October 2, 2022

The Hidden Risks Of Money Printing

By Axel Merk

While Treasuries are said to have no default risk as the Federal Reserve (Fed) can always print money to pay off the debt, hidden risks might be lurking. As oxymoronic as it may sound, the biggest risk to the economy and the U.S. dollar might be, well, economic growth! Let us explain.

The U.S. government paid an average interest rate of 2.046% on the $11.0 trillion of Treasuries outstanding as of the end of November. Treasuries include Bills, Notes, Bonds and Treasury Inflation-Protected Securities (TIPS). At 2.046%, the cost of carrying the Treasury portfolio currently costs the government $225 billion per annum; about 6% of the federal budget was spent on servicing the national debt. 1

While total government debt has ballooned in recent years, the interest rate paid by the government on its debt has continued on its downward trend:

We only need to go back to the average interest rate paid in 2001, 6.19%, and the annual cost of servicing Treasuries would triple, paying more than Greece as a percentage of the budget. Not only would other government programs be crowded out, the debt service payments might likely be considered unsustainable. Except for the fact that, unlike Greece, the Fed can print its own money, diluting the value of the debt. In doing so, the debt could be nominally paid, although we would expect inflation to be substantially higher in such a scenario.

These numbers are no secret. Yet, absent of a gradual, yet orderly decline of the U.S. dollar over the years – with the occasional rally to make some investors believe the long-term decline of the U.S. dollar may be over – the markets do not appear overly concerned. Reasons the market aren’t particularly concerned include:

  • The average interest rate continues to trend downward. That’s because maturing high-coupon Treasury securities are refinanced with new, lower yielding securities.
  • Treasury Secretary Geithner has diligently lengthened the average duration of U.S. debt from about 4 years when he took office to currently over 5 years.

For the U.S. government, a longer duration suggests less vulnerability to a rise in interest rates, as it will take longer for a rise in borrowing costs to filter through to the average debt outstanding. The opposite is true for investors: the longer the average duration of a bond or a bond portfolio one holds, the greater the interest risk, i.e. the risk that the bonds fall in value as interest rates rise.

Debt management by the Treasury only tells part of the story on interest risk. When the Treasury publishes “debt held by the public,” it includes Treasuries purchased in the open market by the Fed. By engaging in “Operation Twist”, the Federal Reserve stepped onto Timothy Geithner’s turf, manipulating the average duration of debt held by the private sector. Notably, the private sector holds fewer longer-dated bonds, as the Fed has gobbled many of them up.

However, investors may still be exposed to substantial interest risk in their overall fixed income holdings as, in the search of yield, many have doubled down by seeking out longer dated and riskier securities.

The Fed, many are not aware of, employs amortized cost accounting, rather than marking its holdings to market, thus hiding potential losses should interest rates go up and its portfolio of Treasuries and Mortgage-Backed Securities (MBS) fall in value.

Quantitative easing to increase interest risk

Whenever there’s a warning that all the money created by the Federal Reserve is akin to printing money, some dismiss these concerns as the money created out of thin air to buy securities has not caused banks to lend, but park excess reserves back at the Federal Reserve. As of December 14, 2012, $1.4 trillion in excess reserves is parked at the Fed. Substantial interest risk might be baked into reserves:

Consider that the Fed has been paying about $80 billion in profits to the Treasury in recent years. Think of it this way: the more money the Fed “prints”, the more (Treasury & MBS) securities it buys, the more interest it earns. That’s why Fed Chair Bernanke brags that his policies have not cost taxpayers a cent, even if the activities may put the purchasing power of the currency at risk. Now, Bernanke has also claimed he could raise rates in 15 minutes. In our assessment, it’s most unlikely he would do so by selling long-dated securities; instead, in an effort to keep long-term rates low, the most likely scenario is that the Fed will pay a higher interest rate on reserves. Up until the financial crisis broke out, the Federal Reserve would have intervened in the Treasury market by buying and selling securities to move short-term interest rates. In the fall of 2008, the Fed was granted the authority by Congress to pay interest on reserves.

As interest rates rise, not only will Treasury pay more for debt it issues, it may also receive less from the Fed. Interest rates would have to rise to about 6% for the entire $80 billion in “profits” to be wiped out assuming a constant $1.5 trillion in reserve balances ($1.4 trillion in excess reserves and $0.1 trillion in required reserves that also receive interest); that assumes, the Fed does not grow its balance sheet in the interim (in an effort to generate more “profits” for the Fed) and would not reduce its payouts in the interim as a precaution because bonds held on the Fed’s books may be trading in the market at substantially lower levels.

Should interest rates move up, the Treasury may no longer be able to rely on the Fed to finance the deficit (while the Fed denies the purposes of its policies is to finance the deficit, the Fed is buying a trillion dollars in debt as the government is running a trillion dollar deficit).

Biggest risk: economic growth?

In our surveys, inflation tends to be on top of investors’ minds, no matter how often government surveys show us that inflation is not the problem. Should inflation expectations continue to rise – and a reasonable person may be excused for coming to that conclusion given that the Fed appears to be increasingly focusing on employment rather than inflation – bonds might be selling off, putting upward pressure on the cost of borrowing for the government.

But if we assume inflation is indeed not an imminent concern (keep in mind that the Fed is also buying TIPS and, thus, distorting important inflation gauges in the market), we only need to look back at the spring of this year when a couple of good economic indicators got some investors to conclude that a recovery is finally under way. What happened? The bond market sold off rather sharply! A key reason why the Fed is increasingly moving towards employment targeting is to prevent a recurrence, namely a market-driven tightening, pushing up mortgage costs.

The government should be grateful that we have this “muddle-through” economy. Let some of that money that’s been printed “stick;” let the economy kick into high gear. In that scenario, the “good news” may well be reflected in a bond market that turns into a bear market.

Historically, when interest rates move higher in an economic recovery, the U.S. dollar is no beneficiary because foreigners tend to hold lots of Treasuries: should the bond market turn into a bear market, foreigners historically tend to wait for the end of the tightening cycle before recommitting to U.S. Treasuries.

