiquid asset, formerly called a deposit and now subject to an unknown capital loss, be considered money? Clearly it would not, as its illiquidity and likely decline in nominal value would make it unacceptable as a medium of exchange. 

From November 16th 2014 the large-scale deposit at a commercial bank is, at best, a lesser form of money, and to many it will cease to be money at all as its nominal value can fall and it could cease to be accepted as a medium of exchange.

Fortunately, the developed world’s commercial banks are flush with central bank reserves and these are instantly convertible into the banknotes which they may need to meet demand from depositors. While the huge level of reserves on the balance sheet is a buffer, the funding of fractional reserve banks is still very negatively impacted by a shift from deposits to bank notes. With deflationary forces gathering momentum, this further impediment to the extension of commercial bank credit would be another factor preventing central bank monetary largesse translating into growth and inflation.

As the world’s smartest lawyer Charlie Munger is fond of saying, "Show me the incentive and I will show you the outcome." Some simple mathematics reveals that the November 16th announcement will create a very major incentive for investors to change deposits into banknotes.

In short, the formalization of the G20 accord on the downgrade of bank deposits implies greater risks of bank runs.  Yet the institutionalization of bail INs will not likely to be limited to G20s but should spread even on Emerging-Frontier markets. 

Governments around the world have been in a state of panic. They are desperately manipulating stock markets in the hope that these may produce “wealth effect”, a miracle intended to save their skin or the  status quo (the welfare-warfare, banking system and central bank troika), as well as, camouflage current economic weakness and or kick the debt time bomb down the road.

Yet the same political institutions recognize that inflating stocks are unsustainable. So during this current low volatile tranquil phase, they have been implementing foundations for massive wealth confiscation. 

What better way to confiscate than do it directly. Yet the more the confiscations, the greater risks of runs on banks and on money.

Why The Sell-Offs In Global Markets Are Unlikely Signs Of A Double Dip Recession

``Public choice is like the small boy who said that the king really has no clothes. Once he said this, everyone recognised that the king’s nakedness had been recognised, but that no-one had really called attention to this fact.”-James M. Buchanan, Politics Without Romance

In this issue:

Why The Sell-Offs In Global Markets Are Unlikely Signs Of A Double Dip Recession

-President Aquino’s Baptism Of Fire: The “Wang Wang” Policy

-Misreading The Decline Of Global Markets

-Europe Tightens Monetary Spigot

-Yield Curves Does Not Suggest Of A Prospective Recession

-Gold Challenges The Recession Outlook; From Policy To Market Divergences

-Summary and Conclusion

The Phisix and ASEAN bourses continue to astonish. They weren’t immune from the steep downdraft seen in global markets. However, the degree of decline was starkly less than those suffered by their contemporaries, such as the US S&P down 5.03% or Germany Dax down 3.9% or China’s Shanghai index down 6.7%. In fact, one of the outlier, Thailand SET even rose by 1.12%.

President Aquino’s Baptism Of Fire: The “Wang Wang” Policy

The Phisix endured a 1.83% loss this week.

And if I use mainstream reasoning to connect the dots, by attaching developments in current events, then this implies that President Noynoy Aquino’s ‘baptism of fire’ policy of hunting down illegal police sirens (Wang Wang) and blinkers, which was one of the major points in his inaugural speech, has important link to the market’s loss.

In the speech, the president aims to reduce the perceived gap between the people and the political leaders, which according to this editorial[1], “Walang lamangan, walang padrino, at walang pagnanakaw. Walang wang-wang, walang counter-flow, walang tong,” he said, vowing to put an end to thievery, patronage, petty extortion, the use of sirens and traffic counter-flow.

Nevertheless, the recent populist acts by new President have several important ramifications;

One, this shows that there have been far too many unenforceable laws. The labyrinth of unenforceable laws reveals of the extent of depth of institutional deficiencies.

Two, laws get to be enforced only upon political convenience.

The law, PD 96, which was signed last 1973 have apparently been flagrantly abused, mostly by those in power. As proof of this, an industry emerged[2] to cater to this once “dormant” and ineffective law.

Moreover, when politics arbitrarily dictate on the priorities of enforceability of specific laws, then the other laws get to be overshadowed. Thereby, the ever shifting political priorities, as set by the whims of political authorities, would only undermine the effectiveness of the institutionalization of the current set of laws.

Three, the arbitrariness of application of laws subjects the enforcer and the violating parties into arbitrary relations.

Once the public gets tired of this issue or once other concerns captures or diverts the public’s attention, then this law would only be a source of corruption, extortion and other ungodly compromises. Remember since many of the offenders are from the political class, then we can expect a lot of this behind the scene reactions. Otherwise, such political vaudeville will die a natural death or revert to hibernation.

Fourth, while President Aquino’s good intention isn’t the object of our critique, this policy seems to be an extension of the political euphoria from the recently concluded elections. It appears that President Aquino mistakenly thinks of the Office of the President as a perpetual popularity contest as manifested by such action. Unfortunately the rubber will meet the road and farcical symbolisms will be exposed for what they are.

Fifth, enforcing Wang Wang laws won’t “put an end to thievery, patronage, petty extortion”. That’s because Wang Wangs are not cause of these misdemeanours. Wang Wangs are only symptoms of an underlying disease.

Therefore, this seems no more than a superficial approach to a very complex issue.

What people don’t see is that the arbitrariness of the implementation of laws signifies as one of the major causes of “thievery, patronage, petty extortion” and such political showmanship won’t resolve the deeply rooted issue.

