Gold's Record Run Is A US Dollar Affair So Far

Another interesting outlook from Bespoke Invest on Gold

According to Bespoke, ``While gold is at record highs in dollar terms, the commodity is still down 10% from its highs when priced in Euros and Yen. As shown in the charts, the price of gold is up considerably over the last five years, but the recent run has only been strong in dollar terms. This indicates that the strength is solely a function of a weaker dollar rather than any real pickup demand." (emphasis added)

Additional comments:

As Bespoke noted, gold's rise so far has been a 'pass through' effect from a weak dollar.

Alternatively, this means that gold has so far underperformed the Euro and the Yen.

Also, this appears to be an "interim" trend than a secular trend.

Lastly, given that this short term phenomenon has been insulated to a seeming "US dollar event" so far, this also implies that the impact from policies to collectively devalue currencies (a.k.a. global currency war) hasn't been evident yet.

Applied to asset markets, this could suggest that inflation is still on a 'sweet spot', and would thus, seem favorable for further upside moves.

Government Guarantees And the US Dollar Standard

``At some point, it will become necessary to guarantee failing pension plans, income, Medicare payments, mortgage payments, bank deposits, student loans, commercial paper, insurance policies, jobs, unemployment payments, old age payments, and much else, all at the same time. People will question the worth of shifting massive resources from one set of pockets to another set of pockets. They will see that the government guarantees nothing. It recycles resources it extracts from us back to us. This realization will mark the sunset of belief in federal guarantees.”-Professor Michael Rozeff, The Sunset of Federal Government Guarantees

One of the main objections to the risks of sovereign credit default is the purported faith on government guarantees.

Such belief is representative of unremitting and inexorable dependence in governments as drivers of the economic and financial prosperity. Yet bereft of the lessons of history and the basic principles of economics, never have these people realized that governments EVERYWHERE through the years and through their coercive police and military powers almost always change the rules in the middle of the game, or in accordance to leader’s whims or to fungible political priorities or imposed policies with short term noble sounding relief programs at the expense of negative long term costs or protected a few interest groups in the “name of the patriotism” or have robbed people of their property rights through unjust distributive inflationary policies.

In short, despite the repeated failures to achieve major societal goals, people have come to believe government guarantees mean something.

Yet believing in governments as solution to society’s upliftment could be fatal. What people haven’t realized is that guarantees require real capital or real resources for it to be dependable. Running huge deficits and paying them off with printing press money which can’t be backed by real capital means government guarantees “are not worth the paper they’re printed on” to quote Professor Michael Rozeff.

As we pointed out in It’s a Banking Meltdown More Than A Stock Market Collapse!, Iceland for instance, just last year used to be among the world’s wealthiest economies with a per capita income which was the 6^th highest. As the recent crisis unfolded, the Icelandic government guaranteed the deposits of its financial system and nationalized its overleveraged major banks in the hope to apply the magic wonders of the government wand. Unfortunately, due to the lack of real capital, the country of 320,000 went bankrupt.

Iceland’s banking system which operated like a national hedge fund during the heydays will be paying a pretty stiff price for its misadventures and policy blunders, according to Economist (bold emphasis mine), ``Gross government debt is forecast by the IMF to increase from 29% of GDP at the end of 2007 to 109% of GDP in 2009. Apart from the widening deficit, the increase in debt will result from three main causes: first, the recapitalisation of the failed commercial banks now under public ownership will cost around Ikr385bn, or 25% of GDP; second, the costs of recapitalising the Central Bank will be close to 10% of GDP; and third, meeting the extensive obligations of the failed banks (that is, compensating depositors and other creditors) will cost around 47% of GDP. A sizeable portion of this should, however, be recovered over the coming years as the banks' assets are sold. Nevertheless, there will a large debt-servicing burden on the central government that will have to be met by extensive cuts in government spending or through higher taxes.” Ouch.

The lesson here is that paper guarantees from any government may not even be worth anything unless they are backed by real resources or real capital. The same applies with the US dollar, the world’s preeminent currency backed by full faith and credit by the US government.

The belief that the US dollar is insuperable and is unlikely to seriously suffer from negative repercussions from its accrued reckless and imprudent past and present policies could signify as perilous complacency.

The fact that the recent crisis has its epicenter in the US and has rattled the foundations of the global banking system aside from disrupting the world trade financing have prompted some governments to explore alternative means of conducting trade outside the US dollar system such as:

1. The recent case of rice for oil barter between Thailand and Iran (see Signs of Transitioning Financial Order? The Emergence of Barter and Bilateral Based Currency Based Trading?),

2. Mounting talks about the resurrection of a modern form of Bretton Woods Standard (as previously discussed in Bretton Woods II: Asia Weighing In Too? and in Bretton Woods II: Bringing Back Gold To Our Financial Architecture?),

3. Utilization of a new payment system which uses local currency for trade as in Brazil and Argentina’s Local Currency Payment system. China and Russia has likewise been reportedly mulling to engage in a similar domestic currency based bilateral trade and

4. A pilot form of regional currency standard such as China’s recent proposal to expand the use of its currency as a medium of trade for China, Hong Kong Macau and ASEAN countries (BBC)

So aside from policy induced fundamental deterioration, all these exogenous events serve as ample evidence of the growing vulnerability of the US government guaranteed US dollar standard system.