The point we are making is that for bonds to sell off and the dollar to be under pressure, we don’t need inflation to show its ugly head; we don’t need China or Japan to engage in financial warfare by dumping their Treasury holdings. All we may need is economic growth! And while Timothy Geithner has studiously been trying to extend the average duration of U.S. debt, Ben Bernanke at the Fed has thrown him a curveball.

Perception is reality

One only needs to look at Spain to see that a long average duration of government debt is no guarantor against a debt crisis. Spain has an average maturity of government debt of 6 years, yet it does not take a rocket scientist to figure out that borrowing at 6% in the market is not sustainable given the total debt burden. As such, markets tend to shiver when confidence is lost, even if, technically, governments could cling on for a while when the cost of borrowing surges.

History may repeat itself

It was only 11 years ago that the US government paid and average of 6% on its debt. Sure the average cost of borrowing has been coming down. But no matter what scenarios we paint, if the average cost of borrowing can come down to almost 2% from 6%, we believe it is entirely possible to have the reverse take place over the next 11 years. Given the additional risks the Fed’s actions have introduced, the timing could well be condensed. But even if not, we believe it is irresponsible for policy makers to pretend interest rates may stay low forever (except, maybe, Tim Geithner’s steps to increase the average maturity of government debt; but as pointed out, his efforts may be overwhelmed by those of the Fed).

Fiscal Cliff

What’s so sad about the discussion about the so-called fiscal cliff is that even the initial Republican proposal results in approximately $800 billion deficits each year. Financed at an average 2%, this would add over $900 billion in interest expenses over ten years; financed at an average 4%, it would add almost $2 trillion in interest expense over ten years. Mind you, this is a politically unrealistic, conservative proposal. Democrats pretend we don’t even have a long-term sustainability problem, only that the wealthy don’t pay their fair share.

In our humble opinion, both Republicans and Democrats are distracted. In many ways, the simultaneous increase in taxes and cut in expenditures of the fiscal cliff is akin to European style austerity: if the cliff were to take place in its entirety, we would a) suffer a significant economic slow down; b) continue to run deficits exceeding 3% of GDP before factoring in any slowdown; and c) still not have fixed entitlements.

Entitlements

While our discussion focused on $11 trillion in Treasury securities, the so-called “unfunded liabilities” go much further than the $5 trillion in accounting liabilities set aside. Depending on the actuarial assumptions, unfunded liabilities may be as high as $50 trillion to $200 trillion or higher.

In our assessment, the only way to tame the explosion of government liabilities over the medium term is to tame entitlements. But it is very difficult to cut back on promises made. As Europe has shown us, the only language that policy makers understand may be that of the bond market. As such, unless and until the bond market imposes entitlement reform, we are rather pessimistic that our budget will be put on a sustainable footing. Put another way, things are not bad enough for policy makers to make the tough decisions.

Different from Europe, however, the U.S. has a current account deficit. As a result, a misbehaving bond market may have far greater negative ramifications for the dollar than the strains in the Eurozone bond markets had for the Euro. In the Eurozone, the current account is roughly in balance; while there was a flight out of weaker Eurozone countries, that flight was mostly intra-Eurozone towards Germany and Northern European countries.

So while the default risk of U.S. Treasuries may be less than that of Eurozone members, the risks to the purchasing power of the U.S. dollar might be substantially higher. On that note, while the Fed has indicated to buy another approximately $1 trillion in assets over the next year, we would not be surprised to see the balance sheet of the more demand-driven European Central Bank shrink as some banks pay back loans from the Long-Term Refinancing Operation (LTRO) early.

In early January, we will be publishing our outlook for 2013; Please also sign up for our newsletter to be informed as we discuss global dynamics and their impact on gold and currencies. Additionally, please join us for our upcoming Webinar on Tuesday, January 15th, 2013.

Axel Merk

Axel Merk is President and Chief Investment Officer, Merk Investments.

Gold and Stocks Diverge As Central Banks Pledge Unlimited Money Printing

Both the Federal Reserve and the Bank of Japan have gone all in with their attempts to revive weak, debt burdened economies with a pledge of unlimited money printing.

Japan’s incoming Liberal Democratic Party Prime Minister Shinzo Abe, who ran on a platform of unlimited quantitative easing and higher inflation, has quickly forced capitulation by the Bank of Japan to surrender its independence from political influence.

The Bank of Japan pledged Thursday to review its price stability goal, admitting that the move was partly in response to incoming Prime Minister Shinzo Abe’s aggressive calls for the central bank to step up its fight against deflation.

At its two-day policy board meeting, the BOJ decided to expand the size of its asset-purchase program—the main tool of monetary easing with interest rates near zero—and promised to review next month its current inflation goal, something Mr. Abe demanded during Japan’s parliamentary campaign.

Countering speculation that the board’s decision-making process is being driven by politicians, Gov. Masaaki Shirakawa said the bank reviews its price goal every year. But he acknowledged that the policy board had taken Mr. Abe’s request into account.

The Bank of Japan’s quick surrender of monetary policy independence reflected the fact that they had little choice in the matter.  Mr. Abe had previously threatened a  “law revision to take away the BOJ’s independence if it didn’t comply with his demands.  Mr. Abe said the election shows that his views have the support of the people, and, on the night of his victory, he specifically said he expected the BOJ to do something at this week’s meeting.”

The policy of unlimited money printing by Japan came shortly after similar actions were announced by the U.S. Federal Reserve in early December.  Fed Chairman Ben Bernanke, architect of the U.S. “economic recovery” announced that the Fed would purchase $45 billion of US Treasuries every month in addition to the open ended monthly purchase of $40 billion of mortgage backed securities.  The Fed’s expanded “asset purchase programs” will be monetizing over $1 trillion of assets annually, effectively funding a large portion of the U.S. government’s annual deficit with printed money.

The impact of blatantly unlimited money printing by two of the world’s largest economies surprised many gold investors as the price of stocks and gold quickly diverged, with gold selling off and stocks (especially in Japan) gaining.

