Seeking Alpha
What is your profession? ×
Dividend investing, macro, portfolio strategy, gold
Profile| Send Message|
( followers)

The financial system will survive until it doesn't. Such is the nature of most catastrophes - they arrive without warning. I am afraid the US financial system - specifically the US dollar and US Treasuries (NYSEARCA:TLT) - may be the next unsuspecting victim.

This is not to say that financial catastrophe comes completely out of the blue. On the contrary, most collapses (small and large) are preceded by compounding pressures of some kind. The prescient few (like Marc Faber and Nouriel Roubini) who see the building pressures and forecast a disastrous discontinuous event are often ridiculed, called 'broken clocks' or labeled doomsayers. And because their forecasts can take years to unfold, the few investors that subscribe to their warnings often eventually dismiss them. In the end, catastrophe is a surprise to the average institutional and retail investor because most fail to, are incentivized not to or choose not to listen to dire warnings.

Nobody wants to hear a negative forecast - especially when their surrounding environment appears stable. Often, even when things are clearly deteriorating, people want to believe in a return to the status quo. Frankly, it's just easier to make decisions based on what happened in the recent past. However, human history is littered with the corpses of systems and societies that failed to recognize and adapt to a changing environment, ultimately leading to a sudden collapse.

One only has to look back at the past few decades to see dozens of seemingly unpredictable, disruptive, catastrophic changes: The Asian currency crisis of 1997/1998; 9/11; The Lehman collapse. While some recognized the building pressures, these events were sudden and unexpected for most.

The US dollar is no stranger to sudden shocks. Within the span of 50 years, multiple dollar devaluations sent shockwaves though the gold and currency markets.

April 1933: In 1933, under the auspices of Executive Order 6102, President Roosevelt forbids "the Hoarding of Gold Coin, Gold Bullion, and Gold Certificates within the continental United States". The gold reserve act of 1934 subsequently revalued the fixed price of gold from $20.67/oz to $35/oz - almost a 70% increase in the price of gold. This was a massive dollar devaluation that caught most average citizens totally off guard. However, those with the foresight to own and keep gold - despite Executive order 6102 - profited handsomely.

1971 Nixon Shock: In 1971, after years of declining gold coverage of the US money supply, the drain on US gold reserves became exceedingly dangerous.

According to Guggenheim Partners:

At the outset of Bretton Woods, the value of the United States' gold reserves relative to the monetary base, known as the gold coverage ratio, was approximately 75%. This helped to support the dollar as a stable global reserve currency. By 1971, the issuance of new dollars and dollar-for-gold redemptions had reduced the U.S. dollar's gold coverage ratio to 18%.

According to Guggenheim, during the 12 months leading up to the end of Bretton Woods 15% of US gold reserves left the country as foreign central banks converted dollars into gold, reducing the coverage ratio. The coverage ratio also declined because money supply grew rapidly to finance the Vietnam War and 'The Great Society'.

To stop the drain on gold reserves, to the surprise of the international monetary community, on August 15, 1971 President Nixon 'temporarily' (of course, this turned out to be permanent) suspended dollar convertibility into gold. This disconnected the Federal Reserve from the gold anchor, allowing it greater authority over monetary policy - both expansionary and contractionary.

During the two years after dollar convertibility ended - effectively allowing gold to free-float - gold prices rose about 260% (see chart below, click to enlarge).

After the two year period illustrated in the chart above, gold prices continued to skyrocket through the rest of the decade and the gold coverage ratio eventually reached about 1:1. However, since its peak during the early 1980s, the gold coverage ratio has subsequently fallen to its current level of 17%. The current gold coverage ratio is near the lows seen throughout recent history. As you might have guessed, given the ultra-low gold coverage ratio, global imbalances are intensifying and may be nearing a critical point.

Dollar reserves around the world have relentlessly risen for decades, putting pressure on a one-sided system created by a global dollar-regime that is enforced financially, legally and militarily. This 'petrodollar' system (a system that forces oil producing countries to sell oil in US dollars, effectively forcing oil importing countries to build dollar reserves) has reinforced the imbalance by propping up the dollar and suppressing US interest rates, allowing the US to run what would otherwise be disastrous monetary and fiscal policies. The US has little incentive to right the world financial system as it has enabled the US to finance the worlds largest army, a welfare state and a consumption-driven economy.

