Credit Markets and the Price of Gold 24 comments
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This week saw a fundamental shift in Paulson's approach to restoring the proper functioning of the credit markets. I have been arguing for some time that the credit being pumped into the market is not finding its way into the system. The way that this plays out has direct implications for the price of gold.
As you can see in the chart above, there was a swift shift in the momentum for gold mid week. What happened was that gold was in a solid downtrend because real rates were seen as being high and the Fed is running out of ammo to lower rates. Then Paulson made his announcement, admitting that the recapitalization of banks is not leading them to lend to consumers. He announced that he was shifting his focus to getting credit to consumers.
Following that, gold tried to test $700 as it WAS in a downtrend. However, that shift in policy is inflationary. As I have been arguing, should rate cuts and public credit find its way out to the private market, inflation will hit hard, and seeing as it is unexpected by the market, it would likely be violent. This led to a sharp adjustment upward in price.
This once again brings us to the question of credit finding its way into the market. And although the rhetoric from Paulson is inflationary, the question still remains whether or not the Treasury will be able to get private institutions to lend to individuals. In my opinion this could only be done by nationalizing the banks out right thus giving the government power to control the banks lending practices - very unlikely. Therefore I conclude that deflation remains more of a concern than inflation for the time being.
Inflation/Deflation
The best analogy I have of inflation and deflation is the weather - inflation being a hot day and deflation being a cool one. In general, our credit based economy prefers a little credit growth in the long run, just how most prefer warmer days to cooler ones. Then comes along a really hot day (lots of inflation), but you can always sit in the shade or jump in the swimming pool (raise interest rates Volcker style) to cool off. There are some that REALLY hate the heat (Austrian School of Economics) and even in the middle of winter dread even slightly warmer days.
But as bad as the heat is, the cold is worse. You can start a fire or put on a sweater to warm up, but failing to do so could be very bad for your health - possibly fatal. Extreme heat is uncomfortable while extreme cold is potentially deadly.
As bad as inflation is, deflation is worse as there's only so much medicine that you can take. Once rates reach zero and growth moves into negative territory, real rates are high, and there's nothing that can be done about it. This has a very negative feedback loop as cash gets more valuable by the day. Every cent saved today is worth more tomorrow, which kills real asset prices, deters consumers, and investors. You need to look no further than Japanese real estate to see the ugly face of deflation. The worst part about it is that existing debt becomes more of a burden with each passing day, as the money you borrowed and used is worth more and more in real terms and paying it back becomes an impossible task.
It is for this reason that the world's leaders are focusing on deflation rather than inflation. Some inflation may very well be the consequence of these actions - but the alternative is far more destructive. Then there is still the possibility that the Fed is able to drain the excess liquidity before inflation strikes, although that would be a very impressive feat.
Disclosure: Author owns OTM calls, trading with bear bias
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This article has 24 comments:
Destructive for whom?
I would argue that businesses who went over their heads in debt to take huge risky positions in the markets with money they didn't have SHOULD destruct. They were not helping anyone but themselves via short term generation of huge bonuses at the expense of their shareholders.
Just because Citi, BofA, Merrill, or any of the other big 'banks' won't survive without taking a serious haircut doesn't mean smaller banks won't be around to make loans when people want them or that they can't restructure into smaller and sounder entities via chapter 13 bankruptcy.
Let the foolish gambling banks fail and allow the prudent banks to pick up their customers and succeed. Maybe the remaining banks will remember what NOT to do for the next 50 years and manage to operate without going under.
Any other path is simply transferring the cost of the failure onto the taxpayer's back while sowing the seed of even larger future problems.
"Then there is still the possibility that the Fed is able to drain the excess liquidity before inflation strikes, although that would be a very impressive feat."
Yes. Impressive indeed considering that M1 has increased nearly 50% in the past 2 months, as another Seeking Alpha author has noted.
seekingalpha.com/artic...
The system is very flawed and one of those flaws are that the innocent people pay for the mistakes of others. I like to look at it from a Libertarian perspective where the only time that the government should get involved is where one private party's decisions infringe negatively on another private party, and civil action will either be too slow or unfair on the smaller party.
In the case of these big banks failing, we would see student loans dry up, payrolls become harder for companies to meet without selling valuable assets to free up cash, obviously the auto and real estate industries would completely dry up. Although I hate the precedent it sets, you have to step in and do something. BUT I don't agree with their strategy. What's happening is the opposite and these banks are going to be STRONGER as they gobble up smaller banks deposits aided by Fed money instead of lending it out.
My point is that the public will have high costs whether we save the banks OR if we allow them to fail and the costs would be more visible in the latter case (higher unemployment, increasing defaults, etc). It's unfair to just say that the banks were the irresponsible ones when the whole nation is in debt with a negative savings rate.
