Gold: Double Bubble, Toil And Trouble
John Ing
The War in Iraq has become more costly in terms of lives and money unlike the Persian Gulf War whose $60 billion cost was underwritten by the allies. The United State's fiscal deficit is running at a record breaking $400 billion each year and the rising $58 billion-plus Iraqi occupation cost is not even included. The White House deficit is 50 percent higher than administration forecasts made only six months ago. The reversal from surplus to deficit in the past three years is the biggest since after the Korean War in 1953. At $455 billion, this year's deficit would eclipse Bush's father's deficit, then a record $290 billion. Next year the
projection is for an astonishing $475 billion of red ink. Indeed, money and debt is growing faster than the economy. Simply put, Bush has turned out to be the largest spender in American history.
Deficit Disorder
In the past, foreign money was attracted by a strong US dollar, stock market, and superior financial returns. But now, America's status as the world's ultimate safe haven for capital is looking shaky. This War on Terrorism, Bush's tax cuts, a new Medicare drug bill and Bush's reelection campaign appear to be a recipe for deficits as far as the eye can see - whatever happened to the balanced budget forecasted only eighteen months ago? Moreover, in the first quarter that other deficit, the US current account deficit soared to a record 5.1% of Gross Domestic Product (GDP) or half a trillion dollar annually. America's trade deficit is the
result of years of excessive consumer over-spending. America is buying goods on money borrowed abroad. Because Americans have few savings and because they import much more than they export, they need over $2 billion a day of capital inflows just to finance this shortfall. And the US is not the only profligate borrower. The Europeans' budgetary deficits have breached the 3 percent GDP ceiling threshold. Japan has a budget deficit approaching 8 percent today.
Most worrisome is the serious balance of payment crisis that lies ahead, since the structural problems underlying the American dollar remain. Near zero interest rates have undermined the dollar in favour of higher yielding currencies. The yield premium enjoyed by the Canadian and Aussie dollars have proved popular with traders recently. This "carry" trade transaction is particularly profitable since investors could borrow funds in US dollars investing those proceeds in higher yielding Canadian and Aussie dollars. The Canadian dollar has risen about 15 percent against the US greenback.
Greenspan's Feet of Clay
In 1996 stock prices were soaring and Alan Greenspan cried: "irrational exuberance." Yet last year, determined not to repeat the same mistake Japan made ten years ago, Greenspan lowered interest rates thirteen times. In May, the Spinmeister saw falling prices and cried: "deflation", fueling another bond-market rally that ensured a successful tax stimulus package. That he was "taking his book' was ignored by all. In July however, he saw recovery and burst the bubble he created causing the biggest bond rout in ten years. Alan Greenspan appears to have worn out his welcome. Not only is the economy struggling, but
his jawboning no longer works. Greenspan's musings of natural gas shortages coincided with a peak in prices and storage levels have increased every week.
Greenspan has simply lost the confidence of the market and with it America's fiscal credibility. Support for the Bush administration is also wavering. After boldly calling "to bring them on," Bush appears mired in not only a Vietnam-type war but has unified much of the Western World against him. With confidence in its leaders ebbing and the prospects of massive twin deficits, the inevitable capital flight will doom the United States to a lengthy period of higher interest rates and slower growth. History shows the bigger the problem, the
more painful the eventual adjustment.
Further worsening the dollar picture is that the relentless loosening of monetary policy has unleashed cheap money into the system, spawning an endless supply of bubbles. US policymakers have opened the fiscal and monetary spigots, bringing down interest rates to the lowest levels since 1958 when Buddy Holly was alive. To date, the Fed's massive reflationary pump priming and the willingness of government and households to take on more debt has fueled consumption offsetting the risks of deflation and recession. Corporate debt remains at record levels, prompting many companies to refinance their older borrowings taking advantage of lower rates but increasing total indebtedness. Government, business and consumers are simply living beyond their means.
Debt Must Eventually Be Rolled Over
There is no question that the United States avoided
deflation with a heavy dose of pump-priming,
bringing interest rates down over five percentage
points. The last round of tax cuts was financed by
another round of deficits that generated more 
consumer borrowing and an inflated housing
bubble. New borrowings and mortgage refinancing
set records as new and existing home sales rose to
record levels. The mortgage refinancing binge may
be at an end due in part to the fact that near-zero interest rates have upticked and the financial institutions of Freddie Mac and Fannie Mae, are being scrutinized by the regulators. And, the chaos in the bond market has triggered a rise in rates worsening troubles at Freddie Mac and Fannie Mae. Of concern is that these financial institutions were the conduits that allowed America to remortgage at successively lower interest rates. Good for the consumer? Yes. Good for Freddie and Fannie? No. Freddie and Fannie were huge users of derivatives.
Hedging activity in mortgages is worth more than $5 trillion that is substantially bigger than the market for Treasury bonds. Recent studies show that only a 1.5 percentage increase in interest rates could erase half the value of Fannie Mae's assets. It is these derivatives that led to the wholesale departure of Freddie's management and the European Central Bank's decision to eliminate all Freddie and Fannie's debt.
The Bond Crop Never Fails - Until Now
So far, governments have had a lucky combination of growing debt and falling interest rates. However in recent weeks, the bond market suffered its biggest sell off in two decades. The once flat yield curve is now steepening upwards signaling the end of the 22-year bull market. Of more concern is that almost a third of the government's debt matures within a year
making the US vulnerable to not only recent interest
rate hikes but also funding swings. The US 
Treasury's giant $60 billion offering as part of the
program to raise a record $230 billion in the second
half of this year met a mixed reception. Indeed the
Treasury will need to raise $450 billion over the
course of the next year.
So sooner rather than later, the biggest debtor nation
in the world must rollover this debt. With a negative
real US fed fund rate for the first time in twenty
years, raising money will not be so easy. And Asian
countries, who hold a whopping 70 percent of the
world's currency reserves due to support purchases
and trade surpluses are likely to diversify their
holdings out of Treasuries into precious metals and
euros. At the very least they may demand higher
interest rates for keeping their money in dollar denominated assets. Asian countries currently have over $1.7 trillion in foreign exchange reserves. Japan alone held over $429 billion of Treasuries in May and China held $122 billion of Treasuries. Any falloff in capital inflows or if they sell some of those securities would push the dollar even further down making US investments less attractive. We have been down this road before. Suffering such losses, the exodus may resemble the late seventies when the dollar collapsed, plunging more than 40
percent, the deficit reached a peak of 3.5 percent and 20 percent interest rates ensued.
Gold Is The Real Money
Money is cheap. Too cheap. Today one can buy a car for six years and not pay a single cent of interest. What's the downside then? When borrowings are encouraged with near zero interest rates, there is no incentive to hold cash. When money has no value, then hard assets become dear. After three years of disappointment and an unprecedented build-up of liquidity, there has been a gradual shift to hard assets from paper assets. Our view is that rising commodity prices, imploding bond markets and a pickup in gold are signaling that a sea change has occurred. History shows that gold is an excellent alternative to paper money. Since ancient times gold has consistently been valued as currency. While supply and demand trends are important, gold's role as a store of value has made it a natural hedge in any portfolio. Since July 1999, the US dollar has lost about a third of its value while gold has risen about $100 an ounce or almost 40% from its 21 year low. As a financial asset, gold has
outperformed all asset classes in the past five years. Our concern is that while there is "free" money today, there is no free lunch.
John R. Ing
416-947-6040
22 August 2003
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