Doug Kass' Prediction For 2010: Strong US Dollar, Weak Gold And Equities

This is another post to highlight on the different predictions by various "experts" for 2010.

Here, we quote Barron's Randall Forsyth's entire article on Doug Kass' fearless forecast for 2010 with my comments.

According to Mr. Forsyth, (black highlights original, blue highlights mine) [parenthesis my comments]

``Seabreeze Partners’ Doug Kass today is expanding on his outlook articulated in a recent Barron’s interview (”Skeptical Growth Will Take Root,” Dec. 14), notably about rising populist fervor in the land. One outcome he sees is Goldman Sachs‘ (GS) deciding it no longer wants to be a public punching bag and will revert to private status.

``And why, you may ask, should anybody pay attention to Kass’ prognostications. For one thing, he saw a “generational low” in stocks in early March, just days before the market’s bottom. In any case, here are Dougie’s Top 20 Surprises for 2010:

1. There is a glaring upside to first-quarter 2010 corporate profits (up 100% year over year) and first-quarter 2010 GDP (up 4.5%). It grows clear that, owing to continued draconian cost cuts, coupled with a series of positive economic releases and a long list of company profit guidance increases in mid to late January and early February, there is a very large upside to first-quarter GDP (up 4.5%) and, even more important, to S&P profit growth (which doubles!). The upside on both counts is in sharp contrast to more muted growth expectations. While corporate managers, economists and strategists raise earnings per share, full-year growth and S&P target estimates, surprisingly, the U.S. equity market fails to respond positively to the much better growth dynamic, and the S&P 500 remains tightly range-bound (between 1,050 and 1,150) into spring 2010.

2. Housing and jobs fail to revive. An outsized first-quarter 2010 GDP (up 4.5.%) print is achieved despite a still moribund housing market and without any meaningful improvement in the labor market (excluding the increase in census workers) as corporations continue to cut costs and show little commitment to adding permanent employees.

3. The U.S. dollar explodes higher. After dropping by over 40% from 2001 to 2008, the U.S. dollar continued to spiral lower in the last nine months of 2009. Our currency’s recent strength will persist, however, surprising most market participants by continuing to rally into first quarter 2010. In fact, the U.S. dollar will be the strongest major world currency during the first three or four months of the new year.

[Mr. Kass forgets Bernanke's policy imperative to devalue the US dollar as one major options to save its highly levered banking system and the economy]

4. The price of gold topples. Gold’s price plummets to $900 an ounce by the beginning of second quarter 2010. Unhedged, publicly held gold companies report large losses, and the gold sector lies at the bottom of all major sector performers. Hedge fund manager John Paulson abandons his plan to bring a new dedicated gold hedge fund to market.

[Mr. Kass thinks gold as only benefiting from speculative actions. He joins the camp of populist Nouriel Roubini. My bet would be with Mr. Paulson than with Mr. Kass]

5. Central banks tighten earlier than expected. China, facing reported inflation approaching 5%, tightens monetary and fiscal policy in March, a month ahead of a Fed tightening of 50 basis points, which, with the benefit of hindsight, is a policy mistake.

[This would probably the last thing central banks would do. Central Bankers will likely lean towards erring on the side of inflation, in the mistaken belief that inflation can be domesticated than suffer from a repeat bout of deflation that risks menacing their banking system (am speaking of developed economies). Yet, in the event that markets respond negatively to policy measures, central bankers will hastily regress to zero bound policies]

6. A Middle East peace is upended due to an attack by Israel on Iran. Israel attacks Iran’s nuclear facilities before midyear. An already comatose U.S. consumer falls back on its heels, retail spending plummets, and the personal savings rate approaches 10%. The first-quarter spike in domestic growth is short-lived as GDP abruptly stalls.

[Mr. Kass appears to be reading from the current direction of US policymakers to impose economic sanctions or embargo on Iran by early 2010, of which Cong. Ron Paul rightly argues that this could be a precursor to a war.]

