A “Long” Car Ride with a Gold Bug

Key News

  • China’s CSI 500 Index of companies with a median market value of $841 million trades at valuations 71 percent above the CSI 300 Index. (Bloomberg)
  • There is more downside risk to oil demand than upside risk, the International Energy Agency’s head said on Friday, as the strength of the global economic recovery remains in question and government spending programmes wind down. (Reuters)
  • Business Unity of South Africa will present the ruling African National Congress with arguments against proposals to nationalize the country’s mines, Chief Executive Officer Jerry Vilakazi said. (Bloomberg)

Quotable

Gold? Yellow, glittering, precious gold?…
This yellow slave
Will knit and break religions, bless th’ accursed,
Make the hoar leprosy adored, place thieves,
And give them title, knee and approbation
With senators on the bench.

                             William Shakespeare

FX Trading – A “Long” Car Ride with a Gold Bug
About two weeks ago, I unfortunately had to attend a funeral for my wife’s uncle. He was really a great person—fun, intelligent, and a man with real integrity and deep religious conviction. I admired him greatly. My father-in-law gold bug (MFL)—another of my real life heroes – drove with me on the trip to the fun

The primary reason MFL still likes holding gold is based on a concern we all have—incredible amounts of US debt. He asked me: At what point do people stop buying US bonds with such mounting debt? Of course I had no good answer. MFL believes the probability of a buyers strike for US debt is rising and wants to have gold for insurance if it happens. Can’t argue that one—agreed! The only comment I could muster gets back to the relativity thing: The US ain’t looking so hot, but it does look better when we consider the much greater potential of sovereign default across Europe. (For the record, it does get stale saying things are a bit “less worse” here as an argument.)

His second concern is one many also have—inflation. Being an active investor in the ‘70s, MFL knows all too well the driving force inflation can have on real assets and negative impact on stocks during an inflationary event. MFL’s inflation view is linked tightly to his view on debt. Given the huge debt burden, governments likely only have one way out—inflate it away. Inflation in the end is really the decline in the purchasing power of the currency. The flip-side to that is an appreciation in the price of gold. But one of the problems with the “inflate” their way out argument is the fact that an increasing share of US debt is inflation-linked bonds — higher inflation doesn’t help there.

I read yesterday a very interesting piece on this topic, written by Gerard Minack of Morgan Stanley, titled, “Default or Inflate or…”. Mr. Minack doesn’t believe it will be as easy to inflate away the problem as it has been in the past. Instead, he believes the government may force banks and institutions to hold more sovereign debt as a way to relieve some of this huge burden; excerpt below:

As we’ve noted before, inflation doesn’t solve a debt problem, unanticipated inflation does: Think of it this way: If a borrower’s debt is tied to inflation (along the lines of TIPS), then it’s not possible to inflate away the debt. From a macro view, a sovereign can inflate away the debt if the average interest rate on the debt falls below the growth in nominal GDP. (It doesn’t matter whether it’s volume growth or inflation driving GDP.) This is how the public sector deleveraging after World War II was accomplished. The average interest rate on public debt in the US was below the nominal GDP growth rate.

The key question now is: Can governments get the nominal growth rate above the average interest rate? We’re not persuaded that targeting higher inflation will do the trick. In part that’s for obvious reasons: it would require a wholesale abrogation of many of the institutional arrangements put in place over the past few decades – such as independent central banks and inflation targets – and the hard-won gains achieved through the disinflation period starting from the early 1980s.

In part we’re skeptical because markets are seemingly awake to the risk: Most countries with high debt are already paying interest rates above expected nominal GDP growth. And markets demand a higher premium as debt increases.

In the US there is a clear link between nominal GDP growth and the bond yield (and, with a lag, the average actual rate paid on the stock of public debt). As an additional complication, Dick Berner notes that in the US nearly half of budget outlays are now effectively indexed to inflation.

How to push interest rates below nominal growth? Interest rates were below nominal growth rates in the years after World War II, which was also when the public sector accomplished most of its deleveraging. This was largely due to financial regulation. The Federal Reserve, which was not at that stage independent, acted to cap long-end rates at 2.5%. This arrangement ended with the Treasury accord of 1951.

