Gold: Unsustainable Developments
John Ing
Gold has finally broken out of the narrow trading range between $640 and $665 an ounce, that has frustrated both bulls and bears alike. Gold bounced off the 200 day moving average but for most of the Spring failed to break through the $670 resistance level due to an increase in central bank selling, a bounce in the US dollar and selling from the ETFs. In addition, seasonal demand is typically low at this time which was not enough to offset the increased buying from the hedge buybacks by Barrick, Anglo and Newmont. We view the recent breakout as another purchase opportunity and remain convinced that gold will trade at $1000 an ounce before yearend.
Gold's physical demand remains strong, particularly from Asia and the Middle East. The latest CFTC Gold statistics shows a dramatic reduction in sentiment which is bullish for gold. Particularly promising is the improved technical action of the gold stocks which until recently have been laggards. Gold stocks have shown signs of strength outpacing bullion and we believe that this a key signal for a major move to the upside. However, the key driver will be the strong crosscurrents across the world's financial markets. It is our belief that the gigantic global speculative credit boom which has already created asset price inflation is a move to hard assets and a prelude to higher inflation. Gold's turn is next.
Sustainable development is the rage among politicians, my daughter and environmentalists alike. Yet, more people watched the soccer match between Argentina and Peru on cable than Al Gore's Live Earth on prime time NBC. What is unsustainable are developments in the economy.
Since 2002, asset prices have skyrocketed around the world and bubbles have popped up everywhere from stocks to Chinese paintings to uranium to debt. The CRB Commodity Index is at a 42 year high. The explosion is rooted in the expansionary global monetary policy that has flooded the financial system with liquidity. It involves the United States, the world's biggest economy, continuing to live beyond its means, running up huge deficits which have resulted in the creation of record amounts of debt. According to the Bank of International Settlements (BIS), "the strategy depends on the availability of cheap funding". The liberal use of leverage and the increasing array of financial instruments made debt easier to pile up. Cheap debt has underwritten a global "carry trade arbitrage" enabling the acquisition
of higher yielding equity, companies and real estate with cheaper paper.
Of course this is an unsustainable development.
The liquidity cycle has turned. Fears of the Chinese flu caused a contraction in liquidity. The uptick in
rates and liquidation of the subprime debt markets
also wiped out the "carry trade", further lessening the
level of liquidity. Finally, with piles of American
treasury bills losing value, foreign investors have
converted some of those piles into other asset classes
causing a further contraction in liquidity. The
unwinding of the global "carry trade arbitrage" is at
hand with an increase in borrowing costs.
Almost at the same time, global interest rates have
increased sharply. Bond prices crashed and yields on
European and Japanese bonds climbed. The backup in
yields follows the European central bank maintaining
its main interest rate at 4.0 percent, the highest level
since September 2001. The yield on US ten-year
government bonds registered its biggest jump in years
hitting 5.30 percent before settling back to 5.1
percent. The increase in rates, at long last is a wake-up
call for a complacent market used to stable economic
news, low inflation and massive US deficits.
Competition For Money
There are fears that the sharp rise in yields was driven by a trend towards central bank tightening. Wrong. We believe that interest rates are rising because the global trend of excess liquidity has pushed up the value of assets. Central banks have been on an inflationary money printing binge- witness the asset inflation of today. As measured by M3, money is being created at double-digit rates world-wide. For money to have value, it must be 'dear" and limited in supply.
The move in interest rates then, is a competition for money, particularly by weaker currency jurisdictions. For example, the central bank of New Zealand has increased rates to 8 percent, the highest levels in a decade. At the same time, New Zealand is pushing money growth as measured by M3 at a 14.6 percent annual rate in April. New Zealand is not the only one with exuberant monetary growth. Brazil's M3 is growing at 16.1 percent, Australia's M3 at 13.7 percent and even South Korea's M3 growth 3 at 12.3 percent. Although the United States does not measure M3 growth anymore, M3 growth is
between 13 to 14 percent range.
