The Long-Term Case For Gold

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Includes: GLD, GTU, IAU, OUNZ, PHYS, QGLDX, SGOL
by: Sam Kovacs

Summary

The system is mostly unsustainable and might fail again.

The Federal Reserve is entirely dependent on gold.

Other countries are preparing for the transition, are you?

This is the context within which the case for gold starts.

When currencies evolve in a floating exchange rate system, governments have the ability to use monetary policy to influence the value of their currencies and thus change international trade dynamics which trickles down into the level of net exports, which is one of the four components of GDP alongside consumption, investment and government spending. These currency manipulations have been dubbed "currency wars" by best selling author James Ricards.

In 2010, President Obama unveiled his National Export Initiative (NEI). The goal of his policy was to double exports by 2014. The intuition is obvious, to spark growth when investment had yet to kick back in, consumption was weak and government intervention was ineffective, increasing the exports seemed to be the last card left to play to spark GDP growth. Straight from the trade website, we can read:

To strengthen America's economy, support additional jobs here at home, and ensure long-term, sustainable growth, President Obama launched a government-wide strategy to promote exports. The National Export Initiative (NEI) is one essential component of that strategy.

And surprisingly enough, he managed to somewhat achieve what he set out to do. Exports increased by 26.4% between 2010 and 2014. Not exactly a double, but by government standards, definitely not too far off.


Source: World Bank

What you must realize, though, is that to increase exports, foreign countries need to buy more goods from you. Twice as much it would be, according to President Obama. China interpreted the message correctly: We are going to devalue the U.S. dollar.

This came as a particularly strong blow to the Chinese who had at the time more than doubled their holdings of U.S. treasuries between 2007 and 2010. At the time, they owned about $1.13 trillion of U.S. treasuries which was equivalent to 20% of their GDP. A weaker U.S. dollar would result in an immediate forex loss on their new investment.

So, the currency war had started. Ben Bernanke put the printers on full blast for a second round of quantitative easing in November 2010. Since the first round of QE in 2008, the money supply has increased considerably in the U.S. Economists like to quibble about whether we should look at M1 supply or M2 supply, which also takes into account non-cash liquid assets which could be converted on short order.

Source: Federal Reserve

Either way, there are way more dollars circulating than there was before. M1 supply is up 110% and M2 58%. There is this joke about Bernanke that when asked if he could organize a piss-up in a brewery, he answered that it depended on whether there were any printing machines on site.

In the end, the U.S. succeeded. The Canadian dollar stayed at parity with the greenback for the following years, and the dollar stayed in a narrow range between 12 and 14 Mexican dollars. This meant that the United States' two best trade partners benefited from cheaper imported goods.

Source: Investing.com

China, eventually capitulated. In August 2008, in the midst of the global turmoil, the yuan was pegged to the U.S. dollar. In order to maintain the peg, China was forced to keep printing money to compensate for the increase in their foreign reserves. The risk of doing so is that you can import inflation. And this is exactly what happened in 2010 in China (Source: Inflation.eu).

In June 2010, China threw in the towel and let the yuan float again, after which it rapidly appreciated. The United States had won a battle in the latest currency wars.

The price of dollar denominated assets went up as the value of the dollar went down. This led to a surge in prices of assets such as gold (NYSEARCA:GLD).

GLD Chart

GLD data by YCharts

Fast forward a few years, and here we are. The United States managed to devalue the dollar and thus increase the value of dollar denominated assets, starting with stocks. The S&P 500 (NYSEARCA:SPY) is up 84% since 2010. We are now once again testing the highs which have been achieved over the last few years.

SPY Chart

SPY data by YCharts

But at what cost? Russia and China now resent the United States more than ever, which was attested by the Chinese foreign Minister's statement on December 2014:

"If the Russian side needs it, we will provide necessary assistance within our capacity"

For now, as long as the dollar is the dominating currency in the world, it has some leeway in terms of applying pressure to other countries. The dollar's dominance explains its strength relative to its level of indebtedness. After the 2001 attacks, the U.S. started monitoring all SWIFT transactions, which are used by over 10,500 banks to make electronic transfers. However, Russia and China have both launched their own SWIFT alternatives last year. In September 2015, it was estimated that more than 90% of Russian banks' international transactions have gone through their own system. The transition was precipitated following the annexation of Crimea. If the U.S. and Europe want to further sanction Russia, the country will be more economically independent.