For laws to be effective, they should be known to everyone, they should be stable for everyone to observe and follow, and they should be always enforced evenly. Therefore, changeability, arbitrariness and selective applications of laws only adds to (and not reduce) these endemic imbalances.

This only puts to light that President Aquino and his strategists reveal of the poor understanding of the drivers of the Philippine political economy and partially affirms our prognosis of the direction of his prospective political actions.

President Aquino needs to deal with the existing cobweb of laws that enables the political power centres to exist and thrive, which prompts for the concurrent inequitable distribution of political (and economic) power from which the Wang Wang pathology has emerged, and the political framework of the bureaucracy--something which incidentally would be politically inconvenient and an exercise he won’t likely underwrite.

Lastly, in my view this seems to be a strategic folly or a misstep for President Aquino. Where the miscue from present post elections euphoria could lead to what Nobel Prize winner James Buchanan[3] would call as “non-performance measured against promised claims”. Political gimmickry can only have a short term impact, thus he would need a bagful of other tricks to keep people entertained.

Yet, an overreach to implement this law at the expense of other concerns would likely lead to failed expectations and subsequently a decline in popularity ratings.

As we have said before, the more things change the more they remain the same.

Misreading The Decline Of Global Markets

Of course, the hyperbolic Wang Wang policies have little to do with the current state of market actions.

The fact is that most of the major financial markets have been in convulsion. Some see this as raising the risks of a ‘double dip’ recession while some see this as “deflation”.

We don’t share both views.

First of all, it is misguided to interpret falling markets as deflation in a monetary sense. Because deflation can used to describe the market activity, such as ‘deflation’ in the prices of stocks, deflation has been mostly utilized as an observation to “effects” rather than the enunciation of causal linkages.

Aside from misreading cause and effect, monetary deflation isn’t the same as deflation in the stock markets because wealth and money are not only different[4] but in stock markets, where every seller (outflow) has a corresponding buyer (inflow), there are NO NET outflows or inflows or transfers of money. Therefore, changes in the pricing of stocks signify as changes in expectations.

And the fudging of definitions won’t make any analysis “sound” or “accurate”, since they are manifestations of (mostly political) bias.

Instead, people’s mental picture of “deflation” is cash hoarding similar to the Great Depression of the 1930s, which arose from frenetic liquidation activities (from intensive government intervention) which led to a massive withdrawal in the banking system. Yet, this scenario hasn’t been true today.

There was indeed a short bout of deflation in late 2008 seen in some developed economies. But this was different from the 1930s. The 2008 episode had been a consequence of a financial gridlock centered upon the US banking system. This affected both payment and settlement activities, from which many in the world resorted to barter trade and in the US the emergence of scrip “local” currency[5].

Deflation, then, didn’t signify outright lack of demand, instead it posited of a “supply shock” from the massive dislocation of monetary or financial flows in the global banking system.

Thus, when global central banks, led by the US Federal Reserve, provided “temporary” patchwork to the immobilized system, aside from applying massive inflationism by absorbing and providing guarantees to securities of dubious quality, global economic activities fiercely rebounded in defiance of the expectations of the mainstream (see figure 1).

Figure 1: Danske Bank[6]: Global Business Monitor

In fact the speed, the magnitude and the ferocity of the ensuing rebound had been so astonishing that global economic indicators as OECD leading indicator (left window- blue line) Global PMI manufacturing (left window- red line) and PMI new orders manufacturing (right window) has equalled, if not surpassed, the highs of the boom days of 2003-2007.

But unless one lives in planet Mars where some harbour the expectations of a sustained rebound in defiance of the laws of gravity, it is natural or normal to expect a “slowdown” to occur following a vigorous V-shaped rebound. Thus the basic axiom applies: no trend goes in a straight line.

True, there are meaningful signs of declines in some economic activities, such as a slowdown in China as her government tries to prevent an overheating (see figure 2), the ongoing fiscal problems and tightening monetary policy in Europe (see below)-which should translate to a temporary slowdown and signs of weaknesses in the US economy particularly seen in the survey of consumer confidence, housing market, durable goods, labor market, mortgage applications, impact from BP oil spill, state budget, and even the Economic Research Institute’s weekly Leading Indicator which has been made by deflation advocates as the primary tool today to declare a bear or market collapse. Some even use the technical death cross in the US markets to suggest of the next crash).

Figure 2: Danske Commodities[7]: Asia: Odds for soft landing in China are good

For instance, the fall in China’s market seem to exhibit manifestations of the ongoing decline in the rate of credit expansion. While this policy induced actions may account for temporary or short term pain, the plus side is that the risk of a ballooning bubble would likely be diminished.

However, the strong showing of fixed asset investments (right window-red line) amidst today’s credit conditions (note: NOT a contraction in credit but a decline in the rate of growth) still implies of a resilient but moderating economic growth.

As a side note: Again, this gives more evidence to our Machlup-Livermore model where China’s current bear market is being driven, not by changes in economic fundamentals but by changes in liquidity conditions. The slowdown in credit conditions in China has prompted for a bear market which seems quite similar to the accounts of 2008 where China did NOT undergo a recession yet the Shanghai index fell by 71%!

My point is that ALL these global economic activities can be construed as reactions by the financial markets to evolving realities from an unsustainable “winning streak” momentum.

Yet again, these indications of economic infirmities hardly exhibit signs of deflation similar to the Great Depression.