Mike Hewitt of Dollardaze.org has made a splendid study on currencies where he observes that some 173 currencies are in circulation in the world today.

Yet not all of the existing currencies are widely used or circulated. Mr. Hewitt gives some examples as the “unofficial banknotes of the crown dependencies (Isle of Man and the Balliwicks of Jersey and Guernsey).”

Importantly Mr. Hewitt provides us some very important facts from today paper currency regime (all bold highlights mine):

-The median age for all existing currencies in circulation is only 39 years and at least one, the Zimbabwe dollar, is in the throes of hyperinflation.

-Excluding the early paper currencies of medieval China (and India, Japan and Persia) as well as the majority of paper currencies that existed in China until 1935, there are 612 currencies no longer in circulation. The median age for these currencies is only seventeen years.

Figure 3: DollarDaze.org: Fates of Currencies

-Both war and hyperinflation have each been responsible for the demise of 145 currencies. The Second World War saw at least 80 currencies vanish as nations were conquered and liberated.

-Second only to war, hyperinflation is the greatest calamity to strike a nation. This devastating process has destroyed currencies in the United States, France, Germany, and many others.

As one can observe, paper currencies tend to be generally short lived. Importantly, the fact that war and hyperinflation have been the main proximate factors which has caused most of the world’s currencies to disintegrate depicts that both are related.

To quote Ludwig von Mises in Nation State and Economy,

``One can say without exaggeration that inflation is an indispensable means of militarism. Without it, the repercussions of war on welfare become obvious much more quickly and penetratingly; war weariness would set in much earlier.”

Welcome To The Mises Moment

``We have seen that each new control, sometimes seemingly innocuous, has begotten new and further controls. We have seen that for governments are inherently inflationary, since inflation is a tempting means of acquiring revenue for the State and its favored groups. The slow but certain seizure of the monetary reins has thus been used to (a) inflate the economy at a pace decided by government; and (b) bring about socialistic direction of the entire economy. Furthermore, government meddling with money has not only brought untold tyranny into the world; it has also brought chaos and not order. It has fragmented the peaceful, productive world market and shattered it into a thousand pieces, with trade and investment hobbled and hampered by myriad restrictions, controls, artificial rates, currency breakdowns, etc. It has helped bring about wars by transforming a world of peaceful intercourse into a jungle of warring currency blocs. In short, we find that coercion, in money as in other matters, brings, not order, but conflict and chaos.”-Murray Rothbard, What has Government Done To Our Money

No investor today can rely on traditional metrics to ascertain investment themes since the financial markets have been living on government steroids.

Government has fundamentally usurped the role of gods as they determine the winners or the losers or which industries or businesses deserve to live or perish.

Such evolving shift towards the consolidation and expansion of government’s power in the marketplace or ‘state capitalism’ will mold a new risk environment from which will determine risk capital’s rate of return and how capital resources would be deployed overtime.

Yet most of the current policies applied are designed to impact immediate concerns and appear to be shrouded with unintended consequences. Hence, any serious investor would need to read into government actions and project their repercussions to the investing sphere.

Government actions today appear to be in unison with the goal to combat threats of “deflationary” recession. The collective belief is that the slack in ‘demand’ prompted by falling asset prices will induce the public to hold onto cash instead of generating consumption via the restoration of the credit cycle.

Thus government policies led by the US appear to be directed at patching up the lapses from an imploding bubble.

The Bernanke Doctrine

The direction of policy actions or what I would call as the ‘Bernanke doctrine’ has been telegraphed to the public since 2001 and has been his deflation fighting manual. I guess most central bankers have adopted his strategy so the seeming “collaborative” and “concerted” efforts.

The US Federal Reserve recently cut interest rates from a fixed target to range between 0 and ¼% which it expects to hold “for sometime”. And now that the US central bank has moved rates to near zero level (Zero Interest Rate Policy-ZIRP), which leaves them limited room to use interest rate as ammunition, they are left with the terminal option of balance sheet management. The Fed recently announced that they would:

1) purchase assets directly from the market- “will purchase large quantities of agency debt and mortgage-backed securities” and “evaluating the potential benefits of purchasing longer-term Treasury securities”,

2) provide credit directly- “will also implement the Term Asset-Backed Securities Loan Facility to facilitate the extension of credit to households and small businesses” and

3) expand the use of the printing press “consider ways of using its balance sheet to further support credit markets and economic activity”.

Notice that these endgame tactics involve the short circuiting the banking system which basically has not been different from Zimbabwe’s Dr. Gideon Gono’s strategy of using the printing presses aided by the an expansive government.

The aforementioned FED monetary policies, combined with the present fiscal package and the purported $850 billion inaugural program for the incoming President Barack Obama, which are allegedly aimed at jumpstarting the economy, seems headed for such direction.

And the buck doesn’t seem to stop here.

``The biggest fear is that people will do too little…like a start-up that fails because it didn't do enough”, the Wall Street Journal quotes an anonymous Democratic leadership aide on President Obama’s inaugural stimulus program.

