They Rang a Bell It is an old adage of financial markets that they don't ring a bell at market turns. This week they did. On September 28th the price of gold exploded. Someday this will be seen similarly for the gold price as the breakout in the Dow Jones in 1982. The day that gold won a battle over fiat specie. It was the announcement from 15 European Central Banks that precipitated the rally. But, to this writer, the most important part of their statement was the first sentence: "Gold will remain an important part of global monetary reserves."
The volume was over 180,000 contracts. To put this in perspective, until last week, volume had been running at 20-30,000 contracts per day. The Floor brokers, who are independent, had cut back staff as the long bear market drained volume and enthusiasm. No one on the Floor was prepared for this explosion and when this writer left the office on Friday evening his clearing firm still had out gold trades from that day. Others were less fortunate. ADM Investors reportedly had 2000 orders that were not even filled that day. Put simply, the volume overwhelmed the capacity to execute. For the sake of accuracy it should be noted that it was the electronic order entry system where the vast majority of the errors occurred.
Subsequently the market pulled back but still ended up 35 dollars on the week. The XAU index of gold stocks showed the same massive breakout on its chart. Clearly whatever the naysayers may try to describe as a short covering rally is something much more. Even if the Central Banks of Europe were tomorrow to repudiate their earlier statement it would not do more that cursory damage to the price. Pandora's box has been opened and the volume of shorts has been shown to the market. This has been demonstrated by the meteoric rise in lease rates. Form 1 per cent a year ago to over the 11% last Wednesday and now at 4.8 %. The Bank of England sold their gold ostensibly to invest in dollar and yen denominated debt. Now they are losers both on the interest and price. U. S Treasuries, currently 4.8 % and Japanese prime rate at 1.37% and Euro three-month deposit at 3%. Well it is clear, even to the less than mathematically inclined that paying excessive rates for your money against lower returns is not a happy position to be in. Lease rates tell the story. Too much paper gold too little real gold. It was one thing when all the hedge funds had on the yen carry trade. At the end of the day paper is not much more expensive in Japan than the US. And computer entries cost even less. The potential liabilities to the money center banks that provide this credit has been provided in detail by Charles Peabody. Or read a cursory summation in Alan Abelson's column Gold.com (Barron's Oct 4, 1999)
What precipitated European Central Banks' sudden reversal? On Friday September 17 Floyd Norris wrote an article in the New York Times titled United States Sets A Record for Living Beyond Its Means "There are few things more enjoyable in life than spending more than you earn. Especially if you are convinced that you can keep doing so indefinitely. The United States is now in that position. As a nation, it is outspending its income more than ever before. That fact does not prove the party is about to end." Perhaps, but with the deficit closing in on 4% of gross domestic product we are at, and soon will be beyond, the levels set in 1987. Let's turn back the hands of time. On February 19, 1988 Pierre Languetin, President of the Swiss National Bank stated, "All central Banks, not just members of the Bank for International Settlements, bought a total of $140 Billion in 1987 to support the US currency and finance the US current account deficit. Since the fundamental imbalances have not been corrected the chances of improvement do not exist. Central banks cannot continue to absorb dollars indefinitely to maintain the currency's stability." And also: "The foreign indebtedness of the United Sates is growing at an unsettling pace. It represents a danger for the future development of the dollar, for the American economy, and for the world economy."
Well, Mr. Languetin retired on April 30th of that year and probably in his wildest dreams could not have foreseen what would transpire over the next thirteen years as the stewardship of the world's reserve currency was placed in the hands of Alan Greenspan. Exponential credit creation. We will let Mr. Lawrence Lindsey, a former Governor of the Federal Reserve provide the apt description. "The irony is that Mr. Greenspan comes across as a dour curmudgeon when in fact his policies make him an economist's version of a wild and crazy guy." (Wall St. Journal Sept.14, 1999)
Mr. Greenspan's policies have been credited with saving the economy when in fact he has merely postponed and magnified the inevitable crisis. I want to go back and remember some of the statements of John Exter who served six years as Vice President of the Federal Reserve Bank of New York. In recent years Mr. Exter has been pilloried on the TV show Wall St. Week as the worst market prognosticator of our time. The fact is that John Exter was never a market advisor but a private citizen and before that a banker. At the old First National City Bank (now Citibank) he invented the Certificate of Deposit, the credit for which has been given to his former boss Walter Wristen. Mr. Wriston, lauded today as an early financial innovator was responsible for policies of extending loans to Latin America that led to a whole series of defaults and the subsequent creation of Brady bonds. Last week saw the first default on Brady bonds from Ecuador. Those of a certain age will remember Mr. Exter's famous inverted pyramid. Gold at the bottom, next T Bills, then corporate bonds and finally junk bonds. To that we must now add the enormous overhang of derivatives. Back in 1987 Exter made a speech called the Continuing Erosion of the Dollar. He made several points:
"Only a deficit currency can become a reserve currency. In other words, its central bank must be more expansionary than those of other major currencies Thus for more than twenty-five years the US has been creating hundreds of billions of dollars itself, mostly by buying government securities, which in turn has stimulated the banking system it oversees to create many hundreds of billions more in dollar deposits."
And grow it must. For in the upside down debt pyramid the creation of new debt allows old debts to be serviced and even repaid. But when the debt creation slows or, heaven forbid, ceases there is no new debt with which to repay the old.
In the first quarter of this year foreigners were net sellers of $17.5 bln. The Faustian pact between the US and the rest of the world appears to have run its course. In this context the announcement by the Central Banks of Europe takes on a more ominous light.
In his rather quixotic manner John Brimelow, of Donald & Co., explained to Reuters on Sept 27th, "Another answer may have to do with some sort of struggle between the US and the rest of the world on the issue of hegemony and the dollar. The argument runs that the Americans believe themselves to be major economic beneficiaries of the fact that the world uses the dollar as the reserve currency and therefore, the other central banks have become extremely jealous. Hence, the opposition of the Americans to proposals by the Japanese for an Asian currency zone. This is a very deep issue which will take people a long time to figure out."
It is certainly not something that they will learn in the mainstream financial press. In his column gold.com Mr. Abelson speculates on the cause of gold's rise as being due to either the Central Banks or fears of inflation. These are both manifestations of the root cause. It is the role of the dollar that is being questioned and that is something obviously too sensitive to merit discussion.
We are familiar with the refrain that there have been crises all through the nineties from Mexico to South East Asia to Russia to LTCM, none of these have caused either gold to rally or the demise of the dollar.
My Uncle Egbert said much the same thing for years only his concerns were culinary not financial. "All this crap about cholesterol, I eat what I want and look at me, fine after all these years." Subsequently he died without warning of massive heart failure.
Remember that in 1987 Languetin worried about the US becoming a huge dollar debtor. In the intervening years this problem has grown exponentially. Foreigners invested in dollars whether they be equities, bonds, real estate or derivatives will want out. So if you are a dollar holder ask not for whom the bell tolls, it tolls for thee.
Greg Pickup
October 6, 1999Greg Pickup hedges risk for commercial agricultural firms and speculates for investors. He can be reached at 312-902-6720, or email him at gpickup@ix.netcom.com. He posts a daily overview of the grain markets at http://www.chicagoperspective.com
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