Why would gold, the only currency with intrinsic value that cannot be debased by governments, sell off as governments pledged to flood the world with freshly printed paper currencies?  Here’s one insight from John Mauldin.

When you reduce the amount of leverage in the system, you’re actually reducing the total money supply. So the Fed can come in and print money, and the money supply – the total amount of credit and leverage and material that’s going through the system – really hasn’t increased.

A lot of monetary economic theories say “the money supply is directly related to inflation.”

It is, but the amount of leverage and credit in the system is also directly related to inflation. It becomes a much more complicated mix. What happens at the end of the debt supercycle, as you’re reducing that leverage, you’re actually in a deflationary world. That is the whole debate between deflation and inflation.

If you read the polls in the United States, we’re just totally dysfunctional. We want to pay less taxes and we want more health care – that doesn’t work. We are going to have to be adults and recognize that problem.

The reason is the Fed is going to do everything they can to fight deflation. The only thing they can do is to print money. They’re going to be able to print more money than any of us can possibly imagine and get away with it without having inflation.

Mr. Mauldin may have a valid point, but a more likely explanation is the suppression of gold prices by governments and central banks as voluminously documented by GATA.

“Those who follow GATA may not be surprised when the monetary metals markets don’t make sense, since they really aren’t markets at all but the targets of constant intervention by governments.”

Gold Becomes The Ultimate Store Of Value As Central Bankers Create Unlimited Fiat Money

By Vin Maru

Lately we have seen many articles about China and many other central banks continuing to buy and increase their holdings of gold as part of their effort to continue diversifying out of foreign paper currencies. Who can blame them? Would you want to hold paper promises to pay off financial obligations from countries that are essentially bankrupt as a part of your currency reserve? China is doing what is the right thing and in the best interest of China, buying more gold to hold as a part of your reserves in order to make your currency more marketable. They want to make the yuan a competing currency to the other major currencies around the world and they will succeed and owning gold is part of their strategy.

There is some speculation that China is increasing its gold holding to make the yuan a gold-backed currency in an effort to make it a world currency reserve. While it is an interesting concept, it will most likely never happen. In order to back a currency, their gold holdings must increase or decrease alongside the increase or decrease in the number of currency units in the system. A gold backed currency would entail having a fixed rate of convertibility for each ounce of gold to a specific number currency units issued by that country. There is probably no country in the world that will honour convertibility on a fixed basis, it would be financial suicide and is part of the reason why Nixon closed the gold window. Also having a gold backed currency would mean the country would be continually increasing gold purchases to match the inflation of currency units issued. Tracking the amount of gold that is backing currency would also be next to impossible since there is a complete lack of transparency around the amount of currency units being issued by central banks and the amount of gold held by them. Currently currencies can be converted to gold on a floating basis at market price, but going to a gold backed currency would likely never happen.

China is making its currency more readily available for trade, thus bypassing the US dollar and making its currency the payment of choice for its export. Currently the yuan is fixed to the US dollar, but over time it will most likely have to adopt a floating currency like the rest of the world. Until then, expect China to continue adding to its gold reserve in an effort to make the yuan a competing currency for international trade. The US will lose its reserve currency status over time (most likely some time this decade) but it most likely will never go away completely and the yuan will not take over completely. We will most likely just have bi-lateral trade agreements with several national currencies being used for payments. The yuan is just the new kid on the block but there is still the Euro, British pound, Japanese yen, the US$ and probably the IMFs SDR that will also be used. Even the Canadian dollar has been strengthening lately, as the IMF said it’s considering classifying the Canuck buck and the Australian dollar as reserves currencies.

While gold may not be convertible at a fixed rate any time soon, VTB Group is Russia’s first lender to sell perpetual bonds and debt linked to the country’s benchmark equity index and is now selling the nation’s debut notes tied to the price of gold (see Bloomberg article). VTB is offering 1 billion rubles ($32 million) of securities that will be redeemed in December 2013 that will pay a rate on returns based on the gold price up to a limit of 20 percent. Being a pioneer in the Russian market, VTB is the 2nd largest bank and will provide pension funds an alternative to invest in gold without the limits placed on commodity holding by regulators. The article even talks about how even Western financial institutions such as JP Morgan, Barclays, and Credit Suisse are issuing notes tied to gold this month. This is just another example of how gold is becoming an important financial asset. The need to diversify and protect wealth becomes more apparent in an era of currency wars which will destroy the value of fiat money. Financial institutions realize that central banks will continue down the path of printing money, inflation and currency devaluation, there is no other choice. They see the writing on the wall and are now capitalizing on a new markets by providing financial assets tied to the price of gold price.

All these currencies will continue to inflate and I doubt the bankers will allow gold to become a competing currency for everyday transactions. However its role as a store of value will continue to appreciate as long as fiat money continues to exits. So we should be happy that government and central bankers will continue to use and expand fiat currency, it makes their currency worth less and gold will continue to benefit in the long run.

What we are seeing now, with short term fluctuations in the price of gold is just market noise and short term trading opportunities created by the gold market high frequency traders and bullion banks. This will come to pass as the price of gold gets smoothed out and then slowly advances higher with a two steps forward one step back dance along a rising trend. All this talk about gold by mainstream media is just market noise to try and explain very short term movements in price. They have very little understanding of gold and the role it will play in the future as a store of value. Being the good slaves and puppets for the central bankers, MSM is only good at misdirecting the public and they are paid very well for doing so. Once gold finishes this consolidation, the price should continue to advance to all time highs in 2013 and 2014 with a possibility of doubling from the current price to reach a minimum target of $3500 in the next few years.

If you enjoyed reading this article and are interested in protecting your wealth with precious metals, you can receive our free blog by visiting TDV Golden Trader. Also learn how you can purchase and protect your gold holdings by getting a copy of our special report Getting Your Gold out of Dodge or protecting the stock investments you currently own with Bullet Proof Shares.

