The Wizard of Fed

October 23, 1998

Last week the Fed made its celebrated preemptive strike on the financial markets by lowering the Fed funds rate by ¼%. The timing of the cut, coming after bond futures had closed and the day before the expiration of October equity options had all the hallmarks of a classic short squeeze. The fact that it was widely applauded in the financial press demonstrates that manipulation has become the status quo in what currently passes as a financial system.

Of course we are assured that drastic measures are called for given the instability in world financial markets. It was only the week before that Japan's leading financial journal the Nihon Keizai Shimbun had bluntly stated in a front page editorial, "The nightmare of a global financial panic, emanating form Japan, is becoming a reality."—Wall Street Journal, Oct 7, 1998. In this light, and given the global contraction in credit, it is understandable that the establishment media once again showered praise on the Wizard of Fed for his bold action at thwarting the decline in equity markets.

But before we quietly attempt to relegate to the history books the recent excesses of financial leverage let us consider for a moment what they mean. Are these not the classic examples of exuberance that years of a "too big to fail psychology" has produced? It is the unwillingness of the Fed to allow any individual failure either on the part of large corporations or banks that has produced an environment that puts the entire system at risk.

An example of how far official manipulation has progressed was published in the weekend Financial Times of October 10/11. We refer to a brief article titled "UBS [Union Bank of Switzerland]' Breached Guidelines' on Investment in LTCM." The information in the article was obtained from an internal document obtained by Reuters and confirmed as genuine. The article stated that Union Bank of Switzerland entered into its investment with Long Term Capital Management assuming that the hedge fund had overall leverage of at least 250 times, breaching the Swiss Bank's own guidelines. The document further stated that "LTCM has eight strategic investors, generally government owned banks in major markets" which then owned 30.9% of its capital. They gave LTCM a window to see the structural changes occurring in these markets to which the strategic investors belong.

In other words, UBS was willing to breach its own internal guidelines because they believed that LTCM had a window into official sector knowledge and therefore could profit from changes which would not be apparent to outside observers. This is perhaps the most massive insider-trading scheme ever realized and it is fitting that it blew up in the participants' collective face.

It is significant that LTCM was widely believed to be short 300 tons of gold and that the price did not explode when the bullion price rose above $300. This was reported to be because of a central bank's willingness to allow the new owners of the firm, the largest investment banks and brokers on Wall Street, out of the trade.

In fact, Alan Greenspan said in testimony to Congress on the issue of CFTC supervision of the derivatives market, "Nor can private counter parties restrict supplies of gold, another commodity whose derivatives are often traded over the counter, where central banks stand ready to lease gold in increasing quantities should the price rise." (Italics mine.)

His willingness to state that central banks would increase lending on any price rise demonstrates that central bankers still regard the price of gold as a barometer of faith in the financial system as it is presently constituted.

One of the nuggets that emerged from last week's IMF conference was a remark made privately by one of the preeminent Wall St. Bankers to the effect that of course their firm used the gold market as a source of funds for their general corporate funding.

If this firm a member of the Gang of Eight that rescued LTCM finds 1% money attractive, one can be certain that the others do as well. Because for all the hand wringing over excess leverage these Wall St. banks and brokers employ exactly the same leverage to achieve their own returns. And it is widely believed that the reason the Fed engineered the rescue was that the counterparts in the Gang of Eight all held similar positions in the derivatives markets as LTCM so unwinding it would be near impossible.

We have been asked why given the explosion in the yen carry trade these firms would continue to risk essentially the same position in the gold market? Our answer is that these masters of the universe simply can't conceive of the fact that they might be wrong. Look at Tiger Management. It was clear at the end of August that the yen was not weakening and in fact was, in the face of all odds, strengthening against the dollar. And yet Tiger waited until October to cover a massive trade that cost 9% of their assets. Why should the investment banks and brokers that have for so long and so profitably manipulated the gold price believe this time is any different? For two years they have been successful in thwarting any rally, all the while availing themselves of interest rates as low as 1%. In fact judging from their current efforts they have reason to congratulate themselves. The price has dropped back under $300, the XAU has retreated and the goldbugs are mired in gloom.

But as Alan Greenspan said last week that he hasn't seen anything like this before. He was talking of course about the risk premium that the market had swiftly imposed on anything but the safest interest rate instruments. But what he is conceding is that there is systemic risk. In such an environment there will inevitably be an increasing premium placed on capital preservation.

The masters of the universe would have us believe that gold is not only a poor investment but an irrelevant one. After all, their investments are hedged. But as Henry Kaufman put it, "you can live in the illusion you can trade out of something that is doing poorly, which, of course, you can't when everybody reaches that conclusion." (WSJ Oct 7, 1998)

Everybody in the financial world has reached the conclusion that over time equity prices are consistent winners and that gold is irrelevant. There is a tremendous amount of borrowed gold. In The Gold Book Annual Frank Veneroso estimates the total at 8000 tons. This amount cannot be covered in an orderly process. The only action that the masters of manipulation can follow is to fight any price increase until the world financial markets return to an aura of stability. But this high wire act of financial improvisation is doomed to failure. As anyone familiar with the tenets of the Austrian school of economics will understand, credit inflations inevitably are followed by credit deflations.

A credit deflation, once begun, cannot be reversed by rate cuts. The cuts do nothing to reduce the overcapacity that years of malinvestment has produced. Perhaps even more severe is the misallocation of labor. A fire sale can clear the capital markets far quicker than the time it takes to retrain an excess of financial consultants. And the consequences of global unemployment, at best socially painful, can quickly turn politically explosive. This is a process of change that will be measured in years.

The current rally in equities is allowing an opportunity for investors to liquidate their long positions. This is a corrective rally and may even go back to test the old highs. But it is a rally based on the premise lower interest rates can reverse the decline. Look for increased volatility, abrupt reversals and record volume. And finally, in this writer's opinion, a swift and stunning decline. What will the Fed do then?

Remember that unlike commodity accounts equity accounts are not segregated. If you invest in a margin account your positions can and will be loaned or used as collateral. Your only protection is that individual accounts are insured up to $50 million. But in the case of systemic risk that insurance is only as good as your counter party.

Investors who hold gold stocks should take delivery of their stock certificates. As capital preservation becomes paramount the inevitable consequence of years of manipulation will be felt in an upward move in bullion that will make the recent rise in yen look mild in comparison.

India and the U.S. trump Italy as top gold jewelry exporters.