Foreign authorities have become less and less at ease with the U.S. dominance and manipulation, and have been moving to find a replacement for the dollar as the world's major reserve currency. It is becoming obvious that it won't be the euro, which nobody considers to be a safe haven right now. Since the debt crisis, the stability and viability of the union is constantly questioned.

As of October 1st, 2016, the Chinese yuan will be included into the IMF's SDR. The revised weightings make for a less euro-centric SDR, while barely changing the U.S. dollar's weight. This is to be expected given the economic situation in Europe through the last few years.

Source: IMF

For those of you who are unfamiliar with SDRs, here is an abstract from the IMF:

The SDR is an international reserve asset, created by the IMF in 1969 to supplement its member countries' official reserves. As of March 2016, 204.1 billion SDRs (equivalent to about $285 billion) had been created and allocated to members. SDRs can be exchanged for freely usable currencies. The value of the SDR is currently based on a basket of four major currencies: the U.S. dollar, euro, the Japanese yen, and pound sterling. The basket will be expanded to include the Chinese renminbi (RMB) as the fifth currency, effective October 1, 2016.

So the transition is happening. The inclusion of the yuan might be seen as symbolic, and it might take time before central banks start owning yuans, but nonetheless, it raises some questions. If a reduced confidence in the euro is enough to slash 7 points from its weighting, what happens when the confidence in the dollar wanes? And, more importantly, what could erode the confidence in the dollar?

Confidence in the U.S. dollar is synonymous with confidence in the Fed. The Federal Reserve was created in 1913 with one main mandate: maintain the purchasing power of the dollar. Since then, the dollar has lost over 95% of its value. In comparison with the Roman Republic's silver denarius, which maintained 100% of its purchasing power for over 200 years, we can say the Fed has failed. However, this is somewhat besides the point.

What is scary is the amount of leverage the Fed is taking on. As of the latest H 4.1 release, the Fed is leveraged 112 to 1, which means that it would take less than a 1% decline in the value of assets to wipe out the Fed's equity. In contrast, Lehman Brothers was leveraged 30:1. Some say that it doesn't matter because the Fed can't officially be bankrupt, and could always print more money (thus further devaluing the dollar) to save themselves.

Luckily for them, the Fed are not required to mark their assets to market. But it is worth wondering what would happen if they did. Throughout QE2 and QE3, the Fed also purchased longer term treasuries. These securities are a lot mot volatile than the shorter term securities since a change in the discount rate assumptions impacts cash flows which are compounded over more periods. In other words, these bond durations are higher. During QE3, the purchasing started in September 2012.

Source: Investing.com

Between September 2012 and May 2013, the Fed was acquiring these assets at a yield of 1.5-2%. It acquired $120 billion of treasury securities with a maturity of over 10 years and $93 billion of treasury securities with maturities between 5 and 10 years. It also acquired $333 billion worth of mortgage-backed securities. If we assume an average duration of about 10 years on these securities, the 1% change in yield between May and July would have been enough to wipe out the Fed's $55 million worth in equity just from those securities. Yes, you can read that again, it would seem that the Federal Reserve would have been bankrupt between June and December 2013.

Stop the madness, you might be thinking. It is nothing new, however. We all know that it isn't sustainable. The Fed owns more U.S. treasuries than anyone else by far, and unloading the treasuries would probably move the price, locking in losses. What has to be asked is how can the Fed wiggle its way out, if such a feat is even possible?

There are two ways:

First, the obvious way. Print more money to offset the losses. This subsequently deteriorates the dollar value and increases dollar denominated assets, such as land, art, and precious metals.

Second, and this is interesting. James Rickards points this out in his book. On the Fed's balance sheet, it holds 8,000 tons of gold certificate accounts which are priced at the statutory price of gold, which was last set in 1973 at... $42.222 an ounce. The statutory price of gold is set by law and hasn't been reviewed since. In 1934, all of the Fed's gold was shipped to the Treasury, and Americans weren't allowed to own physical gold until 1975. The Treasury issued the Fed gold certificates which cannot be redeemed for gold. Funny fact is, all of the Treasury's gold only exists to back the Fed's certificates.