Regards,

Why Silver Will Hit $100

By GE Christenson

There are many predictions for the price of silver. Some say it will crash to nearly $20, and others proclaim $100 by the end of 2012. The problem is that some predictions are only wishful thinking, others are obvious disinformation designed to scare investors away from silver, and many are not grounded in hard data and clear analysis. Other analysis is excellent, but both the process and analysis are difficult to understand. Is there an objective and rational method to project a future silver price that will make sense to most people?

Yes, there is!

I am not predicting a future price of silver or the date that silver will trade at $100, but I am making a projection based on rational analysis that indicates a likely time period for silver to trade at $100 per ounce. Yes, $100 silver is completely plausible if you assume the following:

  • The US government will continue to spend in excess of $1 Trillion per year more than it collects in revenue, as it has done for the previous four years, and as the government budget projects for many more years.
  • Our financial world continues on its current path of deficit spending, debt monetization, Quantitative Easing (QE), weaker currencies, war and welfare, ballooning debts, and business as usual.
  • A massive and devastating financial and economic melt-down does NOT occur in the next four to six years. If such a melt-down occurs, the price of silver could skyrocket during hyperinflation or stagnate under a deflationary depression scenario.

Still with me? I think most people will accept these simple and rather obvious assumptions.

Many individuals find it difficult to believe any projections for silver, either higher or lower, because silver is hated, loved, often ignored, and seldom recognized as another currency. However, most people know that the US government national debt is huge and will grow much larger during the next decade. Examine the following graph:

Click on image to enlarge.

National debt is plotted on the left axis – yes, it was larger than $16 Trillion as of September 30, 2012. Silver is plotted on the right axis. The data covers an 11 year span from September 2001 through September 2012. This period includes the time after the stock market crash of 2000, the game-changing events of 9-11, the real estate crash, and the new bull market in commodities. Each month represents one data point. Note the similarity between the two trends. The statistical measure R-Squared for this 11 year period of monthly data is 0.838 – quite high. R-Squared increases to about 0.90 if national debt is correlated to the monthly price of silver after it has been smoothed with 9 month moving average.

This expansion in the national debt is a simple proxy for expansion of the money supply and the devaluation of the dollar. The exponential growth rate for the national debt averaged over this period is 9.7% compounded annually, while the rate averaged over the last five years is 12.3%. The exponential growth rate for silver is a bit larger – about 20% per year compounded annually. I attribute this larger rate, in excess of 12.3%, to the realization that silver is a competing currency, mining supply is growing slowly, most governments are aggressively “printing money,” industrial demand is increasing, and some investors are actively buying silver. In short, demand is increasing while the realization that silver is still an undervalued investment and cannot be “printed” at will (like dollars and euros) has reached the awareness of individual investors. I believe it is very likely that national debt and the price of silver will continue their 11 year exponential growth trend.

Since silver correlates relatively closely with national debt, we can use national debt as a clear, objective, and believable proxy to model the future price of silver. Extend national debt and silver prices forward for the next six years based on the exponential increase from the last five years, and the result is the following table. Bracket silver prices, high and low, based on past annual volatility of roughly +60% and -35%. You can see from the graph that silver prices are very erratic – silver rallies too far and too fast, and then crashes to absurdly low levels. These stunning rallies and crashes have happened for at least 35 years and probably will continue throughout this decade.

Whether or not prices and crashes are manipulated, and there seems to be credible evidence to indicate such, the “big picture” view is that silver has rallied from about $4 to nearly $50, crashed back to about $25, and is set to rally to well over $100 in the next few years. The week to week movements will become even more extreme so focus on the long-term trend to reduce anxiety and fear.

As you can see, this projection for silver prices indicates that silver could reach $100 as soon as late 2015, with a theoretical projected price of $100 about 2017. The price of silver is about $32.00 as of November 1, 2012.

The next graph shows the price of silver, on a logarithmic scale, with high and low trend lines. The horizontal line at $100 shows the earliest and latest dates at which the trend lines project silver will reach that price. Those dates are 2015 through late 2017, which are consistent with the above projection based on the tight correlation to the national debt. The important realization is that $100 silver is just a matter of time – say three to five more years – depending on the level of QE “money printing,” inflationary expectations, dollar devaluations, fiscal insanity, government deficit spending, wars, and welfare. We have been warned!

Conclusion

We may be skeptical of price projections for silver, but projections for national debt are quite believable. Since the correlation is very close, future silver prices can be projected, assuming continuing deficit spending, QE, and other macroeconomic influences. A dollar crash or an unexpected bout of congressional fiscal responsibility could accelerate or delay the date silver trades at $100, but the projection is reasonable and sensible. Silver increased from $4.01 (November 2001) to over $48 (April 2011). A silver price of $48 seemed nearly impossible in 2001, yet it happened. An increase from about $32 (October 2012) to $100 (perhaps in 2015 – 2016) seems much easier to believe, especially after Bernanke’s recent announcement of QE4-Ever. Read We Have Been Warned.

“Inflation is as violent as a mugger, as frightening as an armed robber and as deadly as a hit man.” – Ronald Reagan

GE Christenson
aka Deviant Investor

Weak Dollar Policies Could Result In Trade Wars and Higher Consumer Prices

By Axel Merk

Our leaders want a weaker dollar and a stronger Chinese renminbi (RMB). That’s our assessment based on recent comments by President Obama, presidential hopeful Romney and Federal Reserve (Fed) Chair Bernanke. If you join them in that call, OK, just be careful what you wish for, or at least consider taking action to protect your portfolio.

In the past few weeks, Bernanke has become ever more vocal in encouraging emerging market countries to allow their currencies to appreciate against the dollar; and Obama and Romney have both been advocating for a weaker dollar versus specifically the Chinese RMB. In the recent presidential debates Romney continued his call for declaring China a currency manipulator, and Obama proudly stated that the RMB had appreciated 11% against the dollar since he took office. It has actually been about 9% according to the data we look at; nevertheless, the point that both were clearly trying to make is that a weaker U.S. dollar is in our economic best interests. Likewise, in an IMF speech Bernanke essentially admitted that accommodative monetary policy in the U.S. causes upward pressure on foreign exchange rates between emerging market currencies and the dollar, and suggested that foreign central banks allow that dollar depreciation to take hold, rather than intervene to prevent it.

