The Gnomes of Zurich Will Have Their Revenge

Includes: GLD, UUP
by: Justice Litle

The “Gnomes of Zurich” scored a great victory over the dollar’s defenders in the 1960s. Now their time looks to be coming around once again.

Take a look at this long-term gold futures chart.

Gold Futures Monthly

Stepping out to a longer-term chart is a bit like seeing the world from a higher altitude. As you head further out, the drama begins to recede. (From a far enough distance, the world is little more than a pale blue dot – as Carl Sagan liked to point out.)

So, too, with gold. There has been a lot of yellow metal angst in light of the recent credit implosion. But if we look back to the genesis of the gold bull market in 2001, we can see that the long-term uptrend is still intact. Gold would have to close below $650 to break it.

Hedge Fund Deluge

What, then, about gold stocks, which have been hammered through the floor?

As we now know, the carnage in gold stocks – as in the entire market – had a lot to do with investor panic and forced hedge fund selling.

Third quarter data on hedge fund stock sales recently came available, and the numbers are staggering. Among the larger players, fund after fund with holdings of $5 to $10 billion slashed equity exposure by 90 percent or more. At the same time, very few new positions were picked up. Almost to a man, asset managers have been bracing themselves against the threat of further investor redemption.

With that kind of deluge – not to mention forced margin-call selling on the part of many company execs – it’s no wonder hard asset stocks got crushed. The funny thing, though, is that this is exactly the kind of thing the old hands talk about when they chuckle over tops and bottoms. Near the top, the public can’t buy enough. Near the bottom, they refuse to buy for love or money. And so it goes.

But anyway, now let’s take a look at another chart.

1-Year U.S. Treasury Yield

Money is Getting Cheap (Again)

As you can see above, the yield on 1-year treasuries (the rate you get loaning money to Uncle Sam for 12 months) currently hovers above 1 percent. It hasn’t been down this low since 2003.

During the time when “Easy Al” Greenspan was cutting rates and keeping them low, interest rates just kept on falling. Money went from super cheap to ridiculously cheap to insanely cheap. Then, beginning in 2004, yields slowly began to rise again. (But not fast enough to wreck the party that was by then in full swing.)

Now we’re back on the old downward slope, with rates on a kamikaze path towards zero. (“Turning Japanese” as Bill Bonner likes to say.)

The upshot is that right now the Fed and the Treasury are absolutely flooding the system with money. They do this because they are desperate to jumpstart the U.S. economy.

You’ve seen it before in these pages, but it’s still hard to beat this chart for shock value:

Adjusted Monetary Base

That is a chart of the adjusted monetary base, courtesy of the Federal Reserve Bank of St. Louis. It shows how the Fed has rolled up its sleeves since September. Boy howdy, have they rolled up those sleeves.

Holy Balance Sheet Batman!

Rolled-up sleeves aside, it might even be fair to whisper that the Fed has gone nuts.

Proof of nuttiness, you say? Ask and you shall receive.

As Jim Grant of Grant’s Interest Rate Observer recently observed, it took the Fed a full 75 years – from 1914 to 1989 – to get its balance sheet up to $100 billion.

From there (under care of The Maestro) it only took another 10 years to hit $500 billion.

Eight years or so later, the Fed’s balance sheet hit the big “T” for the first time – a whopping $1 trillion – and within the space of just three weeks in late 2008 doubled that from $1 trillion to $2 trillion. (Do I hear a bid for $3 trillion?)

"So a second order effect which might not be subtle,” Grant suggests, “might be inflation.”

Enter the Gnomes

The “Gnomes of Zurich” was originally an insult, dreamed up by a British politician named Harold Wilson to disparage Swiss Bankers.

Mr. Wilson didn’t like the fact that the “gnomes” were gunning against the British Pound in the 1960s. As it turns out, the gnomes were gunning against the U.S. dollar too – and one of the ways they did it was by buying gold.