As Friedrich von Hayek described[8], (all bold highlights mine)

``How confused ideas still are with respect to the problems of the liquidation and readjustment of the economic system after a crisis is well illustrated by the vague and indefinite way in which in recent years financial journalists and others have discussed the problem of liquidation of the present depression. The analysis of the crisis shows that, once an excessive increase of the capital structure has proved insupportable and has led to a crisis, profitability of production can be restored only by considerable changes in relative prices, reductions of certain stocks, and transfers of means of production to other uses. In connection with these changes, liquidations of firms in a purely financial sense of the word may be inevitable, and their postponement may possibly delay the process of liquidation in the first, more general sense; but this is a separate and special phenomenon which in recent discussions has been stressed rather excessively at the expense of the more fundamental changes in prices, stocks, etc.”

In short, we seem to seeing natural adjustments in relative pricing and the attendant fine-tuning of economic activities from the recent dramatic ascension. Hence, the recent fall does not necessarily imply a double dip recession or deflation.

Europe Tightens Monetary Spigot

Europe seems to be defying the US in terms of monetary policy approach.

Despite the G-20 rapprochement on growth and deficit targets, which according to the Businessweek[9], (bold emphasis added)

``Advanced economies will aim to at least halve deficits by 2013 and stabilize their debt-to-output ratios by 2016, according to a statement released as leaders finished meeting in Toronto today. The G-20 said banks need to raise capital “significantly” and countries will be allowed to phase in new rules, with a goal of meeting new standards by the end of 2012…

``The G-20 had to bridge a gap between leaders such as President Barack Obama who want to focus on growth and officials such as Merkel who favor budget cuts. The statement says the global recovery, which has been faster than expected, remains “uneven and fragile.”

Europe’s ardent desire to cut deficits seems being reflected on the monetary policies (see figure 3).

Figure 3: Danske Bank: Europe Debt Crisis Watch

The European Central Bank (ECB) has been slowing its liquidity provision to the banking system (right window) while simultaneously engaged in monetary tightening by sopping off liquidity in the marketplace (left window).

According to the Danske Bank research team[10],

``The expiry of the ECB 12-month LTRO [Long Term Re-financing Operation] on Thursday is creating jitters in the European money markets, where conditions have worsened despite a tightening of the EONIA EURIBOR spread. The 3M EONIA has risen to the highest level since July 2009, as markets are worrying that weak European banks may have difficulties rolling over short-term funding, although the ECB has announced that it will continue to provide liquidity at 1% full allotment in a three-month LTRO.

``ECB’s purchases of PIIGS government bonds remain very limited and the market is increasingly questioning the central bank’s commitment to support PIIGS.”

So like in China, falling stock markets in Europe have been evincing of a policy based liquidity slowdown, which basically reflects on the adjustments based on these events.

In other words, there seems to be a brewing policy divergence between the US, on the one side and Europe and China on the other, where both Europe and China seem willing to accept the pains of a slowdown as tradeoff to unsustainable spendthrift policies as advocated by US authorities.

These imply that economic activities that had emerged out of the false market signals via inflationism will bear the pain of losses which markets apparently have been pricing in.

As Friedrich von Hayek explained[11], (all bold emphasis mine)

But if prices then do not rise more than expected, no extra profits will be made. Although prices continue to rise at the former rate, this will no longer have the miraculous effect on sales and employment it had before. The artificial gains will disappear, there will again be losses, and some firms will find that prices will not even cover costs. To maintain the effect inflation had earlier when its full extent was not anticipated, it will have to be stronger than before. If at first an annual rate of price increase of five percent had been sufficient, once five percent comes to be expected something like seven percent or more will be necessary to have the same stimulating effect which a five percent rise had before. And since, if inflation has already lasted for some time, a great many activities will have become dependent on its continuance at a progressive rate, we will have a situation in which, in spite of rising prices, many firms will be making losses, and there may be substantial unemployment. Depression with rising prices is a typical consequence of a mere braking of the increase in the rate of inflation once the economy has become geared to a certain rate of inflation.

On the account of this policy divergence, the Euro surged by 1.59% this week.

Moreover the results of the banking stress test[12] will be published on July 23^rd, which if the results are positive should diminish the negative sentiment.

Nonetheless, outside the emergence of any unforeseen tail risks, the temporary slowdown which signals a move away from mainstream Keynesian policies, presents a medium term bullish case for European and China equities. Perhaps we shall see a bottoming of these markets in the coming quarter.

Yield Curves Does Not Suggest Of A Prospective Recession

Figure 4: News N Economics[13]: Japan And US Yield Curve, ECB[14]: Euro Area Yield Curve

The yield curve, by far, is the best indicator of recessions. The yield curve signifies as perhaps the most potent price signal which shapes the public’s expectations that coordinates the distribution of resources across the economic sphere.

As Dr. Frank Shostak explains[15], (all bold emphasis mine)

``To the extent that investors are forming expectations regarding future course of monetary policy, this only tends to reinforce the shape of the curve as set by the central bank. This means that the shift in the shape of the yield curve is ultimately set by the central banks monetary policies and not by investors’ expectations. At best, expectations can either reinforce or moderate the slope of the yield curve.

``Whenever the central bank reverses its monetary stance and thus alters the shape of the yield curve, it sets in motion either economic boom or an economic bust. The effect of a change in monetary policy shifts gradually from one market to another market, from one individual to another individual. It is this gradual increase in the effect of a change in the monetary policy that makes the change in the shape of the yield curve a good predictive tool.”

Thus, if the yield curve is instrumental in generating business cycles, then this means that part of the cyclical activities is the incentives which the yield curve provides the public to arbitrage through interest rate spreads or by profit spreads.

True, US yield curves have been flattening of late, but it is misplaced to suggest that this presages a recession, because as seen from the larger picture, US yield curves remain significantly steep since the onset of the crisis (left window).