It may be superficially plausible that RMB appreciation is the key to alleviating our economic woes, by promoting exports and therefore jobs in the U.S. However, while lowering one’s currency might give a boost to corporate earnings for the next quarter (as foreign earnings are translated into higher U.S. dollar gains), it is difficult to imagine that the U.S. can truly compete on price – the day we export sneakers to Vietnam will hopefully never come. An advanced economy, in our assessment, must compete on value, not price. Without discussing the merits of this argument in more detail, let’s look at the flip side of a stronger RMB, which is a weaker dollar and potentially higher prices for goods imported from China. Notice that there is a lot of table pounding about China stealing manufacturing jobs, but no protest when it comes to the low prices consumers enjoy as a result of China trade. After all, not all Americans are producers of export goods, but certainly all are consumers of goods in general, many of which are imported from China and emerging Asia.

Even if we accept the argument that a weaker dollar may be good for certain sectors and perhaps for the U.S. economy at large, not all will benefit, in particular, not retirees facing diminished purchasing power. Retirees would not see the nominal wage increases that the active labor force could expect to experience, meaning rising costs of living without an offsetting rise in income, which may only be coming from a fixed-income portfolio still earning zero interest as Bernanke has made it clear that “policy accommodation will remain even as the economy picks up.”

We agree with our policy makers to the extent that the dollar may be generally overvalued and many Asian currencies undervalued; and therefore the path of least resistance may lead to Asian currencies grinding higher across the board. The below chart illustrates this trend. China’s appetite for currency appreciation against the dollar may have a good deal to do with its currency’s relative strength or weakness compared to its Asian neighbors, who are export competitors. As these other Asian currencies appreciate they provide the RMB more room to appreciate as well.

Asian Currency Relative to Dollar

While many Asian currencies may rise over the coming years, we think Asian countries like China, that are moving up the value-added chain, are in a better position to handle more rapid currency appreciation than others. As production processes become more complex, it is harder for low-price competitors to easily replicate that output. As such, higher value-added products provide China’s exporters with greater pricing power in the global market, limiting the need and effectiveness of a cheap currency policy. Additionally, over the medium to longer term, as the Chinese economy continues to grow and the middle class becomes wealthier, domestic consumption will play a larger and larger role in their GDP, and that shift away from economic reliance on the American consumer will also diminish the need for an export oriented currency policy. In fact, we believe a stronger RMB will be beneficial for the Chinese consumer and help that transition along.

The gradual shift towards greater domestic consumption is occurring in many other Asian countries that have been following the export growth model and, as Bernanke puts it, that “systematically resist currency appreciation.” As we can see in the above chart many Asian currencies haven’t been resisting appreciation as much as you might think, and this gets to Obama’s point on the RMB appreciation since he took office. From an investment standpoint, 9% in four years isn’t a bad return in this environment; it would take over 78 years to reach that return rolling 3-month T-bills at their current yield of 0.11%.

American consumers (and Chinese exporters) have been subsidized by the artificially weak Chinese currency, to the detriment of Chinese consumers who have faced stunted purchasing power. However, we believe this dynamic will continue to change and suggest that a stronger RMB is very likely not only on Bernanke, Obama, and Romney’s wish list, but increasingly in China’s own interest. That would mean the tables getting turned on the American consumer.

By the way, there is a good reason no President has called China a currency manipulator. Once China is labeled a currency manipulator, it sets in motion a process in which Congress takes up the matter. Without going into detail, our recent Presidents have preferred to seize rather than delegate power: by calling China a currency manipulator, the President would essentially tell Congress to have a stab at the issue; whereas the President has far more flexibility at the executive branch in dealing with China without consulting with Congress. Once Congress gets involved, the threat of a trade war does become more likely. Even if Romney is correct that China may have more to lose in a trade war, our analysis shows that the currency of a country with a trade deficit may be under more strain in a trade war. That may well be what Romney wants to achieve, but again, be careful what you wish for.

If part of what investors consume is produced in another region, then holding some local currency or local currency denominated assets may be prudent. American consumers should ultimately not be concerned with the number of dollars in the bank, but rather with what those dollars can buy in terms of real goods and services. We suggest that Bernanke may be the currency manipulator to be more afraid of, and moreover, that our de-facto weak dollar policy may be reason to take the purchasing power risk of the dollar into account.

Please register for our Webinar on Thursday, November 8th, 2012, where we will dive into implications of US policies on China and Asian currencies in more detail. Also sign up to our newsletter to be informed as we discuss global dynamics and their impact on gold and currencies.

Axel Merk

Axel Merk is President and Chief Investment Officer, Merk Investments

Big Money Is Bullish On Gold

Big money managers are bullish on gold according to the pros interviewed in Barron’s latest fall survey.  A resounding 69% of big money managers are bullish on gold and 22% forecast that precious metals will be the best performing asset class over the next six to twelve months.

Courtesy Barron’s

The big money is bearish on Federal Reserve strategy with over 60% of poll respondents disapproving of the Fed’s current interest rate policy.  Reinforcing their low opinion of Fed strategy, an overwhelming 78% of the pros believe that additional Fed easing policies will be counter productive.  Summing up the general opinion on Ben Bernanke’s money printing schemes, one money pro said “The Fed is well past the point of interest-rate policy having any meaningful impact on the economy.  Bernanke & Co. now risk damage to both the dollar and the Fed’s own balance sheet.  This is the biggest misallocation of capital in the history of mankind.”