If the statutory price of gold were to be changed to the current market value of $1,230 per ounce, the Fed's leverage would all of a sudden only be 12.8:1. A much more acceptable ratio, similar to that of a well capitalized bank.

The bottom line is that the only way the Fed is viable as an entity is thanks to the gold which the Treasury keeps for them.

Furthermore, the United States would only change the statutory rate of gold in the case of a return to a gold standard. Why would it have to do that? To try and save the dollar's importance in the world economy once China, Russia, and other countries push the dollar out in favor of a new monetary system.

The U.S. dollar price at which the government sets an ounce of gold in the case of a return to a gold backed system is extremely important. The price must be set in order to properly back the quantity of money in circulation. Failure to do so can be fatal. In the 1920s, the U.K. lost an entire decade because of Winston Churchill's inability to set the correct price. The U.K.'s price levels had increased 3 fold during the war, and its debt to GDP level had increased from 20% to over 120%. The quantity of money and its value had decreased substantially, but it was decided that the U.K. would return to the pre-war exchange of 1 pound for $4.8. Robert Skidelsky describes the situation better than I could in his blog, so I won't attempt to do so:

Given the British commitment to the pre-war sterling-dollar exchange rate, Britain had to follow the deflationary course set in America; and more savagely, since British prices had risen higher.

Policymakers were not apparently conscious of having any choice in the matter. Underlying the deflationary stance in both countries was the conviction that justice to the bondholder required that war loans be paid back in currency which as nearly as possible equalled their pre-war purchasing power.

Thus, the process of back to gold involved, for Britain, two years of unprecedentedly high real interest rates, the effect of which was to cripple British industry and leave as its legacy an unemployment rate of 10 per cent which lasted until 1940.

By the time the Great deflation had ended in 1923, British wholesale prices had fallen from their 1920 peak of 324 (1913 = 100) to 160 and weekly wage rates from 252 to 180 in the same period. Unemployment had gone up from 3 percent in 1920 to 22 percent in the second quarter of 1921 before falling back to 11 percent. The sterling-dollar rate, having sunk to 3.5 at the height of the boom, had improved to 4.50 by early 1923, but the wholesale British/price index was still higher than America's.

So, at what price would the price of gold be set in the case of the return to a gold standard? This would depend entirely on the assumptions which are used in the standard. What definition of money supply will be used? Which countries would be included into the standard? And, what percentage of the money supply will be required to be backed by gold. This percentage will depend on the confidence in the system. Finally, there is some leeway in what quantity of gold we use. There are approximately 170,000 tons of gold in the world. Some of this is owned as reserves by different countries, and a good part of it is owned by individuals.

Source: Author's Data

If we assume that the Eurozone, China, and the U.S. agree to back their currencies at the current exchange rates, using M2 as a definition of money supply, they would need to acquire all of the world's gold, and convince the people that a 15% backing is reasonable to justify today's price.

If we use the three regions' gold reserve to back all of their currency at a 30% backing, the implied price would be $21,000.

Some gold ultra bulls say that China has secretly bought way more gold than they are letting everyone know by stashing the gold on accounts which don't appear in official reports, and that they intend on backing the yuan to gold in upcoming years. I tend to have a more nuanced view, but still perform the calculus to check what such assumptions would imply. Even if China had 30,000 tons of gold stashed away, at the current exchange rate, to be able to back only the yuan, the price of gold would have to be significantly higher than it is today in dollars.

Is this scenario going to happen? Hard to say, but in the case of financial turmoil, within which the people lose confidence in the system, we might not have a choice but to return to a gold standard to calm volatility, panic, and another depression. Fiat money depends on confidence, and as we all have witnessed with stock market cycles, when confidence goes, it goes rather quickly.

In any case, it is worth earning some of your liquid assets in gold and other real assets as insurance against the loss in value of your U.S. dollars. During the last few years, every government has become more concerned with bringing their gold back to their country (i.e. Germany) or increasing their gold reserves (i.e.: China and Russia).

Click to enlarge

Source: Tradingeconomics

To be continued.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.