Importantly, US yield curves (red line) can’t be compared to Japan’s lost decade. Japan’s yield curve (blue line) since 1998 has remained mostly flat. So any comparison with Japan is likely to be misguided and inaccurate.

And even the yield curve in the European Union has likewise been steep (right window).

So while the present action of the yield curve in the US may suggest of a slowdown they are far from pointing to a recession in the US or in the EU area yet.

The other point is that the monetary climate remains largely expansionary in spite of the current turbulence. And given money’s relative effects to the economy, this should likewise impact financial markets on a relative scale. And perhaps this partly explains the ongoing divergences between ASEAN and global developed markets.

Thus, we differentiate from those advancing the deflation scenario because we see the relative impact of interest rates from the perspective of money’s non-neutrality.

As Ludwig von Mises once wrote[16],

``Public opinion is prone to see in interest nothing but a merely institutional obstacle to the expansion of production. It does not realize that the discount of future goods as against present goods is a necessary and eternal category of human action and cannot be abolished by bank manipulation.”

Gold Challenges The Recession Outlook; From Policy To Market Divergences

Furthermore, as we previously[17] pointed out, another indicator that doesn’t suggest of a market collapse or the imminence of recession is Gold.

True, gold prices fell by 3.55% this week but that’s after setting a new nominal record (see figure 5).

Figure 5: Gold’s Retreat From Record Run, Emerging Divergences

Therefore, gold’s price action can be deemed as merely a routine correction following the new milestone high.

Remember, gold prices have NOT been immune to recessions[18]. Therefore, we take this as signs that gold isn’t a hedge against deflation[19]. Hence, a prospective recession is also likely hammer hard on gold prices. So far this hasn’t been the case yet.

Unless gold continues to fall hard, we should take the recent action to be a normal phase of adjustments based on evolving conditions.

I would like to further add that the so called fiscal austerity or the shift away from Keynesian policies is likewise going to somewhat hurt gold. That’s because gold has essentially been riding on global government’s reckless adaption of Keynesian policies.

And as the G-20 meeting has demonstrated, the policy divergences by Euro-China relative to the US would likely have disparate impact on gold prices. Gold is likely to underperform in Euro and Yuan terms, but outperform based on the US dollar terms as the US government is likely to pursue policies of inflationism.

And such policy divergences will also likely disharmonize the impact on financial asset markets.

And possibly the current disparities in the gold-copper market (where gold drifts near record highs while copper prices have been lethargic) and the emerging market stocks (EEM)-bonds (XESDX) [where EM stocks have been sluggish while EM bonds have been recovering) have been suggesting of these developments.

Finally it’s also a mistake to equate falling commodity prices as signs of deflation.

As Ludwig von Mises explained[20], (all bold highlights mine)

``As soon as the depression appears, there is a general lament over deflation and people clamor for a continuation of the expansionist policy. Now, it is true that even with no restrictions in the supply of money proper and fiduciary media available, the depression brings about a cash-induced tendency toward an increase in the purchasing power of the monetary unit. Every firm is intent upon increasing its cash holdings, and these endeavors affect the ratio between the supply of money (in the broader sense) and the demand for money (in the broader sense) for cash holding. This may be properly called deflation. But it is a serious blunder to believe that the fall in commodity prices is caused by this striving after greater cash holding. The causation is the other way around. Prices of the factors of production--both material and human--have reached an excessive height in the boom period. They must come down before business can become profitable again. The entrepreneurs enlarge their cash holding because they abstain from buying goods and hiring workers as long as the structure of prices and wages is not adjusted to the real state of the market data. Thus any attempt of the government or the labor unions to prevent or to delay this adjustment merely prolongs the stagnation.”

In short, while falling commodity prices may suggest of a forthcoming recession, they do not automatically suggest signs of deflation-since recessions are manifestations of adjustments from the misallocation of resources through price signals.

Summary and Conclusion

To recap:

Falling global markets doesn’t necessarily imply a forthcoming recession or deflation. More importantly little of the current market actions signal “monetary deflation”.

Following a surge in the activities in the global economy it would be normal to see a moderation of activities which may have been reflected on the markets. Thus the retreat in the momentum suggest of a market misread by some as a “double dip” or deflation.

Despite the G-20 consensus, US and Europe appears to have drawn the proverbial line on the sand; there will be policy induced divergences among G-20 member nations.

Europe and China appears to be in a tightening mode, hence their markets seem to be reflecting on such policy actions.

Europe seems signalling a retreat from Keynesian policies. Current weakness should be seen as temporary. The Euro is already affirming this action.

The US will likely continue to inflate, where more signs of market distress would possibly lead to the reactivation of the Quantitative Easing facility.

Policy divergences are likely to impact markets distinctly. Therefore, we may be seeing further signs of market disaccord or decoupling.

The yield curve remains steep in the US and Europe or in Asia. This hardly signals a double dip or of deflation. Perhaps too, the steep yield curve has prompted Europeans to engage in tightening and to veer away from Keynesian policies.

Gold’s recent retreat from its record run doesn’t signal a return of recession.

There seem to growing signs of divergences across asset markets seen even in the commodity and in emerging markets.

Falling commodity markets doesn’t automatically translate to deflation.

Philippine President Noynoy Aquino’s first “Wang Wang” policy shouldn’t have any impact on the markets and could herald the general direction of his administration’s policy.

ASEAN markets continue to display peculiar resiliency. Should global markets begin to recover, ASEAN markets are likely to go on full throttle and outperform the rest. This includes the Philippine Phisix.

This means a buy on the Phisix and the Peso.

