***** SOURCES OF MONEY FLOWING INTO GOLD & SILVER *****
US TREASURY DEBT SECURITIES:
This market is five times larger in size than the US stock market. The shorterm yield on the 3-month TBill is a paltry 1.2%, which fails to cover even the reported price inflation. Negative real rates have ranked as the primary sentinel signal heralding a new longterm bull market in gold. This more liquid source of money helped gold to reverse off the bottom in autumn of 2001 when the Federal Reserve began to take down the FedFunds target rate below 2%. It diverted money toward gold with more vigor after the Fed reduced its target in November 2002 to 1.25% in an act of concealed desperation. At the opposite end of the maturity curve, the 10-yr TNote (which I call longterm) has obediently come down to 4% and below, to the pleasure of the Federal Reserve. Its stubborn refusal to comply was a frustration through most of 2001. The prospect of price deflation amidst continued debt collapse, coupled with unrelenting price pressure from China, has sent longterm Trez yields lower and lower. However, the USDollar decline now establishes a solid floor on the TENS yield. Gold has made bold strides toward #400. My catch phrase has been
"the flipside of a dollar is a Treasury Bond, they trade interchangeably"
The USDollar decline will inflict damage next on the Treasury market, slowly sending longterm yields higher. If dollar-based Trez securities drop in value, the market will employ its natural pricing mechanism to attract buyers. Thus longterm rates will rise, which will surprise the Fed and Dept of Treasury to foil their monetization plans. In fact, that is the cost of such plans. Higher rates and a lower dollar constitute the market effect of such oversupply destruction heaped on the once almighty dollar at the expense of loyal foreign investors. Owners of Trez debt will flock into gold instruments. Recall that the Weimar Republic attempted the same tactic in the 1930 decade. Will we become Weimar Amerika ? Eventually the Fed will be coerced to raise even shorterm rates. The Liquidity Trap in falling rates will pull the Fed toward no change, but the declining USDollar will force their hand as a crisis builds. If dollar-based assets are being abandoned, then be sure that foreigners holding approximately $3000 billion in Trez debt issuance will turn toward gold for real safe haven. The dollar will deliver losses to US-based securities. And let's not forget about the Americans who hold an even larger stake in US govt debt. They will increasingly seek out gold also, shunning the negative real rates on the short end, not wanting to assume the inflation risk on the long end (preferring gold). Flat performance in bonds assist gold demand, but faltering bonds power gold demand bigtime.
CHINESE AND RUSSIAN CENTRAL BANKS:
China is running a huge trade surplus, with the United States the largest component. Evidence provided by the Prudent Bear Fund indicates that increases in Fed printing press volume and consumer debt match with increases in China's trade surplus with the US. Last summer Chinese leaders announced publicly their intention to diversify their current USTBond reserves evenly across our TBonds, EuroBonds, and Gold. Their level of reserves held in US Treasurys will someday rival the Japanese. Rumors circulate around Hong Kong that its two large private gold participants, Dr No and Hung Fat, are facilitating the official Chinese Central Bank in replenishing a gold supply. I conjecture that when they have an adequate supply of gold, after continued surpluses are enjoyed, only then they will offer a yuan revaluation upward in return for political concessions. I will not discuss what they might demand here (see ref#7), but I do believe their next intentions will be on Taiwan, now that Hong Kong has been successfully absorbed. I believe China is purchasing far more gold than they lead on, realizing that a long-awaited dollar depreciation stage is underway. China's monthly trade surplus with the US is growing fast, now about $6 billion. A portion is set aside for gold bullion.
Many critics are now urging a yuan upward valuation. They devote little thought to the consequences of having their demand granted. Some experts in the currency markets fully anticipate a higher valued yuan would immediately precipitate a USDollar decline acceleration. Asian currencies would all revalue to higher levels, with an eye set on competitive rank with respect to the Chinese currency. All Asian import prices would rise in lockstep when this occurs, setting off import price inflation within our shores, a rise in longterm USTBond yields, further crimping US economic growth in a world still overly dependent on US-centric growth. Gold would correspondingly accelerate upward during this dollar deterioration.