This captures what we’ve been saying all along…political motives will shape policy decisions more than economic concerns. Officials will use the cover of popular demand to continually spend taxpayer money organically meant to keep afloat its US dollar standard fractional banking system even to the point where Ben Bernanke could resort to the nuclear option of the printing press based currency devaluation to inflate away the unsustainable debt levels.

The desire to print money to solve economic ailments can only lead to further financial or economic disorders.

Bernanke’s Asymmetric Playing Field

Yet the shift from interest rate to balance sheet or money supply management policy comes with many unknown effects.

One, the directives of US monetary policy seems to revolve heavily towards Ben Bernanke. This makes him, unknowingly to the public, the most powerful man in the world, an unelected official. Remember, the world operates around the US dollar standard system from which Bernanke’s clout has been strengthening.

As we pointed out in Is Ben Bernanke Turning The US Federal Reserve Into A Dictatorship?, the concentration of powers towards the center, by bypassing legal requirements or procedures and circumventing organizational hierarchy in the decision making process, could signify as consequence to the ongoing policy directional shift from ZIRP to the money supply.

According to Economist Bob Eisenbeis of Cumberland Advisors, ``The size of the Fed’s balance sheet is largely dependent upon the Board of Governors and its lending programs and is not the province of the FOMC”, and since balance sheet management involves day to day decisions ``it is neither feasible nor practical for the Reserve Bank Presidents to move to Washington and meet daily.” Thus, the FOMC would probably be “mothballed” until ``the return of normalcy to policy formulation.” This explains the rational behind the apparent arrogation of power by Ben Bernanke.

Thus, the fate of the US and the world’s financial system (markets and banks) and even the economies now resides in the palms of Mr. Bernanke, see figure 1; ironically the same person who wrongly predicted the containment of the subprime crisis.

Figure 1: Cato.org: US Credit Triangle

Two, informational changes in the size and composition of the balance sheet or Bernanke’s present actions will be critical to market participants. The assets which the Fed buys today or in the future will give undue advantage over the assets it won’t be buying. Thus the fate of the markets depends on Mr. Bernanke’s biases, values or priorities (marginal utility). As we always say, inflationary policies always favor those with closest ties to the government.

Three, since the Fed relies on 17 primary dealers (including some foreign affiliates) to implement its purchasing activities, the said institutions will have “real informational advantage” (since they have access to Fed activities) or an information asymmetric edge over most market participants. Essentially, such developments makes markets today tilted towards an insider’s game.

In all, Ben Bernanke has altered the global financial market’s landscape into a casino like environment by playing with a loaded the dice, constantly changing of rules in the middle of the game to suit his predispositions and fostering an uneven playing field-where he assumes the role of the house. His newly assimilated omnipotent powers will likely shape world markets, economies or even implicitly political developments which could be laden with a minefield of unforeseen consequences. Hence, the risks are that policy mistakes made by omission or by commission will exacerbate further suffering to the world.

Global Central Banks Adopt The Bernanke Doctrine

The switch from interest rates to balance sheet policy management isn’t a development restricted to the US as Japan and Switzerland has also joined the trend of consolidating central bank power to wrench open the spigot of money supply with the goal to “stimulate” their respective economies.

The Bank of Japan (BoJ) cut rates from .3% to .1% last week and declared that it would increase purchases of government bonds, including inflation-linked bonds, floating rate bonds and 30-year bonds, aside from commercial paper. It will likewise consider buying corporate debt products (forextv.com).

The Swiss National Bank (SNB) also slashed rates by half a percentage point, last week, from 3-month Swiss franc LIBOR rate of 0.50-1.50 percent to 0.00-1.00 percent, its fourth cut in two months.

With policy rates at zero levels, the SNB is said to consider “quantitative easing” (running printing press) through unsterilized currency intervention by possibly buying ``Swiss franc bonds to lower borrowing costs or try to weaken the franc either by verbal or physical intervention.” (IHT.com).

According to Morgan Stanley’s Joachim Fels (highlight mine), ``the may choose to implement QE partly through unsterilised currency intervention, i.e., buying foreign currency without offsetting the impact on their balance sheet through open-market sales of other assets. The reasoning behind this is that for small open economies like Switzerland, the exchange rate is a more important driver of the economy than mortgage rates or other interest rates, and in the case of Japan, currency intervention might help to stem the recent sharp appreciation of the yen.”

Both the SNB and BoJ basically will be utilizing the same Bernanke’s textbook approach!

So as global central banks become more desperate they are likely to resort to their home printing presses aimed at devaluing their currency against everyone else. This raises the risk of a currency war or a tumultuous upheaval in the present monetary system, especially when Mr. Bernanke opts for the nuclear option.

Again this reminds as again of Ludwing von Mises who presciently wrote in Human Action, ``The wavelike movement affecting the economic system, the recurrence of periods of boom which are followed by periods of depression, is the unavoidable outcome of the attempts, repeated again and again, to lower the gross market rate of interest by means of credit expansion. There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as the result of a voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved”

The currency markets will be the natural release valve for all these accrued government actions in 2009.

Welcome to the Mises Moment.