---

[1] Philippine Star, EDITORIAL - No more wang-wang, July 2, 2010

[2] GMANEWS.TV, Cops helpless vs 'wang-wang' dealers, July 2, 2010

[3] Buchanan, James M. Politics Without Romance

[4] See Are Recessions Deflationary?

[5] See Emerging Local Currencies In The US Disproves The 'Liquidity Trap’

[6] Danske Bank, Global Business Monitor

[7] Danske Bank, Commodities Monthly: New price floors materialising, June 30, 2010

[8] Hayek, Friedrich von The Present State And Immediate Prospects. Of The Study Of Industrial Fluctuations Profits, Interest And Investment P.176

[9] Businessweek, Bloomberg G-20 Agrees to Cut Deficits Once Recoveries Cemented, June 27, 2010

[10] Danske Bank: Europe Debt Crisis Watch, June 29, 2010

[11] Hayek, Friedrich August von Can We Still Avoid Inflation? The Austrian Theory of the Trade Cycle

[12] ABC News, European Bank Stress Test Results Due on July 23, July 4 2010

[13] News N Economics, Yield curves in Japan and the US: similar but not the same, June 29, 2010

[14] European Central Bank, Euro Area Yield Curve

[15] Shostak, Frank, What's With the Yield Curve?, Mises.org

[16] Mises, Ludwig von The Monetary or Circulation Credit Theory of the Trade Cycle, Chapter 20 Section 8, Human Action

[17] See What Gold’s Latest Record Prices Mean

[18] See Why The Current Market Volatility Does Not Imply A Repeat Of 2008

[19] See Gold Unlikely A Deflation Hedge

[20] Mises, Ludwig von, The Gross Market Rate of Interest as Affected by Deflation and Credit Contraction Chapter 20 Section 7, Human Action

Update: Since I'm not familiar with the new Google doc set-up, I am having a hard time trying to integrate the new format to my blog. Hence the bold highlights noted above were not reflected.The original document can be found below...

Four Reasons Why ‘Fear’ In Gold Prices Is A Fallacy

``The danger from all forms of paper money controlled and regulated by governments or their appointed central banks is that they remain creatures of the political process, and dependent upon the knowledge and policy preferences of those who have the power over the monetary printing press. The history of paper monies is a sorry story of inflations, currency depreciations, and resulting social and economic disorder.”-Richard M. Ebeling, IMF Special Drawing Right "Paper Gold" vs. a Real Gold Standard

The recent weakness in gold prices has prompted some mainstream commentaries to suggest “fear” as the main driving force behind this.

The underlying premise is that since gold competes with every other asset class for the investor’s money, the recent surge in global stock markets may have revived “risk” taking appetite or the Keynesian “animal spirits”. And since gold has been seen as less attractive alternative, investors may have possibly sold gold and subsequently bought into the stock markets. Hence the recent selloff has had “fear” imputed on gold prices.

For me, this represents sloppy reasoning unbacked by evidence which has been “framed” in very short term horizon, the anchoring bias or the ``tendency to rely too heavily, or "anchor," on a past reference or on one trait or piece of information” in their analysis and an innate prejudice against the “barbaric metal”.

Such flawed analysis omits the following perspective:

1. Prices Are Relative.

As we discussed in Expect A Different Inflationary Environment, inflation moves in stages and would likely impact asset classes in a dissimilar mode.

From our perspective the stock markets and commodities have initially been the primary the absorber of government induced “reflationary” measures.

In other words, yes, a rotation will likely be the case, but this doesn’t imply “fear”. It simply means a pause in the trend because NO trend moves in a straight line. It is that elementary.

The same analogy can be ascribed to last year’s dreadful financial markets collapse, where many left leaning analysts have imputed “capitalism is dead”. The truism is that markets aren’t fated to move in one direction, because they always reflect on the fluid pricing dynamics by the different participants in response to perpetual changes in the flow of information as reflected by the changes in the environment.

But when markets are tweaked by governments to achieve a perennial boom, they attain the opposite outcome- a short-term euphoric boom and an equally devastating bust or the bubble cycle.

Mr. Bill Bonner in U.S. Banks Overrun by Dirty, Rotten Scoundrels eloquently describes this phenomenon, ``Capitalism is not a collection of nuts and bolts, gears and switches. Instead, it is a moral 'system.' 'Do unto others as you would have them do unto you,' is all you need to know about it. And like any moral 'system,' it rarely gives the capitalists what they hope for...or what they want. It gives them what they deserve. And right now, it's giving it to them good and hard.” (bold emphasis mine)

In short, losses are inherent features of the marketplace. Hence, they are reflected in trends or in cycles see figure 1.

Figure 1: stockcharts.com: Gold: Where’s The Fear?

Over the past three years we see some correlations among different markets, yet these correlations haven’t retained a fixed balance but instead have been continually evolving in a seemingly divergent fashion.

In 2006-2007 Gold (main window) soared along with the global stock markets (DJW), as the US Dollar index (USD) had been on a decline (see blue trend lines). So from this perspective alone, the premise that gold falls on higher stock markets simply DOESN’T HOLD. One could easily make the oversimplified case where the inflationary ramifications of a falling US dollar had fueled a frenzy over gold and global stock markets until this culminated.

But the past dynamics have been reconfigured.

Late last year, the spike in the VIX or the “Fear” index coincided with a surge in the US dollar as a majority of global stock markets went into a tailspin. Gold similarly melted. But in contrast to the stock markets, gold found an early bottom which corresponded with a peak in the US dollar and the VIX index. This apparently marked the end of an INVERSE or NEGATIVE correlation between gold and the US dollar.