In January of this year, the Russian Central Bank announced its plan to diversify out of dollar-based reserves into EuroBonds and Gold. Clearly, they are selling USTBonds in favor of the same type of assets chosen by China. US citizens are shifting from stocks to TBonds, even as foreigners are selling them. Little known to even the informed Western world investment community is that Russia ranks behind only Japan and Germany in their trade surplus with the USA, amounting to roughly $40B in the last year. Crude oil and heating oil imports have become staples to our economy from this nation rich in energy resources. Combine official Russian demand with the staggering black market in that country, and you have sizeable amounts of gold being purchased. Just this month, official Russian sources announced intentions to boost gold and foreign currency holdings to $55B by the end of this year, a rise of 17%. The movement toward bullion-linked bank reserves is very much underway.
Numerous small Asian Central Banks are woefully overfunded with USTBonds and undersupplied with gold reserves. Their gold bank holdings are less than 5% of total reserves. These Asian banks also have a long way to go before appropriately supplied with gold. They are likely to follow the lead provided by China, their fearsome rival.
ARAB PETRO-DOLLARS:
The World Trade Center attack marked the calendar with a clear watershed event. From an Arab perspective, they must deem their money invested in the United States as no longer safe and secure, even subject to being frozen. The press reported unofficial figures of $500-600 billion in US investments repatriated to Saudi Arabia (more likely to European banks). A big source of steady capital flow lies in petro-dollars. OPEC oil is priced in dollars, sold in dollars, paid in dollars. Those dollars are not staying put, moving out of assets denominated in dollars quickly. The established pattern of recycling may have ended. The recent 10% move in the euro currency relative to the dollar since Thanksgiving is striking evidence that petro-dollars are now being converted into euros and EuroBonds. Imported petroleum sales to the United States total eleven million barrels per day, times $30/bbl comes to $330M per day in revenue to the world market. Of this amount, about 40% goes to OPEC, almost 20% to Persian Gulf producers. These are extremely large daily capital flows, no longer loyal to our financial markets.
As US Military Forces wield their power and turn it on Iraq or any other Arab nation, expect some severe financial reprisals from the Islamic world. Saddam Hussein might be a pariah in their eyes, but he is their brother in the pan-Arab world. Islamics have around $60M per day in oil revenues, which can be diverted from US markets. I believe the Saudis and other Gulf sheikdoms are quietly amassing hefty quantities of gold. In time, they might engage in outright financial terrorism in an attempt to weaken the dollar and our Trez markets. Such is the risk when hostile foreign entities own our federal debt in significant magnitude. We became their servants, and they our masters. For instance, we now defend Saudi Arabia, and overlook Osama Ben Laden's refuge within their border near Yemen. Foreign entities own 45% of our $6400 billion federal debt, a bulging sum of $2900 billion.
The embryonic Islamic Dinar holds legitimate promise for becoming a valid gold-backed currency, used in a limited but important role to settle up bilateral trade within the Islamic world. So far the Malaysian Dinar offers the first true working example when launched this June. The Islamic Dirhim might serve the same role but with silver. Gold in significant quantities will have to be stored in order to execute on this plan, properly reinforcing the commercial trades with hard asset exchange. The US might learn from this system, more firmly rooted in the reality of hard asset reserves. We have lost our way. After the euro has run its course as a USDollar alternative, expect the Dinar to come into its own. Financial terrorism is a strong term. Islamics will soon find pride in their new currency, which with the dollar and euro and yuan might eventually constitute the foundation of our world economic system.
GOLD MINERS:
The trend has been clear for several months now. Large and medium gold producers are covering their hedgebooks. Forward sales of gold were profitable for many years. Now they act like acid on their balance sheets. I expect Barrick Gold to file for bankruptcy before this great game has concluded. They could require a "get out of jail" card from God to avert bankruptcy court. To put the scope of covered forward sales into perspective, in Q3 of 2002, Anglogold closed out and bought back forward contracts amounting to the entire year of Japan's 2001 gold purchases. Even the leader Newmont owns almost a full year of contracts hedged against production, assumed in a recent Normandy acquisition. I find irony worthy of derision in the fact that major buyers of gold on the world market are gold mining firms !!! No indirect forces are at work here, merely survival instincts.