Another point that I should make is that in our discussions my original thesis has been faded out. That is that the demand for gold is keeping it above it's intrinsic value. I am sure you are smart enough to understand that just because something is priced in dollars, it doesn't mean that the asset has a perfectly negative correlation to the value of the dollar. CAT for example is subject to its own supply/demand, although the dollar value does have some implications it is not the whole story - the same with gold.
What I believe we saw in the run-up in gold prices (and oil) is that the idea of limited supply puts pressure of excessive volatility to the upside. Too much money chasing too few goods and the gold price itself over inflated. When you compare it's price to other real goods (real estate, oil, silver) those prices have come down far more than gold has. The gold market still has more inflation priced into it than a lot of other assets, purely due to short term supply and easy fundamentals to understand for retail investors.
At the same time I accept the risks to the upside and should that occur I believe it will be drastic and that's why I hold OTM calls. A flood of demand coming in from the Saudis, China, or anyone could put massive upward pressure.
From the U.S perspective, I think the clearest play is shorting long term treasuries. I just think that the most obvious outcome of all of this is that the U.S will have to pay significantly higher interest rates to borrow long term. Should they aggressively print to the point that gold goes to $2000, I can guarantee you that the long term borrow costs will be through the roof as well. Should they convince the world to keep lending to them and not be forced to print massive amounts of money in the short term, yields will go up as well as supply explodes.
We are impressed with your arguments, can you visit us
crowlee.proboards76.co.../
I have posted some of your work here, my respects, Clavis
PS Apologises to Adam but I am sure that he will not mind.
Adam, posted you here, astute, yet the worm may turn!
I think we agree more than disagree. There will be high costs regardless. The question is who bears the costs?
I would still opt for letting things fail. People who made bad decisions should suffer the consequences and not others. Saving the banks or irresponsible borrowers only hurts those who were not irresponsible and thereby hampers effective recovery efforts from those who have acted in a manner to recover without outside help.
I would contend that a house be foreclosed and sold at half price with a loan from a solvent bank to an investor with sufficient net worth than to 'rob' the investor via taxes or inflation to prop up the original insolvent bank and insolvent homeowner.
The investor will own the home at a price where he can rent it to the original homeowner (within his budget) and still earn a profit, thereby supporting the loan and the solvent bank.
The losers will be the original insolvent bank who made a bad loan and the original homeowner due to the bad credit marks and loss of equity in the house. However, the 'bad' bank will likely go under (setting an example) and the original homeowner will still get a place to live at a price they can afford rather than go bankrupt trying to save the house.
Thus the prudent succeed and the foolish suffer. Each acts as an example for others in the future where, hopefully, there will be more success based behavior and less foolish behavior as a result. This will tend to produce conditions for continued, sustainable growth for the benefit of all.
Long gold and shorting US Treasuries will probably prove to be profitable in the 'long run'. Hopefully your calls won't expire before then.
I am also long GLD OTM calls expecting a nearer term rally. If I didn't think the long term price of gold will be higher I'd be trading puts instead when declines seemd imminent. The current trend is still up for the long term.
Good fortune in your trades.
There are prudent thieves and unwise thieves but FRB is a license to steal via inflation. Plus it artificially lowers interest rates thus discouraging saving and encouraging speculation and consumption.
Let's not blame the people until the government backed fractional reserve banking cartel is abolished.
As a Mises supporter you obviously believe in completely free markets, no govt intervention, etc. You also believe that each individual has the right to make decisions for themselves and no one else should cover the costs if they screw up. If a consumer gets into a loan that he/she knows they cannot afford, or signs a contract that they don't fully understand, they are as responsible as the lenders who misled them. They essentually assumed too much risk and as a result should fully suffer the consequences of losing their house, declaring bankrupcy, and losing all of their assets in the process.
I am not proposing this as a solution, all I am saying is that if you believe in the philosophical principles of Mises, you cannot lay all of the blame on the banks and the Fed, even if they were the root cause.
Very true.
A co-worker of mine told me that when he bought a house a few years ago that his mortgage broker gave him a brochure which touted the ARM reset type loans and included a bullet that said
"Buy more home than you could otherwise afford"
He told me that he gave the brochure back and asked the broker why on Earth would he want to buy something he couldn't afford? Then he got a nice low fixed rate loan that he *could* afford and (presumably) will live happily ever after.
Excellent comment. But artificially low interest rates not only discourage saving and encourage consumption and speculation but they also lead to a "cluster of business errors", the bust part of the boom/bust cycle. People were told that housing prices would always go up. Turns out they don't.
Speaking of housing prices always going up.
uk.youtube.com/watch?v...
Yes, I agree, let the people loose their homes if they can't pay. What bothers me though is the bankers getting the collateral for a loan they created out-of-thin air!
If I give you a gun, it doesn't mean you have to use it. The difference between interest rates being at 4% or 7% should be used by consumers as a savings tool, by buying a house of equal value regardless of current rates. The problem is that the average consumer will use slightly lower rates to buy a more expensive house. If you buy the same house regardless, you will actually have extra money in your pocket at the end of the month. In that environment you stick the savings into gold and you will ultimately be rewarded.