Regulation may be the answer: Here’s our key point: If the way to covertly default is to pay an interest rate below the nominal growth rate, we think it’s possible that policymakers will aim to lower the interest rate rather than lift the inflation rate. In a sense, central banks buying government debt are already a small step down that path. A medium-term approach, however, could be to compel private financial institutions to purchase government debt. Such holdings were often mandated (as prudential measures) prior to the deregulation of financial systems in the 1980s.

In the US, for example, commercial bank holdings of Treasury paper have fallen significantly, both as a percentage of bank assets and as a percentage of the stock of Treasuries on issue. Commercial banks now have a balance sheet of around US$8 trillion. Requiring them to hold 20% of their assets in Treasuries would imply demand for over US$1.5 trillion of Treasury paper. All else equal, this would obviously squeeze the provision of credit elsewhere in the system, unless regulators allowed banks to increase their leverage (which would be justified on the basis that so much of their asset base is in ‘safe assets’). We are not recommending this. But it seems to us that high sovereign debt may be resolved not by a deliberate shift to higher inflation, but by re-regulation that compels buyers to accept uneconomic yields.

My concern is the massive supply we have in the market, in terms of the ability to produce cheap final goods, while there is tepid final demand. Couple that with the continued write-off of private sector debt, and it seems a recipe for deflation — not inflation. (Whether gold can perform well in deflation is an argument we won’t get into today.)

Another of MFL’s concerns is the stock market. He sees gold as a hedge in case we have a real break in stocks. The problem with that argument, I think, is the fact that gold has correlated tightly with stocks during the last cycle, suggesting it has been part of the liquidity-driven asset continuum that has included all types of risk asset classes. That said, gold did act very well during the worst days of the credit crunch and even appreciated along with the dollar for a while. So, the argument has legs. And it has legs now I think especially because of what is going on in Europe. If you have capital invested in Europe and you don’t like the dollar, gold seems one of the only other real alternatives.

Interestingly, as we were driving, about 18-hours roundtrip, we were listening to the various talk-radio programs. Both of us being conservative—he on the neo-con Kool-aide side (sorry, couldn’t resist), I on the old school paleo-conservative, Russell Kirk side—we enjoyed the various shows; I don’t listen to them at all during the week as the trading screens are more critical. Not to get into the politics of it, what was most interesting is how many darn advertisements there were for gold. It seemed every 10-mintues another “buy gold” commercial aired. Radio talk show hosts better hope gold never falls out of favor or they will lose a big source of ad revenue, was my first thought.

My second thought, which I threw out at MFL: Aren’t you concerned when you hear so much advertising to the average investor suggesting now they should buy gold? I’m not sure if he ever answered me on that—other than to laugh.

So far, his arguments were very good and solid reasons to own gold. But my last question was this: Is there any economic environment that you can point to that would suggest it’s time to sell gold? MFL gave me the look (the “how did I ever agree to you marrying my daughter” look; I don’t have an answer to that either, but glad he did agree) and a “not really” comment. But then again if MFL had to sell gold, imagine how much work that would be for him, tearing down all the drywall to find it. LOL (For new readers, MFL has used his walls as a hiding place for buckets of precious metals in the past…true story. He wants me also to tell everyone he doesn’t do that anymore, but is beefing up security in case you don’t believe him.)

I understand the arguments for gold. And most of them make great sense. In a world where it seems every government can’t create enough debt or rush to debase its currency fast enough to beggar-thy’s-neighbor on trade, gold is the answer. But, though not perfectly analogous, I remember that in the midst of the Nasdaq-cum E-company boom, it didn’t look as though it would ever end. Analyst after analyst justified the environment as far as the eye could see. If you didn’t own tech stocks you were a moron. This environment was so darn persuasive it led Julian Roberts and George Soros, arguably two of the best hedge fund managers ever, to capitulate right near the top of the Nasdaq boom. They took some major hits.

I guess the lesson to me, and why I am concerned by gold here is this: When you cannot define any environment that would make gold go down, it probably represents some type of sentiment extreme. And we know what Mr. Market likes to do when he sees that—slam!

Have a great weekend. And thanks Dad for a making it a fun and interesting trip despite the event. You’re the best even if you do like gold!