These imbalances cannot grow forever. One day - seemingly out of the blue - there will be an 'event' (e.g. bond market crash or massive US dollar devaluation) created by any number of dangerous or innocuous triggers. Perhaps countries stop selling their oil in US dollars. Or maybe a major dollar holder, like China, decides to dump their US assets. Or perhaps - like the straw that broke the camel's back - the trigger will have some seemingly irrelevant source, like the cost of bus tickets in New York City. Who knows.

The point is not to look for the trigger - the point is to understand the vulnerabilities in the system. Current massive and growing imbalances could at some point cause the financial system to collapse. While astute investors sense the building pressure, the next financial collapse won't come with a warning sticker and will be a shock to most.

There are already signs that America's ability to support the current system is waning. While there is no official policy admitting this, many argue that the US has started/supported wars and revolutions to protect the petrodollar system when various countries (e.g. Iraq, Libya) threatened to move away from selling oil in US dollars. Iran, which sells oil in Euros, is next in the sights.

While some optimists may argue that the Iraqi and Libyan government overthrows were 'successes', Iran is proving that dollar hegemony can only go so far. With Russia and China backing Iran, America's ability to defend the petrodollar is at risk. The global financial system is left with massive systemic imbalances and a weight the US cannot move to continue supporting those imbalances. This is as good a reason as any to trigger a US bond market and dollar meltdown, but few investors anticipate such an event or they are waiting for the 'warning signs' that will never arrive.

The global financial spring is wound extremely tightly, and a shock today could be swift and devastating to the value of the dollar. Today, the average person has a better sense of the impending risk, but unfortunately still hopes for a return to the status quo. Only a few 'doomsayers' and 'preppers' predict the demise of the dollar. And how are these doomsayers treated? Like relics of the 2008/2009 financial crisis. They are seen as talking heads who repeat the same story over and over, and were 'accidentally right' in 2008. What most people don't realize is that the 2008 crisis never ended. We've papered over the cracks, yet the problems that created the 2008 crisis - debt and global imbalances - still grow.

Frankly, the off-kilter global financial system can continue for many years. After all, it has survived decades already. But like shocks of the past, the financial system collapse will come without warning. The time to prepare for such an event is before it is front page news.

The best way to mitigate such an occurrence is to own gold, including perhaps one of the following gold ETFs:

  • SPDR Gold Shares (NYSEARCA:GLD)
  • ETFs Physical Asian Gold Shares (NYSEARCA:AGOL)
  • ETFs Physical Swiss Gold Shares (NYSEARCA:SGOL)

Of course, I also believe there is great merit to owning physical gold stored in a safe place outside of the banking system.

Gold is a store of wealth, can transition currency regimes and is a globally-recognized currency. While gold prices may remain volatile, if the US bond market and dollar were to collapse one would probably benefit from owning an asset that a) isn't priced based on discounted cash flows and b) can't be easily diluted.

If the dollar were to devalue to a point where the gold coverage ratio returned to a historical average, gold prices could rise significantly. According to Guggenheim, today's 17% gold coverage ratio suggests a gold price of $2,200/oz. If the gold coverage returned to its historical average of 40%, gold would need to rise above $5,000/oz. If gold coverage ratio were to reach 1:1, gold would need to rise to almost $13,000/oz.

While this isn't a forecast for gold, these figures provided by Guggenheim do give some historical context on the abuse of the US dollar over the past several decades. Given the growing imbalances, even if the next collapse is years away I think it is important for investors to consider ways to protect their assets for the long-haul.

Disclosure: I am long SGOL. 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.

Disclaimer: This is not advice. While the author makes every effort to provide high quality information, the information is not guaranteed to be accurate and should not be relied on. Investing involves risk and you could lose all your money. Consult a professional advisor before making any investing decisions.