The Emperor Has No Clothes
Hit by US sinking subprime loans, the near collapse of Bear Sterns' subprime hedge funds exposed investors to the harsh mispricing of the $850 billion mortgaged backed CDOs or collateralised debt obligations which back subprime mortgages. Merrill Lynch, to realize its collateral, attempted to force the fire-sale of $850 million of CDOs but could only find sufficient bids for $200 million. In addition, it was disclosed that up to $2 trillion of debt was falsely priced and bids for "A" rated securities were placed as low as 30 percent of face value and not the 85 percent for previous "A" rated paper. So far there have been 87 players that have failed in the wake of the subprime implosion. Bear Stearns, the biggest broker to the hedge funds is now locked in a battle with other investment banks. And there are concerns that the Bear contagion would spread to junk bonds and the red hot leveraged loans. Risk premiums have increased, spreads have widened and with it excess liquidity has been extinguished overnight. In any case, investors are demanding greater protection, higher premiums and less leverage in an attempt to close the barn door. Amazingly, the subprime mortgages are less than 11 percent of total outstanding securitized debt. With the credit markets closed, hedge funds, private equity and the big investment banks just had their portfolios revalued downward and there is not enough protection or capital.
What is then to hedge investors from the over-extended institutions sitting with bloated mispriced inventory? The emperor has no clothes and rather a value of $850 billion, the underlying value of the CDOs on the books of the hedge funds, investment banks and insurers may be something less than $300 billion. Indeed, the mark-to-market losses exceed the capital of the big investment banks that underwrote the CDOs. Are the defaults the tip of the iceberg? No. Titanic has already sunk. With access to credit becoming tight, the big investment banks must also handle the bridge financing requirements of the big private equity buyout boom since the buyers are on strike. Credit markets are not ready for the big bust. Losses are projected to be even higher because of the "slicing and dicing" of risk by Wall
Street has left buyers illiquid assets. We believe that the inevitable unwinding of this debt binge will cause a credit crunch implosion that could easily turn into a harbinger of crisis. Gold is a good thing to have.
This is Why Gold is a Good Thing to Have
Once upon a time the greenback was good as gold. Under the Bretton Woods Agreement, the dollar was exchangable into gold which lasted from 1946 to 1971. During the Bretton Woods era, America's large deficits and prolificacy was sustained by external borrowings. Gold rose to over $40 an ounce and the Bank of England together with the Federal Reserve were forced to sell their gold reserves to maintain a price at $35 an ounce. This gave way in early 1961 to the creation of the Gold Pool to maintain the price of gold at $35 an ounce. Each time however, the Americans continued to run significant deficits and US gold reserves declined. Gold creeped higher. The Americans also fought a war that they could not afford.
The Vietnam War resulted in massive budgetary deficits and by 1968, the Gold Pool was disbanded (US gold reserves had fallen some 50 percent). For much of this time, the US dollar was supposed to be as good as gold.
Inflation of course was in double digits for a decade and unemployment not far behind - an unsustainable development. Bretton Woods fell apart when the dollar problems began to mount and countries opted for gold instead of dollars. As a result in August 1971, President Nixon went off the gold standard to avoid a run on the dollar. Ever bigger deficits ensued, the dollar was devalued and gold peaked at $850 an ounce in 1980.
Déjà Vu, All Over Again
Since its peak five years ago, the dollar has lost about 35 percent against the major currencies. America has become the largest debtor in the world. With record debt loads, and the reluctance by its creditors to invest in more dollars (there is no gold convertibility anymore), we believe the dollar will lose another 35 percent. Like the Johnson and Nixon Administrations in the 1960s and 1970s, the Bush Administration continues to run up huge budget and current account deficits. Each time, Johnson and Nixon had been forced to revalue the dollar. Bush has no choice. A sharp fall in the dollar is in the offing. The worst case scenario? With no savings and credit, the government's access to borrowing will be cut off, creating a cash crisis throwing our financial markets into chaos.