In this landscape marked by FEAR, one can infer that the US dollar functioned as the sole “safehaven” from the banking meltdown triggered investor exodus in global stock markets and in gold. But apparently this dynamic appears to be a short term affair and may have signified as a ‘one-time’ event that marked the extraordinary market distress or dislocation-our Posttraumatic Stress Disorder PTSD.

In 2009, these dynamics have been rejiggered anew. From the start of the year, Gold strongly rallied but “peaked” alongside the US dollar index (see red arrows) concurrent to the decline in the fear index and a revival in global stock markets.

The falling US dollar and declining gold prices have reversed the NEGATIVE correlation to a POSITIVE correlation where both have moved in the same direction. The implication is that the US dollar, the VIX “fear” index and Gold encapsulated the investor’s negative sentiment, all of which have recently declined. And subsequently, the stock market rally has been “fueled” by the revival of the animal spirits, according to the fear believers.

Hence, the swift “rationalization” that investor’s negative sentiment has reversed course and has passed on the “fear factor” burden to “gold”.

Yet, this ignores the fact that both the US dollar index and gold are still on an UPTREND from the basis of the simultaneous lows last October. To reiterate, from their lows both had been positively correlated.

Stretching the picture, gold remains entrenched in a bullmarket since 2001, while the US dollar’s newfound virility could signify as either a cyclical rally within long term bear market or as a fledging bull.

But since gold represents as the nemesis of the paper money system (as seen by Keynesians-ergo “barbaric” metal) epitomized by the US dollar hence price action should reveal an inverse correlation. But this hasn’t been the case today, or as it had similarly been in 2005, where both the US and gold rose even amidst a milieu of rising stock markets.

Yet such positive correlation between gold and the US dollar may account for many variable reasons for the aberration. Since the US dollar index is significantly weighted towards the Euro this could mean a frailer European economy than the US, investor’s perception of Europe’s banking system as relatively more vulnerable, the deleveraging process continues to manifests of sporadic US dollar shortages in the global financial system, and etc.., but this seems likely to be temporary.

Nonetheless given that gold has been in a longer and a more solid trend of 8 years, combined with the fundamentals of the growing risks of unintended consequences by the collective money printing financed spending spree by governments, our money is on gold.

2. Governments Have Been Distorting Every Market Including Gold.

It’s quite naïve for anyone to docilely believe that the gold markets have been efficiently reflective of the genuine market based fundamentals, when almost every financial markets have seen massive scale of interventions from global governments.

To consider, the gold markets despite its relative smaller breadth (estimated at $4 trillion of above gold stocks and $150 billion gold mining stocks measured in market capitalization) has been a benchmark closely monitored by Central Bankers. For example the speech of Federal Reserve Chairman Ben Bernanke entitled as Money Gold and the Great Depression reinforces this view.

It is because gold has functioned as money for most of the years since humanity existed. So it isn’t just your ordinary or contemporary commodity.

In fact, this has been the 38^th year where our monetary system has operated outside the anchors of gold or other commodities. Alternatively, this represents as the boldest and grandest experiment of all time [see our earlier article Government Guarantees And the US Dollar Standard]. Remember, all experimentations of paper money system that has ever existed perished due to “inflationary” abuses by governments.

In other words, government distortions may cloud interim activities in the gold market, but this doesn’t suggest of a reversal of its long term trend. Thus, this isn’t fear.

The unstated overall goal of collective governments today is to revive the status quo ante environment predicated on the paradigm of borrow-spend-speculate policies. Thus an all out effort is being waged.

That’s why global central banks have geared policy interest rates towards ZERO-in the name of providing liquidity. That’s why global central banks have resorted to the printing press or in technical terms “quantitative easing” and absorbed various junks from the banking system-in the name of “normalizing” the credit process. And that’s why governments have thrown or indiscriminately spent enormous sums of money into the global financial and economic system-in the name of sustaining aggregate demand.

In essence, they want everybody to stop saving and indulge in a binge of borrowing, spending or speculating in order to drum up the “animal spirits”.

For those with common sense, we understand that these policies are simply unsustainable. And unsustainable policies eventually will unravel.

Yet why are these being practiced? Because of sundry political reasons-primarily to expand the presence of government in the system.

When gold defied the “deflationary outlook” which infected almost all asset classes, we argued that governments could have wanted a higher gold prices as signs of reviving inflation [see Do Governments View Rising Gold Prices As An Ally Against Deflation?]. With the present developments, this has changed.

Since the overall goal of governments is to revive the “animal spirits”, then rising stock markets serves as a vital instrument to project these reinvigorated investor sentiment. Now that stock markets have been sensing signs of emergent inflation, gold markets are being targeted as the traditional adversary.

Proof?

Take the publicized plan by the G-20 to sell part of IMF’s gold stash of 403 tons out of the 3,200 tons it holds which is the third largest after the US and Germany.

You’d be wondering why the efforts by the G-20 to broadcast sales, considering the substantial size, would have a negative short term impact on gold prices even prior to the actual sales.

A normal seller in the marketplace would have the incentive to get the best possible price in exchange for the goods or services being sold. Hence if the IMF aims to achieve optimum prices from its sales it should conduct its program discreetly. But this isn’t so. Obviously the announcement of proposed gold sales would result to depressed prices even prior to the action itself. Therefore, this wouldn’t account for an “economically rational” seller but one shrouded by political motivations.

Factually, this is just one of the psychological tools employed by central bankers when manipulating the currency market. They call this the “signaling channel”.