Boom/bust cycles exist in part due to the fixing of interest rates, but ALSO because of how consumers react to those changes. If you spend prudently, lower interest rates can actually be a savings mechanism. Obviously this doesnt apply if 1 consumer does this because other consumers will force up real estate prices and the same house will cost the responsible consumer more. Rather, this is education that the general public should be recieving.
YES too many people believed housing prices would always go up - what a stupid thing to believe. However I personally think gold bugs make the same mistake by thinking that gold must always go up.
But the only thing they can do with the collateral is sell it to pay off the loan (which then 'destroys' the fake money). You would see the same sort of thing happen if it was a loan from actual savings. The lender want's collateral for the loan's repayment as a condition of making the loan.
The borderline 'crime' is that they charge interest on the fake money which they create out of thin air, or seen from a different perspective they charge interest on the same money up to 9 times.
You could make a pretty good living by borrowing $1 Billion at the FED window for 1%, then lending out $8 Billion at 6%.
(That's $470 Million per year in interest differential - minus expenses).
Turn that on its head. Gold will hold its purchasing power over time within the limits of supply/demand effects.
At any time during the past 30 years you could purchase a median home for 435 oz of gold (or less), even though the gold 'price' varied from $38 to $1030 in that interval and the 'price' of a median house went from $17,000 to $219,000.
Calling someone a 'gold bug' for accumulating gold on a cost averaging basis over time results from missing the point that those 'bugs' are converting current purchasing power into equavilent future purchasing power, regardless of gold's 'price' in depreciating dollars.
Whether they charge interest or not, the actual purchasing power of the loans came out of the hide of the general public without their consent and without compensation.
"But the only thing they can do with the collateral is sell it to pay off the loan (which then 'destroys' the fake money)." Smarty
Yes, with FRB money must be destroyed.
I could reverse what you said and say that housing prices maintained their purchasing power as well (up until the recent crash of course).
If you had purchased gold in the 70's for $800 you would be down a lot in terms of purchasing power.
BUT, I must point out that you have proven my original point. I have been arguing that compared to real estate, silver, and oil, gold has not lost enough value to reflect real prices. It may simply be discounting future inflation, but that's why its over valued right now as an inflation hedge. There's far more value in the others mentioned above. Real estate has come off significantly more than gold. Should the structural demand problems continue (and I think they will for oil and housing), those two will likely continue to trend lower and there is no reason for gold to move higher while those are moving lower. That would completely distort the theoretical idea behind gold preserving value if it's purchasing power increased to an even wider spread. Alternatively if you believe gold will go up and the ratio will normalize, then real estate prices must rise at a faster rate than gold. Based on last months median home price of $218,400, that equates to approximately 300 ounces at todays prices. Gold prices have not gone down as far as they need to.
www.plusev.ca/gold-dol.../
www.telegraph.co.uk/fi...
I would contend that pricing changes due to supply/demand are separate from changes due to currency devaluation. Many might not agree, but I believe that using them interchangeably is misleading.
The supply of dollars has increased much faster than inflation levels in general, mainly because foreign governments and banks use the dollar as a reserve currency and sop up a lot of the supply available and lock it away. If those dollars were circulating dollar inflation would be much higher than we are experiencing now.
(The current US adjusted monetary base, M1, is about $1.3 Trillion and China alone has $2 Trillion in reserves.)
Given the ever rising US debt and money supply (adjusted monetary base up nearly 50% in 2 months) the dollar's reserve status is on shaky ground. If foreign governments start selling dollar reserves and put only a fraction of that money into gold, we will see much higher gold prices. China is starting to drop hints in that vein already.
While it may be a 'slow boat' to higher prices waiting for the bailout money to work its way through the economy and drive prices up, it is becoming more likely (though remote yet) that the dollar could devalue very quickly if foreigners start a stampede to get out while it is still worth something.
You are correct in that near term prices may decline, but I believe that it won't last. The long term trend is up, it's just a matter when the bottom drops out of the dollar. I could be wrong, but it's a risk I have considered and am willing to take.
My plan remains to use short term trading (gold and market) to generate profits which can then be put into physical gold. It's not all my money, not even most of it, but the goal is a growing pile of gold in my clammy hands for disaster insurance and I'm moving that way.
If that makes me a 'gold bug' then I'll wear the badge proudly.
So far it's working for me. ;-)
Link to adjusted monetary base data:
research.stlouisfed.or...
I completely agree and that;s why I think that gold is overvalued. The fact that there is a limited supply causes this when there is a rush into the asset - it then takes a while to unwind the price that was overshot due to excess demand. That's the reason why I wouldn't be shocked to see the dollar and gold both weaken simultaneously.
Did some research today that you may want to see:
www.plusev.ca/gold-pri.../