The Rules Have Changed
Heinrich Leopold
The recent relentless rise of commodities as well as precious metals raises the question why commodities cannot be controlled anymore in comfort fashion as it has been during the last two decades. What has been the strategy and mechanism so far to depress precious metals and commodities over two decades and what has changed now?
High commodity prices have been also a challenge during the seventies beginning of the eighties. The high commodity prices had a huge political impact on the United States and Europe as nearly all incumbent governments have been changed during this time and Reagan, Thatcher and Kohl could win impressively over their socialist and democratic counterparts.
High inflation, interest rates and unemployment as well as sluggish economic growth have forced governments, businesses and central banks to find a sustainable strategy how to ensure economic growth, low inflation and low unemployment.
The US Central Bank decided after the aftermath of high inflation in 1982 to do the unthinkable at this time: it raised real interest rates (=nominal interest rates - inflation) to a record high. Many observers and economists thought this would be the end of the world as high real interest rates would finally throw the economy into a black hole. During this time most economists thought that only low real interest rates would foster economic growth.
Nevertheless, just the opposite happened. High real interest rates made it attractive for local and foreign investors to invest into government and corporate bonds and the economy could find vast sources of capital, especially on a global basis. It has been exactly high real interest rates, which enabled the worldwide asset and debt bubble of the last two decades.
High real interest rates has been also a wonderful tool to control currencies without running a current account surplus as high real interest rates supported a currency despite large fiscal and trade deficits. Reagonomics (economic policy under President Reagan) has been the first outcome of this strategy: a high US dollar combined with high real interest rates and trade and fiscal deficits resulted in phenomenal economic growth.
In addition - in the case of the US - a high US dollar supported by high interest rates could control the worldwide economic growth as a high US dollar made it more difficult for many emerging countries to serve their foreign debt mostly nominated in US dollar. In that sense the US central bank could control worldwide growth (and thus commodity and precious metal prices) by setting interest rates. Even more beneficial has been for the US that high real interest rates supported the capital inflow into the US thus increasing the US economic growth despite high dollar and worldwide weak economic conditions. So, the US had the perfect strategy to control its own and the world economy to its own benefit for nearly two
decades.
Especially during the nineties, the US controlled the world economy through FED Funds movements. During this time US production (and the US economy) could excel over ten years as high real interest rates ensured high capital inflow into the US and consequently high production despite worldwide sluggish growth (Asian crisis ; see shaded area).
Nevertheless, this strategy did not work anymore at the beginning of the new century. Despite interest hikes end of 1999 the capital inflow to the US has not been enough to prevent a recession in 2001. The US economy needed stimulation from extremely low FED Funds. End of 2005 it looks like that the recent US interest rate hikes are once again harming more the US economy rather than the Asian economies and the rest of the World. This is why the US Central Bank is extremely cautious with its interest hikes as it wants to avoid another steep recession.
The reasons for the change of the rules of the game are manifold. The world has changed and so has the financial environment. Emerging countries are not anymore that much dependent on US debt financing. Many countries can now finance their investments in their own currency. This is largely the case for China and India. Many emerging countries sit also on vast foreign currency reserves and carry a trade surplus. Secondly, the Euro is now today also a cheap source of financing and a lot of emerging debt is today nominated in Euro. Thirdly, the size of economies in emerging countries is today much bigger in relation to the US and European economies, thus making the emerging countries much less dependent on foreign economic financing. In addition the US and Europe are in a very mature stage of an asset and debt bubble, which makes new debt harder and harder to finance and serve. Last not least there is worldwide a dramatic shift of moving jobs into emerging countries and consequently moving jobs out of developed economies.
The consequence of the changing worldwide economic forces is an increasingly difficult environment for the US Central Bank (as well as for the European Central Bank) to maintain high interest rates without harming their own economies.
Despite ten consecutive interest rate hikes in the US, real US interest rates are barely above zero. This provides the US economy with ample liquidity. Yet, despite the vast liquidity, US production growth is below 3 percent and is likely to fall substantial over the next few months. The weak financial conditions for developed economies is also expressed in the yield differential between high yield debt of developed and emerging countries which for the first time ever turned favourable towards emerging countries. High interest rates also threaten to dent the housing boom, which is in a very mature stage. In that sense the US and Europe are in the same situation as Japan 10 years ago.
As it is increasingly difficult to maintain economic growth for the US and Europe, the twenty year old strategy of keeping real interest rates high in order to engineer economic growth through an asset bubble looks now like a pact with the devil.
Despite high liquidity on the one side and high commodity prices on the other side, the Central Banks of US and Europe have to shift liquidity into overdrive. Soon it will be necessary to reduce interest rates which will increase liquidity even more. Since June 2005 it became also clear that a higher dollar harms the US economy more than global growth, so the inverse relationship between US dollar and gold broke down as well.
The consequence is that the World economy - and thus commodity prices - are unchained from the control of the US Central Bank. The gold price, which is a very sensible indicator for worldwide economic and financial conditions, is already anticipating this trend by rising strongly despite relative strong US dollar and high nominal US interest rates.
As many investors and institutions are still playing the game according to the past rules (high US interest rates and US dollar slow down commodity prices) there is a gigantic short covering rally for gold and silver in the making until the last short discovers that the rules for the World economy - and commodity prices as well as silver and gold - have changed. The sea change of investment rules is the time when vast fortunes are made or lost.
I look forward to receiving your comments.
Heinrich Leopold
hgleopold@yahoo.com
28 December 2005
Certain statements included herein may constitute "forward-looking statements" with the meaning of certain securities legislative measures. Such forward-looking statements involve known and unknown risks, uncertainties and other factors that may cause the actual results, performance or achievements of the above mentioned companies, or industry results, to be materially different from any future results, performance or achievements expressed or implied by such forward-looking statements.
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