Not to be left out are the accomplices to the gold miners, who may not escape with any less harm than their overly hedged miner clients. I mention the private gold bullion bankers, who pushed and sold to excess these dangerous forward contracts. Many are so opaque and exotic that the miner firms themselves are unaware of their actual risk as the price of gold rises. See the story of Ashanti Gold in 1999 for details, where consultants and accountants were hired to analyze the company's risk exposure. Diversion of funds from legitimate operations further limits the ability for mining ventures to bring gold production to market. Most contract buybacks cost more than the original sum taken in. They deprive productive operations, and better yet, they add to gold demand. The gold market shows strong evidence of being an inelastic market. Demand rises with a rising price. And a rising gold price has a detrimental effect on supply, just the opposite of what one would expect ! Relief in funding operations will eventually arrive from Wall Street equity financing, now viewed as an unlikely source.
FEDERAL RESERVE MONETIZATION:
The Fed effort to thwart the powerful forces of monetary deflation and its associated price deflation (not to be confused) will bring with it some unplanned and unexpected consequences. They can purchase Trez debt, or corporate debt, or S&P contracts, but they cannot control where the money from those purchases goes. Right now, a credible argument can be made that a siphon directly captures large sums of newly created fiat currency for the benefit of the Chinese banks. Additions to money supply, increases in consumer debt, and changes to Chinese trade surpluses all equal roughly the same number. That was certainly not intended by Bernanke, and probably angers him. They cannot control where money goes, as seen in the 1999 stock bubble. Published figures cite $20 billion in new money printed per month, which far exceeds the rate of expansion of the economy. Wait ! What expansion? Are we now at the dreaded point warned by the Austrian School of Economics, where accelerating money supply is necessary to maintain flat economic growth ??? I believe we are, sadly.
Imagine you are a very large private holder of Trez securities. You see the Fed gratuitously pumping phony money into Treasuries, with a clear motive to prop up their values and prevent a natural rise in the TENS yield. You are a savvy fellow. You diversify into other asset groups including gold. Imagine you are a large Fanny Mae investor. Same story, where you see the Fed propping up your investment. You diversify into other groups. The siphon witnessed now for the benefit of the Chinese will be repeated for US asset holders on the domestic front. The entire monetization effort is artificial, distorts the equilibrium, and cannot be viewed as permanent. Assorted securities subsidized by our government's desperate actions will diversify and seek a safer safe haven. At first it has been Treasurys. The next safer haven is to be gold.
Acceleration in the USDollar supply only exacerbates an already oversupply in the currency. Fed monetization broadcasts a dangerous message to foreigners who hold large sums of our debt in the form of USTBonds: "your investment will be written down!" It is not a coincidence that the dollar went below parity on its trade-weighted index within weeks of Bernanke's speech on "limitless" printing of dollars to avert deflation. Foreigners took notice. It is also no coincidence that gold broke above its "line in the sand" at #330 during the same time. Dollarized securities are being converted to gold. The USDollar decline has entered a treacherous phase for our nation's foreign creditors.
EURO BONDS:
The euro currency has been the only major currency to enjoy a substantial rise versus the USDollar in the last 18 months. This development did not occur in a vacuum. European bonds have offered a yield premium over shorterm US Treasurys, the favorite bond instrument for hot money moving across the continents. EuroBonds have served as the investment vehicle by which the dollar has been dealt its decline. Many find the euro rise as a surprise, since Europe's economy has no vibrancy to speak of, innovation is not native to its corporate culture, labor regulatory rules are prohibitive, more energy supplies are imported than in the US, corporate balance sheets are also damaged from overpriced acquisitions, and its stock market is also languishing. Furthermore, the euro is an odd concoction of member currencies, further challenging its credibility.
So why has the euro risen? I have written about the expected rise in the euro since the spring of 2002, in the face of naysayers who beat their chests and boast of US supremacy in capitalism. The answer is not simple. Dollar supply continues to rise, and dollar demand is on the wane. Supply of USDollars is high, growing, and out of control, while demand must remain exorbitant in order to keep our economy in equilibrium. Foreigners are becoming frightened. They are seeking alternatives and finding them in Europe, a fully established and mature financial system. Europe also has a much longer tradition with the Arab world. However, the answer lies in both the supply-demand equilibrium and the monetary birth-death process. Our entire economy has abused credit extension to the extreme, which has invited capital destruction. Cross currents now pit rising money supply against the deflationary force of this capital burning. Dangerous eddies now swirl, adding risk to both analysis and investment. Investment capital is finding greater temporary safety in Europe. USDollar fundamentals are terrible for balance of payments and federal budgets, getting worse, and probably nearing crisis proportions. The first alternative to the USTBond has been the EuroBond, given the bias toward both govt bonds and Western financial markets. We have seen this in unmistakable fashion. Arab petro-dollars have been diverted from US market recycling, in defiance of our War of Terrorism, adding to the migration. In fact, Arab diversion of capital toward Europe could be the dominant factor "at the margin."