Not surprisingly, the overwhelming consensus (89%) of the big money pros think that treasuries are severely overvalued.  Although the pros don’t see interest rates rising significantly in the next six months, Barron’s notes that even a small increase in interest rates would result in losses to bondholders.  The Fed has manipulated interest rates to such a low level, that few money pros see any value in treasuries.  One money pro noted that without massive security purchases by the Fed, the 10 year bond would currently yield 5%, representing a real yield of 2% plus 3% for inflation.   Absent Fed efforts to suppress free market yields on treasuries, bondholders would be faced with shocking losses as interest rates rose.

The big money bearish sentiment on Bernanke and bullish forecast for gold tells us that the pros don’t expect implementation of sound monetary policy by the Fed any time soon.

Federal Reserve Policies Have Put The Nation On The Road To Economic Chaos

By Axel Merk

The FOMC has crossed the Rubicon: our analysis suggests that the Federal Open Market Committee is deliberately ignoring data on both growth and inflation. At best, the FOMC’s intention might have been to not rock the markets two weeks before the election. At worst, the FOMC has given up on market transparency in an effort to actively manage the yield curve (short-term to long-term interest rates):

  • On growth, economic data, including the unemployment report, have clearly come in better than expected since the most recent FOMC meeting. FOMC practice dictates that progress in economic growth is acknowledged in the statement. Instead, the assessment of the economic environment is verbatim. Had the FOMC given credit to the improved reality, the market might have priced in earlier tightening. The FOMC chose to ignore reality, possibly afraid of an unwanted reaction in the bond market.
  • On inflation, the FOMC correctly points out that inflation has recently picked up “somewhat.” However, it may be misleading to blame the increase on higher energy prices, and then claim that “longer-term inflation expectations have remained stable.” Not so, suggests an important inflation indicator monitored by the Fed and economists alike: 5-year forward, 5-year inflation expectations broke out when the Fed announced “QE3”, its third round of quantitative easing where the emphasis shifted from a focus on inflation to a focus on employment. This gauge of inflation measures the market’s expectation of annualized inflation over a five year period starting five years out, ignoring the near term as it may be influenced by short-term factors:
Inflation Expectations

The chart shows that we have broken out of a 2 standard deviation band and that the breakout occurred at the time of the QE3 announcement. In our assessment, the market disagrees with the FOMC’s assertion that longer-term inflation expectations have remained stable. At best, the FOMC ignores this development because they also look at different metrics (keep in mind that the Fed’s quantitative easing programs manipulate the very rates we are trying to gauge here) or has a different notion of what it considers longer-term stable inflation expectations. At worst, however, the FOMC is afraid of admitting to the market that QE3 is perceived as inflationary.

In our assessment, inflation expectations have clearly become elevated. Ignoring reality by ignoring growth and inflation may not be helpful to the long-term credibility of the Fed. Fed credibility is important, as monetary policy becomes much more expensive when words alone don’t move markets anymore.

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Axel Merk

Axel Merk is President and Chief Investment Officer, Merk Investments
Merk Investments, Manager of the Merk Funds

Would A Romney Victory Cause Gold To Collapse?

By Axel Merk & Yuan Fang

Monetary Cliff?

As the presidential election is rapidly approaching, little attention seems to be getting paid to the question that may affect voters the most: what will happen to the “easy money” policy? Federal Reserve (Fed) Chairman Bernanke’s current term will expire in January 2014 and Republican candidate Mitt Romney has vowed that if elected, he would replace Bernanke. Given the tremendous amount of money the Fed has “printed” and the commitment to keep interest rates low until mid-2015, the election may impact everything from mortgage costs to the cost of financing the U.S. debt. Trillions are at stake, as well as the fate of the U.S. dollar.

Should Obama be re-elected, Bernanke might continue to serve as Fed Chairman; other likely candidates include the Fed’s Vice Chairman Janet Yellen and Obama’s former economic advisor Christina Romer. With any of them, we expect the Fed policy to be continuingly dominated by the dovish camp, and moving – with varying enthusiasm depending on the pick of Fed Chair – towards a formal employment target, further diluting any inflation target. We are not only talking about Bernanke and the other two candidates’ individual policy stances (though all three are known as monetary “doves”, i.e. generally favoring more accommodative monetary policy), but also the composition of voting members of the Federal Open Market Committee (FOMC), as we will discuss below.

If Romney were to be elected, a front-runner for the Fed Chairman post is Glenn Hubbard, Dean of Columbia Business School and a top economic adviser to Romney. Hubbard has expressed his skepticism about the mechanism that Bernanke used to boost the economy. In our analysis, an FOMC led by Hubbard (or another Romney appointee) will be leaning toward mopping up the liquidity sooner. Extending forward guidance to mid-2015 will also be under question. It will no doubt add uncertainty to monetary policy and increase market volatility.

More importantly, however, a “hawkish” Fed Chair, i.e. one that favors monetary tightening, might put to the test Bernanke’s claim that he can raise rates in “15 minutes”. Technically, of course, the Fed can raise rates by paying interest on reserves held at the Fed or sell assets acquired during various rounds of quantitative easing. The challenge, no matter who the Fed Chair is going to be, is the impact any tightening might have on the economy. Bernanke has cautioned many times that rates should not be raised before the recovery is firmly “entrenched.” What he is referring to is that market forces may still warrant further de-leveraging. If the stimulus is removed too early, so Bernanke has argued, the economy might fall back into recession. A more hawkish Fed Chair, such as a Glenn Hubbard, may accept a recession as an acceptable cost to exit monetary largesse; however, because there is so much stimulus in the economy, just a little bit of tightening may well have an amplified effect in slowing down the economy. Keep in mind that European countries are complaining when their cost of borrowing rises to 4%, calling 7% unsustainable. Given that the U.S. budget deficit is higher than that of the Eurozone as a whole, and that our fiscal outlook is rather bleak, it remains to be seen just how much tightening the economy can bear. Our forecast is that with a Republican administration, we are likely to get a rather volatile interest rate environment, as any attempt to tighten may have to be reversed rather quickly. Fasten your seatbelts, as shockwaves may be expressed in the bond market and the “tranquility” investors have fled to by chasing U.S. bonds may well come to an end. Foreigners that have historically been large buyers of U.S. bonds may well reduce their appetite to finance U.S. debt, with potentially negative implications for the U.S. dollar.