7. Stocks drop by 10% in the first half of next year. In the face of renewed geopolitical tensions and reduced worldwide growth expectations, stocks drop as the threat of an economic double-dip grows. Surprisingly, though, the drop in the major indices is contained, and the U.S. stock market retreats by less than 10% from year-end 2009 levels.

[Again Mr. Kass ignores two factors: policies directed to pump different markets to save the banking system and too much distortions from government intervention which muddies market signals. Nevertheless, a correction like that of gold's present actions could occur on the truism that markets don't move in a straight line-a midsized probability]

8. Goldman Sachs goes private. Goldman Sachs stock drops back to $125 to $130 a share, within $15 of the warrant exercise price that Warren Buffett received in Berkshire Hathaway’s (BRKA) late 2008 investment in Goldman Sachs. Sick of the unrelenting compensation outcry, government jawboning and associated populist pressures, Warren Buffett teams up with Goldman Sachs to take the investment firm private. The deal is completed by year-end.

9. Second-half 2010 GDP growth turns flat. The Goldman Sachs transaction stabilizes the markets, which are stunned by an extended Mideast conflict that continues throughout the summer and into the early fall. While a diplomatic initiative led by the U.S. serves to calm Mideast tensions, flat second-half U.S. GDP growth and a still high 9.5% to 10.0% unemployment rate caps the U.S. stock market’s upside and leads to a very dull second half, during which share prices have virtually flatlined (with surprisingly limited rallies and corrections throughout the entire six-month period). For the full year, the S&P 500 exhibits a 10% decline vs. the general consensus of leading strategists for about a 10% rise in the major indices.

10. Rate-sensitive stocks outperform; metals underperform. Utilities are the best performing sector in the U.S. stock market in 2010; gold stocks are the worst performing group, with consumer discretionary coming in as a close second.

[Mr. Kass evidently is in the deflation camp. Yet he sees rate sensitive issues outperform, i.e. aside from utilities which I also interpret to mean banks, insurance companies, REIT, etc... Nonetheless this would be quite inconsistent with the "deflation" outlook]

11. Treasury yields fall. The yield of the 10-year U.S. note drops from 4% at the end of the first quarter to under 3% by the summer and ends the year at approximately the same level (3%). Despite the current consensus that higher inflation and interest rates will weigh on the fixed-income markets, bonds surprisingly outperform stocks in 2010. A plethora of specialized domestic and non-U.S. fixed-income exchange-traded funds are introduced throughout the year, setting the stage for a vast speculative top in bond prices, but that is a late 2011 issue. [More evidence of Mr. Kass' deflation bias]

12. Warren Buffett steps down. Warren Buffett announces that he is handing over the investment reins to a Berkshire outsider and that he plans to also announce his in-house successor as chief operating officer by Berkshire Hathaway annual meeting in 2011.

[This is a high probability event considering that Mr. Buffett is 79 years old and is already grooming several candidates for his replacement. Stephen Burke's inclusion to the Berkshire board makes it all in the family according to this Bloomberg news]

13. Insider trading charges expand. The SEC alleges, in a broad-ranging sting, the existence of extensive exchange of information that goes well beyond Galleon’s Silicon Valley executive connections. Several well-known long-only mutual funds are implicated in the sting, which reveals that they have consistently received privileged information from some of the largest public companies over the past decade.

14. The SEC launches an assault on mutual fund expenses. The SEC restricts 12b-1 mutual fund fees. In response to the proposal, asset management stocks crater.

15. The SEC restricts short-selling. The SEC announces major short-selling bans after stocks sag in the second quarter.

[Obviously Mr. Kass looks at an environment where more regulation would be implemented (13-15) yet is ironically bullish over interest rate sensitive issues]

16. More hedge fund tumult emerges. Two of the most successful hedge fund managers extant announce their retirement and fund closures. One exits based on performance problems, the other based on legal problems.