Money will remain invested in EuroBonds until the gap between the Federal Reserve sponsored rates and European Central Bank sponsored rates closes. A 2.0% differential is currently at work, attracting hot money to Europe. Their longterm rates are virtually identical to ours. Each economy faces similar current threats with price deflation on the finished product side. But with a rising euro, Europe has no complementary threats with commodity price inflation. They import commodities to the same extent that we do, but pressures on supply costs are offset by a rising euro. Most commodities are priced in dollars. Their energy costs are more stable than in the United States, except possibly for natural gas, which will be a worldwide problem soon. We share food cost consequences from harsh weather -- drought in the US last summer, floods in Europe. The European Central Bank is exhibiting sheer stupidity in keeping shorterm rates high. Chairman Win Duisenberg is suffering from severe delusion and ineptitude. He and the his ECB governors fear an overheated economy, incredibly. German mfg and the eurozone economy are in the process of stalling badly. Germany is now seeing large declines in its export business from currency shifts. In time, EuroBond shorterm rates will drop to close the gap, removing the attraction of the interest rate differential.
Our economies have many similarities, with the exception that the European Union has far less internal debt within its community of nations. Their consensus deflationary risk is somewhat less from burned capital resulting in monetary deflation, and somewhat less from the shared product overcapacity effect. Their corporate earnings are troublesome, but I believe they are not in as much jeopardy as ours. Two events could keep our rate gap wide. The US Economy might fall into the Liquidity Trap, with low rates begetting still lower rates. A USDollar crisis might unfold, triggered by a vicious circle decline in our currency. Longterm rates held low through direct Fed monetization of the 10-yr Trez Note probably ensures it. Each event is a real possibility, and would keep money flowing steadily from the US to Europe.
When returns stagnate on EuroBonds, investors will look elsewhere. I believe the euro is a rest stop, a temporary sanctuary for capital. Credit markets remain the primary sanctuary for capital fleeing the equity markets. Our economy may remain weaker for a period of time. So hot money will continue to seek out the higher rates offered by EuroBonds. Europe is likely to lose some of its appeal as terrorism is shipped to that continent. Britain offers direct support for US efforts; other European leaders offer tacit support. Regardless, a euro currency overshoot will invite a correction before long. Political pressure from the US Leadership will also jawbone European rates closer to ours, softening the threat to the dollar. Fading prospects for wide differentials and still lower rates will eventually leave investors seeking alternatives. I believe they will turn to gold. The path will lead from the USTBonds to EuroBonds, and then ultimately to gold. The Arabs will assist in this two-step process, probably even lead the way.
JAPANESE SAVINGS:
The Japanese people are the most prolific savers in the world. Their recorded personal savings is in the neighborhood of $11 trillion. Since early 2002, they have discovered the benefits of preserving capital in gold. Hanging on with cash in yen or with investments in their Nikkei stocks would have resulted in deep wounds. Recent TOCOM data suggests the spring 2002 gold metal frenzy may be in the process of resuming once more. The Japanese economy enjoys a trade surplus versus the United States equal to 2.5% of their GDP. The USA suffers its largest bilateral trade deficit with Japan. Hence, fundamentals dictate both a rise in the yen and a fall in the dollar, generating a capital flow that will be formidable to prevent. Do their exporting companies continue the mindless recycling into US Treasurys? Do their private citizens continue to toss valued savings into stocks, which either depend on America's endless consumption or are closely aligned with "walking dead" keiretsus (conglomerates) ? Pensions for govt workers are already forced by law to invest in sub-1% bond funds.