According to IMF’s Division Chief of the Research Department, in his article Turning Currencies Around, ``Through the signaling channel, the central bank communicates to the markets its policy intentions or private information it may have concerning the future supply of or demand for the currency (or, equivalently, the path of interest rates). A virtuous expectational cycle can emerge: for instance, if the central bank credibly communicates its belief that the exchange rate is too strong—and would be willing to change policy interest rates if necessary—then market expectations will lead to sales of the currency, weakening it as intended.” (bold underscore mine)

In short, G 20 policymakers have been using conventional currency manipulation tactics to put a kibosh on the gold market.

Moreover, the same article on the G 20 gold sales from CBS Marketwatch reports that the European Central bank had “completed the sale of 35.5 tons of gold” late March.

Another, there have been discussions in cyberspace on the unverified interventions by the European Central Bank to save Deutsche Bank from its short positions.

The point is you can’t ascribe fear when knowingly such markets are being cooked up for some political purposes, although the superficial nature of market manipulations ensures that the impact will be felt on a short term basis.

But even as the G-20 has been attempting to maneuver the gold markets, actions by one party appear to be offset by the actions of another.

Apparently China has been doing the opposite of the G-20. Instead of publicly airing its intent to increase gold reserves, it has tacitly been amassing gold from its domestic producers and from the domestic market (mineweb.com) to see a 75% surge in gold reserve holdings to 1,054 tonnes in 2008 from the 600 tonnes in 2003. (AFP)

While other analysts downplay the significance of this reported gold hoarding citing that China has been buying up almost everything from US treasuries, US equities to other commodities, we believe that China seems to be positioning its currency, the yuan, as a candidate to replace the US dollar as the world’s reserve currency as discussed in Phisix: The Case For A Bull Run or possibly working to provide an insurance cover on its currency against the growing risks of hyperinflation, which would translate to massive losses in its US dollar holdings on its portfolio [see Has China Begun Preparing For The Crack-Up Boom?].

In presaging for times of trouble, commodities essentially could function as the yuan’s potential “anchor”.

It makes no fundamental sense to excessively store up on gold, other metals, oil and other commodities unless severe shortages have been perceived as a potential problem.

As a political institution, China won’t be much concerned with the “convenience yield” or “the benefit or premium associated with holding an underlying product or physical good, rather than the contract or derivative product” (answers.com), even as commodities don’t generate interest income which is offered by financial assets.

Besides what’s the point of disclosing the sharp increase in gold reserves by China after 5 years of covert accumulation operations?

Thus, China’s actions can be construed as essentially more politically motivated (timed with its bleating over the increased risks of the US dollar) with economic and financial ramifications.

The other point is NOT to look at China’s holdings of US dollar assets on an absolute level but from a relative standpoint: where has China’s concentration of US assets been-in long term or short term securities? Remember although China may continue to buy US securities in order to hold its currency down, if it does so by accumulating assets in mostly short term duration, then this may be extrapolated as an attempt too reduce its currency risks exposure.

Finally, despite the ongoing official manipulations gold market isn’t just an issue for central banks as private institutions have been feverishly accumulating on gold holdings as seen in Figure 2.

Figure 2: Casey Research: Gold ETFs are rapidly catching up with top Central Banks

According to Casey Research, ``SPDR Gold Shares (GLD), an exchange-traded fund, first hit the market in November 2004 with 260,000 ounces of gold. Today, GLD is the world’s 6th largest holder of physical gold with over 35 million troy ounces in the vault. In fact, since the general market meltdown last fall, the ETF has added over 16 million ounces and ended 2008 with a 5% gain – not many investments can make that claim. Investors worldwide are sending a clear message: Gold is the safest asset in which to store wealth, not the product of the printing press.”

So even when official institutions have been attempting to control the gold markets, the interest from private investors have been strongly accelerating to possibly offset any substantial sales by top gold holders.

As Professor Gary North notes, ``Eventually, governments will run out of gold to sell, and so will the IMF. They will run out of gold to lease. While I do not think the politicians will ever catch on to the fact that their nations' gold is gone, leaving only IOUs for gold written by bullion banks that are on the verge of bankruptcy anyway, I do think that at some point the central banks will stop leasing gold.”

In short, once a substantial segment of gold from official institutions has been transferred to the investing public, governments will lose their power to manipulate gold prices.

Moreover, the relative variances in the holdings of the gold reserves among central banks underpins a possible realignment of gold distribution from crisis affected US and European nations with present heavy gold holdings to the savings and foreign currency reserve rich emerging economies.

So the potential shift likewise favors rising gold prices.

3. Ignores Seasonality Effects of Gold

Those bewailing fear have likewise been guilty of the omission of the seasonality patterns of gold see figure 3.

Figure 3: US Global Investors: Seasonal Patterns

The chart from US Global Investors manifests of the 15 and 30 year pattern of gold.

Basically, the annual trend can be identified starting with Gold’s summit during the first quarter which effectively goes downhill until the early third quarter where it bottoms, strengthens and ascends.

Even if we were to compare the movements over the last 3 years in Figure 1, the seasonality effects almost seem like clockwork but not in exactitude.

So if I were a gold trader, I’d start accumulating the benchmark precious metal during the lowest seasonal risk months of July to September and be a seller at the start of the year. Although in the interim, I should expect gold to firm up going into May where I should expect a summit and weaken into July or August.

Of course the seasonality factors have divergent depth or heights in terms of losses and gains mostly depending on the underlying long term trend. However in the present bullmarket, instead of correcting during the seasonal low months gold could simply consolidate (similar to 2007).

The point is if we understand and become cognizant of gold’s seasonality patterns, we won’t be lulled to the oversimplified anchoring of ascribing “fear” on gold prices.