Let’s dig a little deeper and look at who actually decides on interest rates: it is the voting members of the FOMC that ultimately make the imminent monetary policy decisions, rather than the noise creating pundits and non-voting members.

Three factors will further boost the dovish camp, which already dominates the FOMC committee:

    • Two previously vacant seats on the Fed’s Board of Governors were recently filled by Jeremy Stein and Jerome Powell this May. Like other board governors, both Stein and Powell appear to be in favor of Bernanke’s dovish policy. Stein was a Harvard economics professor and used to be more ‘hawkish’ before he took office. But in his first keynote speech as a board governor on Oct. 11, Stein openly supported QE3 and called for continuing asset purchases in absence of a substantial improvement in the labor market. Jerome Powell was a lawyer and private equity investor as well as an undersecretary under George H.W. Bush. Powell has also expressed support for more easing, with inflation an afterthought. Their appointments not only fill all voting seats at the Fed for the first time since 2006, but also further increase the board’s dove-hawk ratio from 9-1 to 11-1. The influence will also carry on to the following years, as board governors hold non-rotating voting rights.
    • Additionally, four current voting members will be replaced next year, including Richmond Fed president Jeffrey Lacker, who has dissented in every FOMC meeting this year. Regional Fed Presidents, unlike Governors, vote on a rotating basis. In 2013, Kansas Fed president Esther George is likely to be the only voting member who appears to hold a hawkish stance. George has expressed her opposition to QE3 and the Fed’s balance sheet expansion, echoing her predecessor Thomas Hoenig’s hawkish tone. But given that she is not a Ph.D. economist, her passion and influence is likely to be more on regulatory than monetary issues; we doubt she will be as vocal as Hoenig or Lacker. In our assessment, the FOMC committee may be “über-dovish” in 2013.
    • Finally, Minneapolis Fed President Narayana Kocherlakota, who was known as a monetary policy hawk, has recently shifted to a more dovish stance. He surprised the market with remarks supporting the Fed’s decision to keep rates extraordinarily low until the unemployment rate has fallen below 5.5%, as long as inflation remains below 2.25%. Kocherlakota will be a voting member in 2014, but his shift of stance will weaken the hawkish voice. With fewer dissidents on the board, the Fed may continue to err firmly on the side of inflation and stick to to its mid-2015 low rate pledge.

No matter who wins the election, we will see a policy dilemma for the Fed in the coming years: On the one side, should economic data continue to surprise to the upside, it will be increasingly difficult for the Fed to carry on its dovish policies. On the other side, if the Fed were to abandon its current commitment, we foresee rising market volatility. The U.S. economy is likely to face a “monetary policy cliff” in addition to the “fiscal cliff”. With easy money, inflation risks may well continue to rise, possibly imposing higher bond yields (lower bond prices) and a weaker dollar. With tight money, the Fed may induce a bond selloff. Historically, because foreigners are active buyers of U.S. bonds, the dollar has weakened during early and mid-phases of tightening, as the bond bull market turns into a bear market. It’s only during late phases of tightening that the dollar has historically benefited as the bond market turns yet again into a bull market. We encourage investors to review their portfolios to account for the risk that bonds may be selling off, taking the U.S. dollar along with it.

Please sign up to our newsletter to be informed as we discuss global dynamics and their impact on gold and currencies. Please also register for our Webinar on Thursday, November 8th, 2012, where we will focus on implications on China and Asian currencies.

Axel Merk

Axel Merk is President and Chief Investment Officer, Merk Investments

Yuan Fang is a Financial Analyst at Merk Investments and member of the portfolio management group.

The Fed’s Efforts To “Print” New Jobs Is Failing – What Does The Fed Do Next?

In an effort to expand credit and spur job creation, the Federal Reserve has massively expanded its balance sheet with the most aggressive monetary policies in the history of the Federal Reserve.  Since the start of the financial crisis, the Fed instituted two rounds of quantitative easing under which over $2.75 trillion of debt securities were purchased by, in effect, printing money.

The first two phases of quantitative easing resulting in soaring stock and gold prices but did little to reduce the unemployment rate which has remained stubbornly high.  In early September, Fed Chairman Bernanke went all in on his aggressive monetary policies with the announcement of QE3 under which the Fed will conduct open-ended asset purchases.

The Federal Reserve said it will expand its holdings of long-term securities with open-ended purchases of $40 billion of mortgage debt a month in a third round of quantitative easing as it seeks to boost growth and reduce unemployment.

“We’re looking for ongoing, sustained improvement in the labor market,” Chairman Ben S. Bernanke said in his press conference today in Washington following the conclusion of a two-day meeting of the Federal Open Market Committee. “There’s not a specific number we have in mind. What we’ve seen in the last six months isn’t it.”

Stocks jumped, sending benchmark indexes to the highest levels since 2007, and gold climbed as the Fed said it will continue buying assets, undertake additional purchases and employ other policy tools as appropriate “if the outlook for the labor market does not improve substantially.”

Bernanke is enlarging his supply of unconventional tools to attack unemployment stuck above 8 percent since February 2009, a situation he called a “grave concern.”

Bernanke said the open-ended purchases would continue until the labor market improved significantly. “We’re not going to rush to begin to tighten policy,” he said. “We’re going to give it some time to make sure that the economy is well established.”

While the U.S. has “enjoyed broad price stability” since the mid-1990s, Bernanke said, “the weak job market should concern every American.”

Although Bernanke’s goal is laudable, many consider his extreme monetary policies ineffective while massively debasing the value of the U.S. currency.  Printing money is not the primary precursor for job creation or increased national wealth, and the latest economic results prove this assertion.  Sales revenues of America’s largest corporations have declined for six consecutive quarters and companies have fired the largest number of employees since 2010.

Courtesy Wall Street Journal

If economic conditions continue to deteriorate, expect Bernanke to implement even more extreme unconventional monetary policies,  all of which would involve money printing on an unimaginable scale.