Many of its people are totally fed up with the revolving door of coalition leaders, their indecision, and the same old same old senseless federal projects. They are deeply frightened by a federal debt amounting to 140% of their GDP. Their competitive future among other Asian exporters is darkening. China is taking markets away from Japan, offering much cheaper labor, while Japanese firms rush to invest in industrial capacity within the mainland Chinese economy. Threats abound for the Land of the Rising Sun. So bad is the monetary situation, that lenders are now offering slightly negative rates of interest ! I kid you not. Plenty of motivation exists for continuing to sock away money into gold, as this former beacon in Asia declines in wealth, power, stature, and influence. Although Japan as a nation is fading into oblivion, Japanese citizens are chock full of hard cash, eager to have it chase a traditional favorite in gold.
PENSION FUNDS (MANAGED AND UNMANAGED):
American managed pension funds typically diversify across stocks, bonds, commercial property, real estate trusts, and money markets. Professionally directed, they constantly balance funds, moving more so into bonds during the economic slowdown in 2000. Few managed pensions can boast of the success in TIAA/CREF, probably the best of the group, for the benefit of academic workers and some other non-profit organization workers. They have been bitten by poor results in municipal bonds and junk bonds. Pension money tied in Trez bonds and mortgage bonds might falter from the declining dollar, if rates rise. Money tied to commercial properties might suffer from continued vacancies as the economy struggles. If stocks continue to languish, these managers will seek out alternatives. Gold could attract some of their money.
Privately managed IRA, 401k, and Keogh funds have suffered mightily. Together, managed and unmanaged pensions total $8 trillion. Personal inexperience has led to tragic losses; individuals know next to nothing about bonds. I have had dozens of conversations with friends, acquaintances, associates, and ordinary people in the last few years. I have not found a single person who either is aware of bonds or has invested in bonds, except a good friend from my DEC computer days. He is a smart puppy hunkered down in Rhode Island doing consulting work. To make matters worse, fund offerings are pitiful. You can select among largecap stock funds or growth & smallcap stock funds or a nondescript bond fund. And of course a money market fund. Precious metal mutual funds do exist, but they are not usually offered to private pension fund investors. Some day we will see Toqueville Gold Fund offered, but not yet.
HEDGE FUNDS:
A diverse group, hedge funds include a large core of mainstream investors who have been burned badly. Many believed the standard Keynesian decrees put into action in January 2001. They misread the extent of lethargy and failed traction within the economy, resulting from extreme overcapacity and debt collapse. Several hundred funds have closed down. The survivors are showing active interest in precious metals, responding to recent performance success noted each quarter and annually. Certain leading hedge fund research outfits are now recommending gold & silver futures contracts, bullion, and mining firm stocks. The hunt is on. These speculative investors use and abuse leverage, borrowing money and then employing leverage atop leverage. The infamous LTCM was such a hedge fund. These guys chase performance with a vengeance. They have found gold, and will certainly deepen their commitments. While they do not command multiple billions of dollars, their methods often utilize such intense leverage that it seems they exert multi-billion dollar muscles. They might be an important factor in supporting gold during pullbacks, and thrusting gold during breakouts.
REFERENCES:
- Jim Willie CB: "25 Reasons Why Gold Will Rise" (Nov 12, 2002)
- Jim Puplava interview of Ian Gordon: "The Kondratieff Winter" (July 2002)
- Jim Sinclair: "Gold to be Remonitized!" (Jan 24, 2003)
and "Gold's Role Redefined" (Feb 1, 2003)
- Jim Willie CB: "A Statistician's Indictment of Economists" (Dec 2, 2002)
- John Murphy: "Gold Bull Market is Based on More than Iraq" (Jan 27, 2003)
- Clive Maund: "Gold, the HUI and XAU" (Jan 13, 2003)
- Jim Willie CB: "Predictions for the 2003 Year - Bear Claws" (Jan 27, 2003)
- Jim Puplava interview of Doug Noland: "Structured Finance & The Bifurcated Financial System"
(Jan 25, 2003)
Jim Willie CB is a pseudonym used since 1998 on Silicon Investor. Jim works as a statistical analyst for a private consulting firm engaged in consumer packaged goods marketing research. He holds a Ph.D. in Statistics. His career has stretched over 22 years, involving work at Digital Equipment Corp in manufacturing consulting and marketing research, and work at Staples in retail forecasting analysis. Visit his free fledgling website to read other articles and material, as well as to enjoy light-hearted satire, under the name: " www.GoldenJackass.com ." Many links appear for significant articles written by other authors. Future works are planned, including a mock interview of Sir Alan Greenspasm, director of the reactive inflationary pendulum.
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