Although as a caveat, considering that in the past 15-30 years gold’s annual cycle has been predicated on the demand configuration centered on mainly Jewelry (as I have shown in a chart last February), the accelerating interests on identifiable investments could diminish the seasonality effect variable.

4. Neglects the Risks of Accelerated Inflation Due To Flawed Economic Principles

Most believers of the “Fear” in gold see the risks of deflation more than the risks of inflation. That’s because they live in a simple world of known variables such as “liquidity traps”, “aggregate demands”, “animal spirits”, “current account imbalances” and “overcapacity”. On the same plane, they believe in the “neutrality” of money.

Let me remind you that the fundamental reason global governments are inflating have been due to the perceived risks of deflation, or said differently, for as long as the perceived risks of deflation is in the horizon, governments will continue to inflate, as they have been practicing what can be described as their ideology or textbook orientation-where policymaking or the decisions of a few is reckoned as better than the decisions of the billions of people operating in the marketplace.

As you can see, the irony here is that governments essentially FEAR falling prices in everything. Where falling prices are good for the individual (as it translates to more purchasing power), they are deemed bad for the society, so it is held.

And the same applies to savings; “savings” defeat consumption, so it is held, as reduced consumption equates to diminished “demand” which is equally bad for the society. Hence, to counter falling prices, means that governments and their coterie of mainstream supporters exalt on the furtherance of borrowing, spending and speculative inducing policies, the very policies that brought us this crisis.

Unfortunately the US and European banking system remains fragile as governments have kept alive institutions that needs to expire. The losses have now escalated to a sink hole-some $4.1 trillion of toxic assets, according to the revised estimates of the IMF. This means more redistributive processes is in the offing given this ideological framework, where more money especially from crisis affected nations will be used to prop up zombie institutions. The US has pledged or guaranteed a stupendous $12.8 trillion and growing (as of March 31), while UK’s support for its financial industry has already surged to a remarkable $2 trillion and counting.

Apart, every nation have been urged to do their role of printing money, borrowing and spending from which global policymakers have gladly obliged. The local crocs have been jumping with glee as Philippine stimulus spending of Php 330 billion or ($7 billion) translates to a surge in “S.O.P” (Standard Operating Procedure or other term for kickbacks).

The unfortunate part is that not every country or region has been affected by an impaired banking system. Emerging markets have primarily been affected by the transmission mechanism of the US epicenter crisis via external linkages of trade (falling exports), labor (reduced remittances) and investments. Hence, the deflationary pressures seen in nations which presently endure from busted credit bubbles and emerging markets suffering from sharp external adjustments or two distinct diseases have been administered with similar medication but in varying dosages.

Apparently, since money, for us, has relative impact on prices, these concerted government sponsored programs has begun to ‘leak out’ to the marketplace-through stock markets first then commodities next, as expected.

The recently published World Economic Outlook from the IMF gave me an eye popping jolt over the very compelling fundamentals of food!

Thus, we’d deviate from gold and discuss about food. See figure 4.

Figure 4: IMF’s WEO: Supply side dynamics for select Food

According to the WEO (p.55) , ``In the face of weaker demand from emerging economies, reduced biofuel production with declining gasoline demand, falling energy prices, and insufficient financing amid tightened credit conditions, farmers across the globe have reportedly reduced acreage and fertilizer use. For example, the U.S. Department of Agriculture projects that the combined area planted for the country’s eight major crops will decline by 2.8 percent (year over year) during the 2009–10 crop year. At the same time, stocks of key food staples, including wheat, are still at relatively low levels. These supply factors should partly offset downward pressure from weak demand during the downturn.” (bold underscore mine)

Did you see spot the fun part in the chart? Notice that the inventory cover for the world’s major Food crops (middle) has been nearly at the lowest levels since 1989!

Despite the surge in Food prices in early 2007 these hasn’t translated to a boom in the production side. Now that the crisis has been the underlying theme which has also impacted the food industry, production has further been impeded by “tightened credit conditions” which has “reduced acreage and fertilizer use”. Whereas consumption demand is expected by the WEO to be maintained at present levels (yellow line middle chart).

Remember the shelf life for food is short. Hence, surpluses are likely to be minimal.

Moreover, we have a looming structural long term demand-supply imbalance.

According to Earth Policy, ``Demand side trends include the addition of more than 70 million people to the global population each year, 4 billion people moving up the food chain--consuming more grain-intensive meat, milk, and eggs--and the massive diversion of U.S. grain to fuel ethanol distilleries. On the supply side, the trends include falling water tables, eroding soils, and rising temperatures. Higher temperatures lower grain yields. They also melt the glaciers in the Himalayas and on the Tibetan plateau whose ice melt sustains the major rivers and irrigation systems of China and India during the dry seasons.”

What is this implies is that this episode of intensive money printing on a global scale will have a tremendous impact on food prices!!! If the boom in financial markets in emerging markets does extrapolate to “reflation” then there will be a tidal wave of demand to be met by insufficient supplies!! The next crisis may even be a food crisis!

In addition, the inelasticity or poor or lagged response from the price action, possibly due to overregulation, subsidies, import tariffs, etc… , suggests of a prolonged supply side response; as I earlier noted -the boom in food prices in 2007 didn’t translate to a meaningful supply side adjustment.

So those obsessing over the “deflation” bogeyman will most likely be surprised by a sudden surge of Consumer Price Index especially when food prices hit the ceiling.

This is equally bullish for gold.

Moreover, for governments and those fearing deflation who are in support of policies operated by the printing press, it seems to be a case of “be careful of what you wish for!”