The ludicrous assertion by Fed Chairman Bernanke that the U.S. has “enjoyed broad price stability” since the 1990’s is revealed as an outright falsehood by the Fed’s own statistics on the loss of purchasing power of the U.S. dollar.  Meanwhile, gold, the only currency with any intrinsic value is reflecting the true extent to which the U.S. dollar has been debased by Fed policies.  As the economy weakens and the Fed expands its monetary madness, the price of gold will continue to soar.

 

The Fed’s Outrageous Attempt To Debase The Dollar Will Send Gold Soaring

By Axel Merk

Doubling down on QE3, the Federal Reserve (Fed) Chairman Bernanke tells China and Brazil: allow your currencies to appreciate. One does not need to be a rocket scientist to conclude that Bernanke wants the U.S. dollar to fall. Is it merely a war of words, or an actual war? Who is winning the war?

The cheapest Fed policy is one where a Fed official utters a few words and the markets move. Rate cuts are more expensive; even more so are emergency rate cuts and the printing of billions, then trillions of dollars. As such, the Fed’s communication strategy may be considered part of a war of words. Indeed, the commitment to keep interest rates low through mid 2015 may be part of that category. But quantitative easing goes beyond words: QE3, as it was announced last month, is the Fed’s third round of quantitative easing, a program in which the Fed is engaging in an open-ended program to purchase Mortgage Backed Securities (MBS). To pay for such purchases, money is created through the strokes of a keyboard: the Fed credits banks with “cash” in payment for MBS, replacing MBS on bank balance sheets with Fed checking accounts. Through the rules of fractional reserve banking, this cash can be multiplied on to create new loans and expand the broader money supply. The money used for the QE purchases is created out of thin air, not literally printed, although even Bernanke has referred to this process as printing money to illustrate the mechanics.

Why call it a war? It was Brazil’s finance minister Guido Mantega that first coined the term, accusing Bernanke of starting a currency war. Here’s the issue: like any other asset, currencies are valued based on supply and demand. When money is printed, all else equal, supply increases, causing a currency to decline in value. In real life, the only constant is change, allowing policy makers to come up with complex explanations as to why printing money does not equate to debasing a currency. But even if intentions may have a different primary focus, our assessment is that a central bank that engages in quantitative easing wants to weaken its currency. It becomes a war because someone’s weak currency is someone else’s strong currency, with the “winner” being the country with the weaker currency. The logic being a weaker currency promotes net exports and GDP growth. If the dollar is debased through expansionary monetary policy, there is upward pressure on other currencies. Those other countries like to export to the U.S. and feel squeezed by U.S. monetary policy. Given that politicians the world over never like to blame themselves for any shortcomings, the focus of international policy makers quickly becomes the Fed’s monetary largesse.

Bernanke speaking at an IMF sponsored seminar in Tokyo pointed to the other side of the coin: if China, Brazil and others don’t like his policies because they create inflation back home, they should allow their currencies to appreciate. But these countries are reluctant as stronger currencies lead to a tougher export environment.

Now keep in mind that it is always easier to debase a currency than to strengthen it. Switzerland, the previously perceived safe haven by many investors, has taken the lead. Using a central bank’s balance sheet as a proxy for the amount of money that has been printed, the Swiss National Bank’s printing press has surpassed that of the Federal Reserve considering relative growth since August 2008. Again note that no real money has been directly printed in these programs; also note that some activities, such as the sterilization of bond purchases by the European Central Bank, cause a central bank balance sheet to grow, even if sterilization reflects a “mopping up” of liquidity:

Japan has warned about intervening in the markets on multiple occasions, but the size of the Japanese economy as well as the lack of political will make an intentional debasement more difficult. Indeed, the Japanese did their money printing in the 1990s, but forgot we had a financial crisis in recent years.

Bernanke does acknowledge the concerns of emerging markets, but argues they are blown out of proportion. He elaborates that undervaluation and unwanted capital inflows are linked: allow your currencies to appreciate (versus the dollar) and you won’t have to be afraid of excessive capital inflows, inflation and asset bubbles. Ultimately, and importantly, Bernanke says the Fed will continue its course, suggesting that it will strengthen the U.S. economic recovery; and by extension, strengthen the global economy.

Let’s look at the issue from the viewpoint of emerging markets: policy makers like to promote economic growth, among other methods, through a cheap exchange rate, up to a certain point. They don’t want too much inflation or too many side effects. Historically, they manage these side effects with administrative tools. However, taking China as an example, taming price pressure through, say, price controls, has not been very effective. We believe that’s a good thing, as China would otherwise experience product shortages akin to what the Soviet Union experienced. Conversely, however, China must employ a broader policy brush to contain inflationary pressures. We believe – and Bernanke appears to agree – currency appreciation is one of the more effective tools.

So how will this currency war unfold? The ultimate winner may well be gold. But as the chart above shows, it’s not simply a race to the bottom. If one considers what type of economy can stomach a stronger currency, our analysis shows an economy competing on value rather than price has more pricing power and therefore the greater ability to handle it. Vietnam mostly competes on price; as such, the country has, more than once, engaged in competitive devaluation. At the other end of the spectrum in emerging markets may be China: having allowed its low-end industries to move to lower cost countries, China increasingly competes on value. Within Asia, we believe the more advanced economies have the best potential to allow their currencies to appreciate. It’s not surprising to us that China’s Renminbi just recently reached a 19-year high versus the dollar.

What we have little sympathy for is an advanced economy, e.g. the U.S., competing on price. We very much doubt the day will come when we export sneakers to Vietnam. As such, a weak dollar only provides the illusion of strength with exports temporarily boosted. Yet the potential side effects, from inflation to the sale of assets to foreign investors with strong currencies, may not be worth the risk.

Please register to join us as we discuss winners and losers of the unfolding currency wars in our Webinar this Thursday, October 18, 2012.

Axel Merk is President and Chief Investment Officer, Merk Investments
Merk Investments, Manager of the Merk Funds.