[more hedge funds will implode only when markets are extremely volatile-mostly to the downside]

17. Pandit is out and Cohen is in at Citigroup (C). Citigroup’s Vikram Pandit is replaced by former Shearson Lehman Brothers Chairman Peter Cohen. Cohen replaces a number of senior Citigroup executives with Ramius Partners colleagues. Sandy Weill rejoins Citigroup as a senior consultant.

18. A weakened Republican party is in disarray. Sarah Palin announces that she has separated from her husband, leaving the Republican party firmly in the hands of former Massachusetts Governor Mitt Romney. An improving economy in early 2010 elevates President Obama’s popularity back to pre-inauguration levels, and, despite the market’s second-quarter decline, the country comes together after the Middle East conflict, producing a tidal wave of populism that moves ever more dramatically in legislation and spirit. With the Democratic tsunami (part deux) revived, the party wins November midterm elections by a landslide.

19. Tiger Woods makes a comeback. Tiger Woods and his wife reconcile in early 2010, and he returns earlier than expected to the PGA Tour. After announcing that his wife is pregnant with their third child, both the PGA Tour’s and Tiger Woods’ popularity rise to record levels, and the golfer signs a series of new commercial contracts that insure him a record $150 million of endorsement income in 2011.

[This is much ado out of trivialities; if showbiz personalities can be accepted by media as living a more licentious life, then why can't sports champions]

20. The New York Yankees are sold to a Jack Welch-led investor group. The Steinbrenner family decides, for estate purposes, to sell the New York Yankees to a group headed by former General Electric (GE) Chairman Jack Welch.

Paul Volker: Growth In Emerging World Is Like The US In Terms of Impact To The World

Former Federal Chairman Paul Volker recently interviewed by Charlie Ross at the PBS discussed sundry of topics from the US economy, global economy, global imbalances, the US banking system, emerging markets, US dollar, the Obama administration, taxation and etc...

Here are some excerpts on emerging markets and the US dollar:

``It’s pretty unusual but symbolic in the change of the world, instead of the emerging world being the hardest hit by this crisis, emerging world has been coming out pretty well. Now they’ve built out big reserves so they weren’t financially hit…

``But the growth in the emerging world is quite remarkable and amidst of this turmoil the emerging world together, you know, is like the United States in terms of the impact on the world economy, you couldn’t have dreamed of that 20 years ago, 30 years ago…

``It’s good, on the other hand, it is symbolic or more than symbolic of the relative, less dominant position the United States has, not just in the economy but in leadership, in terms of intellectual

``“I don’t know how we accommodate ourselves to it…You cannot be dependent upon these countries for three to four trillion dollars of your debt and think that they’re going to be passive observers of whatever you do.”

``They want to be at a table, but coming to table doesn’t create consensus.

``We will wanna import from China we will export to China, we gotta get more balanced relationship too but I don’t think that balanced relationship is inherently antagonistic…[Not a zero sum game] not at all

``But I don’t think no substitute to the Dollar now, unless we screw up and I hope we don’t, but that will the real danger for the dollar…

``The world needs a currency, the financial world is globalized, they are very much interconnected…

``It’s very convenient to have something that you can use right away for another payment and that’s what the dollar serves and that’s why people hold so many dollars…because it is convenient. And it is reasonably stable and convenient and useable and it won’t go away in a hurry."

Part 1 (if video won't activate pls click on the "part 1" link)

Bloomberg has also an account of the interview here.

Part 2 (if video won't activate pls click on the "part 2" link)

Debating The Fate Of The US Dollar, A Gold Linked Currency And China’s Yuan

In view of the falling US dollar, many articles have emerged to defend the US dollar as being either irreplaceable or will become substitutable only after a defined period of years or the Chinese yuan may follow the unsuccessful attempt of the Japan yen to emulate the US dollar as reserve currency or of inapplicability of a gold linked currency in today’s paper money standard.

While they maybe correct, I inclined to think many of these have been relying heavily on past performances and projecting these into the future.