To understand the Gnomes’ frame of mind, you have to remember that the old gold standard didn’t disappear all at once. It was progressively weakened (the first blow taking place in the 1920s) and receded in stages from there.

In the late ‘60s – when Bretton Woods was intact, the dollar was king, and LBJ was spending like a drunken sailor – the United States remained quaintly determined to defend the dollar’s virtue. That virtue was defined by convertibility into gold, for all comers, at a fixed market price of $35 per ounce.

The problem was that more and more dollars were making their way into the world. As the world’s gold supply did not see a similar rapid increase, the yellow metal’s price began to twitch. The Gnomes and their speculative friends had begun casting votes against the soundness of the dollar by purchasing gold in the London market.

In order to put the kibosh on this misbehavior, the powers that be set up the “London Gold Pool.” This gold pool – made up of eight central banks led by the United States – would sell to all comers in the London market, in order to keep the yellow metal’s price fixed firmly at $35 per ounce. “We will use our gold down to the last bar,” declared the U.S. Undersecretary of the Treasury in 1968. (Nixon proved him a liar of course.)

The tide-fighting central bankers also sought to raise interest rates, knowing gold’s achilles' heel is the fact that it bears no interest. But they couldn’t raise rates too much, as that would hurt the various economies in question... and the Gnomes had a powerful edge.

Simply put, the Gnomes knew they couldn’t really lose. There were too many dollars sloshing around, and the fixed $35 per ounce of the time meant gold’s false ceiling was also a floor. So if the Gnomes failed in driving the price of gold higher, their holdings would stay at $35... no real harm done.

But if the Gnomes were successful in their gold-buying drive, the London gold pool would have to throw in the towel. The price of gold could then break free from the $35 ceiling – and rise higher from that point on.

A Skip and a Hop to 1971

To make a long story short, the Gnomes succeeded in their campaign. They bought so firmly and resolutely that the London Gold Pool gave up on trying to keep the $35 per ounce ceiling intact.

After finally letting the yellow metal rise to $40 an ounce and beyond, the authorities sent out a pooh-poohing statement suggesting they didn’t really care about the market price of gold anyway.

The monetary rules were then quietly changed (surprise, surprise) so that the U.S. government no longer had to bother with redemption requests based on the market price of gold.

After that it was all a slippery slope. From the Gnome’s London victory it was just a hop, a skip, and a jump to President Nixon’s closing of the gold window. That infamous event in 1971 gave birth to our modern-day fiat currency system – a slap in the face to Gnomes everywhere.

Falling Rates, Rising Stimulus

But regimes come and regimes go, including monetary ones... and now it feels like the balance of power is shifting once again.

The whole world continues to mop its brow with the sweat of deflation worries – but that is precisely the excuse the world’s central bankers use as they chug out fresh stimulus like mad.

As for gold’s achilles’ heel, high and rising interest rates, remember which way rates are going now (straight down). The U.S. and Europe have embarked on an aggressive “reflate at all costs” program, and it is still too early to register those costs. The piper may take his time, but he always gets paid.

What’s more, the mandarins that whisper into Obama’s ear are warning him not to be conservative... not to hold anything back... to remember that FDR’s near-fatal mistake in the 30’s was doing too little rather than too much.

New York Times columnist Paul Krugman (a recent Nobel Laureate) has even said this: “My advice to the Obama people is to figure out how much help they think the economy needs, then add 50 percent.”

So we can bank on another round of jaw-dropping government stimulus being thrown into the mix. Dollars, dollars, dollars. “Don’t worry about the deficit this year or the next,” our President-elect tells us.

A Gift to Wise Hands

For those who can take a Gnome’s eye view of things, the dollar’s late 2008 short-covering rally is a gift. It has given the powers that be a false sense of complacency as their printing presses run deep into the night.

We will soon wake up to a time when the world is awash in dollars it neither needs nor wants... and when interest rates drag along at rock bottom, Japan-style, in a bid to prop up the struggling U.S. economy.

When that time comes, the Gnomes will have their revenge.