Gold is a good thing to have; it is also a barometer of currency fears. The US government cannot continue to pursue a policy of fiat money inflation. If people believe the greenback is overvalued and there is no alternative. Gold is a natural safe harbour. Gold has risen from a low of $255 per ounce for a
150 percent increase in the past four years. History shows that gold is money. Gold acts as the world's only true currency. Gold cannot be created like fiat paper currencies. Because gold's supply is limited and central banks cannot flood the market; gold represents the ultimate store of value.
A New Currency?
With the dollar so badly flawed, we believe the market will look to alternate replacements like the euro. After the collapse of the dollar in the mid-eighties, the Europeans established the European Monetary System as a prelude to the creation of the euro. The European Monetary System was established following the breakdown of the Bretton Wood system. The euro today is backed 15 percent of gold and about 25 percent of all global foreign exchange transactions now involve the euro.
Despite having trillions of dollars of foreign exchange reserves, the Asian financial crisis of 10 years ago is still fresh in many Asian central bankers memories. Today, Japan, Korea and the Philippines maintain flexible exchange rates, while Hong Kong, Thailand, and Singapore and of course China have managed floating rates. Unfortunately, all these units are pegged to the greenback and the pool of dollars is growing at $1 billion a day. At a recent meeting, finance ministers from ten Asian nations agreed to set
up a regional reserve pool, augmenting a current pact.
The fact that the US borrows entirely in dollars makes its deficits safer for itself but riskier for its creditors. In essence with growing pools of foreign exchange reserves, a desire to lower risk, and to avoid a repeat of the Asian crisis, Asia is expected to establish a common currency unit similar to the
European monetary system with an Asian central bank. Central banks in South Korea, China, Taiwan and Japan have announced plans to buy other asset classes with higher returns than low yielding and risky US debt. More relevant, by establishing another currency bloc, central banks have more alternatives to the once favoured US dollar. Asian central banks have already lost their appetites for US treasuries. Despite the increase in yields, a recent auction of US 10-year bonds attracted only 11 percent of foreign buyers. Beijing was a net seller of $5.8 billion of US treasuries in April, the first drop in holdings since October 2005. Gold is a good thing to have since the new unit will have a gold backing similar to the euro.
COMPANIES
AgnicoEagles Mines Ltd.
Agnico-Eagle had another terrific quarter, as the company benefited from by-product credits for zinc, copper and silver which resulted in a negative $332 per ounce cash cost for mining gold. Agnico will produce 240,000 ounces this year but will boost production to 1.2 million ounces by 2010, once the five new mines currently in construction come on stream. The newest, Cumberland Resources in Nunavut will produce 400,000 ounces in the first year alone. Agnico recently released drilling results from Pinos Altos in Mexico, where four drill rigs are turning. In addition, Agnico is sinking an underground ramp which will give it access to deeper zones in Santo Nino and Cerro Colorado. Pinos Altos currently has a resource of almost 2 million ounces of gold and 56 million ounces silver. Further drilling is expected to be boost the resource. We continue to recommend Agnico-Eagle shares because they are among the few that are spending aggressively and hence possess the best blue sky picture among the intermediate term players. Buy.
Aurizon Mines Ltd.
Aurizon has begun pre-commercial production at its Casa Berardi mine in the latest quarter. Aurizon produced 32,000 ounces of gold and is expected to produce about 175,000 ounces this year at a cash cost of about $275 an ounce. Aurizon plans to boost the mill from the 1600 tonnes to 2,200 tonnes per day which would allow it to boost production. Aurizon is also conducting an active drill program in the Kipawa Basin in the Quebec area for uranium where it possesses the largest land holding. We continue to recommend Aurizon as a developing mid-tier candidate.
John R. Ing
Maison Placements Canada
130 Adelaide St. West - Suite 906
Toronto, Ont. M5H 3P5
(416) 947-6040
jing@maisonplacements.com
18 July 2007
The information contained herein has been obtained from sources which we believe reliable but we cannot guarantee its accuracy or completeness. This report is not and under no circumstances is to be construed as an offer to sell for the solicitation of an offer to buy any securities. This report is furnished on the basis and understanding that Maison Placements Canada Inc. is to be under no responsibility whatsoever in respect thereof. Directors, shareholders or employees of this company may be beneficial owners of the securities referred to herein.
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