Debating The Fate of the US dollar

For me the issue of the continued privilege of the US dollar as reserve currency will depend on the extent of inflationary policies imposed by its government, and secondly, from the responses of the world to such policies.

Next, the US dollar hasn’t been stable relative to its purchasing power. The fact that it has declined by 95% since 1913, makes it “stable” in terms of the rate of purchasing power lost over the years.

Perhaps the US dollar could be seen as “stable” in relative terms, or against other currencies, as paper currencies in general continue to collectively suffer from eroding purchasing power based on the continued abuse of the elastic currency due to sundry political goals.

Moreover, given mercantilist tinge by many of the world’s central bankers who continue to embrace “cheap currencies for exports” mindset via the imposition of varying degree of exchange rate pegs, assorted subsidies and tariffs and other proscriptions, a global campaign for “competitive devaluation” could lead to a currency war.

To quote, Murray N. Rothbard, in Making Economic Sense, ``The whole world would then be able to inflate together, and therefore not suffer the inconvenience of inflationary countries losing either gold or income to sound-money countries. All the countries could inflate in a centrally- coordinated fashion, and we could suffer manipulation and inflation by a world government-banking elite without check or hindrance. At the end of the road would be a horrendous world-wide hyper-inflation, with no way of escaping into sounder or less inflated currencies.” (bold emphasis mine).

So again we shouldn’t see this as analyzing against a constant but of an action-reaction dynamics to evolving policies. Say for instance if the US will see an upsurge in inflation will global governments continue with the current setup?

My guess is no.

A Gold Link Currency In Today’s Fiat System?

Another, currency volatility has been due to too much distortion brought about by government interventions in the economic system.

A country which adopts a gold standard may indeed be destined to see its currency’s price swings based on gold’s price performance.

However, what must be understood is that the accompanying fiscal restraint brought about by adapting a gold-linked currency system will probably lead to an appreciation based on significantly less politicization of the nation’s political economy that could lead to a productivity spike.

Nonetheless currency values will always fall under natural law of demand and supply, as Ludwig von Mises in Theory of Money and Credit wrote, ``the valuation of the monetary unit depends not upon the wealth of the country, but upon the ratio between the quantity of money and the demand for it, so that even the richest country may have a bad currency and the poorest country a good one. (emphasis added)

This leads us to international trade, currency values aren’t everything; weak currencies don’t necessarily imply export strength, for instance Philippine exports plunged by 25% in July in spite of the underperforming Peso (Inquirer), whereas strong currencies don’t automatically translate to feebleness in exports, for example Europe registered a surplus on “strong exports” in July in spite of the steep appreciation of the Euro (google).

What would crucially matter is the market from which a producer of goods or services sells into, the capital structure of an economy and importantly policies that underpin the trade structure, as discussed in Asia: Policy Induced Decoupling, Currency Values Aren’t Everything.

But of course, a gold linked currency given today’s political setting and economic ideological framework isn’t likely to be in the cards for policymakers, simply because it is not politically appealing. A gold backed currency would restrain politicians from taking advantage of the easiest, least understood and most discreet form of wealth redistribution.

China’s Remimbi As International Reserve?

Finally past performances don’t equate to future outcome.

Figure 2: Wall Street Journal: Yen Denominated Trade Transactions

The Yen’s failure to emulate the US dollar as a reserve currency, see figure 2, doesn’t necessarily extrapolate to the destiny of the Chinese Yuan. The circumstances behind the Yen’s unsuccessful attempt are not exactly the same forces faced by the Chinese today.

Becoming an international reserve standard would depend on many factors that would make a currency accepted as an international store of value, unit of account and medium of exchange, such as convertibility, market economy, depth and sophistication of the financial markets, transparency, low transaction costs, military might and etc…

Nevertheless, one good starting ground is by way of marketability.

