Today’s Markets and Money is an ambitious one. But hey, after you’ve seen James Cameron’s Avatar, you feel like pretty much anything is possible. We’ll save the movie review for later. For now, let’s have a look at some obvious and not so obvious warning signs emanating from the economy. First is the picture below.
It is not April Fool’s day. Federal Reserve Chairman Ben Bernanke is Time magazine’s man of the year. Good on ya Ben! But beware the curse.
On February 15th 1999, Alan Greenspan, Larry Summers, and Robert Rubin made the cover of the same rag with the audacious tag, “The Committee to save the world….the inside story of how the Three Marketeers have prevented global economic meltdown…so far.”
It turned out that “so far” would last about another year. As you can see from the chart below, the S&P 500 peaked in March of 2000, and then crashed. It wouldn’t reach another new high until July of 2007 – right about the time a couple of leveraged funds from Bear Stearns stuffed to the gills with CDOs started to shake the financial system to its foundations.
The world doesn’t look very saved, does it? Judging by today’s Fed statement the world needs more saving. The Fed didn’t change rates. But it didn’t say when it would remove its support for the housing market (via purchases of mortgage-backed securities) or when it would wind down its other programs that support the fragile state of credit in the American market.
The truth is the Fed can’t remove that support yet – or the cost of housing finance would rise in the States. But it may rise anyway. The spread between two-year U.S. Treasury notes and 10-year notes is widening. Thirty-year mortgage rates in the U.S. are tied to the 10-year note. Higher ten-year yields drive up new mortgage and mortgage refinance rates in the States.
Double plus ungood.
By the way, not that we’re a bond sleuth, but we read in the Wall Street Journal earlier this week that the spread between 2-year notes and 30-year U.S. bonds is as wide as it has been at any time since 1980. It’s the yield curve. So what does it mean that the U.S. yield curve is so steep?
We reckon it means that investors want to be paid more to lend money long-term. This means they fear inflation. They’re happy to load into shorter-term notes and bonds. But loan the U.S. government – a government Barack Obama says will go bankrupt if health care costs are not restrained – for 30 years? Fugeddaboutit!
Note that Obama did not say what Senator Barnaby Joyce has said, that America could default on its debt. You have to applaud the Senator for uncharacteristic candour, as far as politicians. Technically, he’s probably not quite correct though.
The U.S. government sells debt in dollars. It also prints dollars. That means it can print new dollars to pay off its debt. It needn’t default, i.e. be unable to find currency to pay its creditors. If it were issuing debt in a foreign currency, say Yuan, then it would have to pay debt off in that currency and COULD default.
But perhaps we are quibbling over details. An inability to service its debt or pay off its long-term obligations, or just a willingness to do so by printing more money, is effectively a devaluation of the U.S. dollar. That’s what the currency markets have been telling us all year. And that’s one reason why the yield curve is starting to look like an Olympic ski jump.
This fear of the sustainability of the U.S. deficits is another reason investors and people who use their brain own at least some gold. And on that subject, we copped it a bit from a friend last night for our comments yesterday. He also trotted out a famous quote about gold from Warren Buffett.
“Don’t you think you were a bit self indulgent yesterday going after Pascoe?”
“Well, it is a fair point.”
“If the world goes to hell like you say, you can’t eat gold. You can’t sleep on it, although you could sleep with it I suppose. How useful is it really going to be as a medium of exchange or a store of value if economic activity grinds to a halt?”
“I don’t know. I’m not Nostradamus. But I’m not recommending people convert all their equity holdings into precious metals either. I AM recommending they own some bullion and, for leverage purposes, some gold shares. That doesn’t seem so radical. Why would anyone find the idea of hedging your bets against monetary policy so kooky?”
“Because monetary and fiscal policy have basically worked, at least here in Australia.”
“Are you drunk?”
“I’m serious. The stimulus worked. It kept Australia out of recession. What more do you want?”
“Less. Less is more mate. The stimulus increased the debt and maintained the appearance of growth. But the economy didn’t need growth. It needed to reduce personal debt levels and consumption and get a less leveraged balance sheet. The government encouraged the exact opposite.”
“Blah blah blah. Even Buffett thinks you’re wrong about gold. What’s that quote of his… ‘Gold gets dug out of the ground in Africa, or someplace. Then we melt it down, dig another hole, bury it again and pay people to stand around guarding it. It has no utility. Anyone watching from Mars would be scratching their head.’ What do you say to that?”
“Buffet is a better investor than I’ll ever be. And obviously he’s a smart guy. But surely he’s heard of Gresham’s Law.”
“Gresham’s Law. Bad money drives out good. Or to quote the late, great Harry Browne, ‘If an individual holds two types of money of unequal value, he will spend the bad money and save the good money.'”
“I’m afraid I’m not following you.”
“That’s because you’re a moron. But it’s the argument between owning all paper and at least some gold. You don’t convert all of your wealth to gold because right now, that’s not useful. You need cash to conduct transactions in the real economy. And when the government is inflating away systematically, it makes absolute sense to get rid of cash before its purchasing power diminishes. Trade it for tangible goods that DO have value or utility like whiskey, cigars, and bullets.”
“How about something less revolutionary like houses? “
“Maybe not a bad idea if you’re using cash and not debt. And it would be a good idea if the price of the asset wasn’t going to collapse imminently. You don’t want to convert your cash into a capital asset that rapidly depreciates in value, which is possible with house prices.”
“But isn’t that possible with gold too? You convert your cash into a tangible asset whose value fluctuates? And it doesn’t even pay a yield! And you can’t exactly live in it either.”
“Of course that’s all true. But the reason central banks and households own gold, and the reason people have hoarded it for thousands of years, is that they KNOW intuitively that gold is good money, sound money, and that paper money is generally not good money – especially when it’s being actively destroyed by bad fiscal and monetary policy. Generally it’s not something you have to consciously think about. Most of the time the money in your pocket is exchangeable for the things you want.”
“So what’s the problem?”
“The problem now is that people are beginning to understand that monetary inflation is theft. If you trade your labour for wages paid in the form of cash, and the government devalues that cash, it’s stealing your productivity. It’s trading its paper product for the fruits of your labour at a discount. It’s cheating you. Gold doesn’t cheat you. It doesn’t love you either. It doesn’t do anything. That’s why people prefer to hold some of their wealth in that form, for those times when they are being cheated by government.”
“Well, that’s pretty much all the time isn’t it?”
“You know what H.L. Mencken said about elections in democracies? He said they are an advanced auction of stolen goods. There’s a whole lot of stealing going on these days. A fiat money system is systematic theft because it’s based on unsound money. That’s what’s being exposed by this financial crisis. The entire funding model of the fiscal welfare state is collapsing because it’s based on debt and fraudulent, counterfeit money.”
“Hey do you want to go see Avatar?”
We’re not saying people who don’t understand gold’s role as money are stupid – although maybe a few of them definitely ARE stupid. What we are saying is that it’s not rational to hedge against what you don’t know is coming. Most people have no experience with a currency collapse. So they don’t prepare for it. It seems so unlikely that it’s not worth hedging against.
Incidentally, until we start hearing this conversation in barber shops, we won’t be convinced gold is in a bubble. But in the meantime, if you are less dogmatic, a strategy for converting your equity holdings to something more tangible is just as practical.
For example, earlier this week we mentioned ExxonMobil’s big natural gas play in the U.S. This matches a theme we laid out earlier in the year at Diggers and Drillers that unconventional natural gas plays – gas from shale formations – would be the next intelligent speculation in Australian energy shares.
That’s a classic case of substitution. The high oil price makes other energy alternatives economically realistic. They can stand in as substitutes for the fuel we get from oil (most of the time). This is what Michael Pascoe correctly pointed out when he said we can “make more” of the stuff.
Unfortunately for Ben Bernanke, the Fed can only make more dollars, not more gold. There are not many ready substitutes for precious metals. That’s part of what gives them their inherent value; their scarcity. Gold is not exactly unobtainable, like the unobtanium in Cameron’s Avatar. But it’s certainly getting a lot more desirable the more sovereign states go into debt they can never repay.
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