Again Murray Rothbard in What Has Government Done To Our Money, ``Now just as in nature there is a great variety of skills and resources, so there is a variety in the marketability of goods. Some goods are more widely demanded than others, some are more divisible into smaller units without loss of value, some more durable over long periods of time, some more transportable over large distances. All of these advantages make for greater marketability. It is clear that in every society, the most marketable goods will be gradually selected as the media for exchange. As they are more and more selected as media, the demand for them increases because of this use, and so they become even more marketable. The result is a reinforcing spiral: more marketability causes wider use as a medium which causes more marketability, etc. Eventually, one or two commodities are used as general media--in almost all exchanges--and these are called money.” (bold highlights mine)

The degree with which China would assimilate a market economy will serve as the pivotal fundamental steps towards achieving such a goal.

Nonetheless, again it will also depend on the underlying policies that China would be undertaking aside from the policies by the US government as the de facto currency reserve and of the world relative to China.

It’s a complex and a highly fluid issue to speculate on.

Big Mac Index Update: Asia Cheapest, Europe Priciest

The Economist has recently released its Big Mac Index as a guide to valuing currencies based on purchasing power parity.

Basically, the idea is, leveraging from McDonald's global presence and its best selling product Big Mac and its worldwide reach to consumers, the Economist uses the Big Mac as a benchmark to estimate on the worth of national currencies compared to the US dollar-since the US dollar has functioned as the world's international currency standard.

According to the Economist, ``WHICH countries has the foreign-exchange market blessed with a cheap exchange rate, and which has it burdened with an expensive one? The Economist's Big Mac index, a lighthearted guide to valuing currencies, provides some clues. The index is based on the idea of purchasing-power parity (PPP), which says currencies should trade at the rate that makes the price of goods the same in each country. So if the price of a Big Mac translated into dollars is above $3.57, its cost in America, the currency is dear; if it is below that benchmark, it is cheap. A Big Mac in China is half the cost of one in America, and other Asian currencies look similarly undervalued. At the other end of the scale, many European currencies look uncompetitive. But the British pound, which was more than 25% overvalued a year ago, is now near fair value." (emphasis mine)

Why Purchasing power parity (PPP) as the selected gauge?

Perhaps using the wikipedia.org explanation, `` Using a PPP basis is arguably more useful when comparing differences in living standards on the whole between nations because PPP takes into account the relative cost of living and the inflation rates of different countries, rather than just a nominal gross domestic product (GDP) comparison." (bold highlight mine)

Of course, PPP is simply a statistical construct that doesn't take into the account the capital structure or the operating framework of the political economies of every nation, which is impossible to qualify and or quantify.

Left to its own devices, theoretically, the currency markets should have closed such discrepancies. But again, national idiosyncrasies and much government intervention to maintain certain levels in the marketplace, as policy regimes embraced by many countries with a managed float or fixed/pegged structure, hasn't allowed markets to work in such direction.

Nonetheless, present trends indicate of a growing chasm in the currency values (based on PPP) where continental Europe has been getting pricier while Asia has been getting cheaper.

As per July 13th based on the currencies monitored by the Economist, Hong Kong is the cheapest currency against the US dollar (-52%) , followed by China, Sri Lanka, Ukraine (-49%), Malaysia, Thailand (-47%), Russia, Indonesia (-43%) and the Philippines (-42%) using the % variance against the US dollar from where the abovementioned currencies are 40%+ below.

Based on the Big Mac Index alone, it would appear that Asia's currencies have much room to appreciate against the most expensive Euro or against the US dollar.

Soaring Oil Prices Isn't Just Relative To The US Dollar, But On Most Currencies!

Oil prices as benchmarked by the West Texas Intermediate Crude (WTIC) recently hit $73 per barrel where many analysts attributed oil's climb to the US dollar.

Having checked on the WTIC compared with different currencies we realized that this had only been partially accurate-oil has been surging across major currencies!

Against the Euro

Against the Aussie Dollar

Against the Japanese Yen

Against the Canadian Dollar (loonie)

Against the Swiss Franc

and even Against the South African Rand!

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!”