Friday, June 04, 2010
This report was originally prepared for Strategic Energy Research and Capital, LLC.
Part 1: Seasonals Favor Gold Buyers
There's a good chance that gold bulls dig in their heels and drive the gold price to its next plateau, perhaps hitting our $1400 target high for 2010 as early as September -after a pullback this month.
The first part of our argument for higher gold is a strong seasonal bias favoring gold buyers in the months of May, June, and July:
That there are exceptions to this pattern need not be objected.
Our investment thesis rests on more fundamental ground.
Like what? Briefly, as the world's fiat governments - particularly those whose currencies are considered the "reserve currencies" - continue to bloat and fund their political aspirations with the printing press, gold will continue to gain respect as a reserve asset in its own rite. Where it will end nobody knows, but it cannot end at least until there is political will to abandon the inflation policy and return to sounder principles of money and state finances.
And it can't end if it's too late, either. How do we know if it's too late? According to the author of the "crack up boom" it is when people come to expect the rise in prices will be permanent and accelerate. Thankfully, if the recurring inflation in deflation fears is any indication, the world is probably not yet at this point. However, nor is it conceivable that governments are ready to abandon the policies that have brought it to this point.
M3 is a "Lagging" Indicator
The popular money statistic, M3, has been contracting, just as the deflation camp prognosticated following the contraction in bank loans and the credit aggregates.
Some people believe this means we have deflation.
Of course, we remember when M3 was inflating madly along with the credit aggregates well into 2007.
The fringe element held it out as proof of conspiracy -that the Fed was hiding its inflation. But, the fed was not inflating money in 2007, according to our measure of money growth (see Austrian measure below), which had already dropped to almost zero by then (somewhat mirroring M1 in the above chart). The fact is, M3 did not predict the bust. Neither did the other credit aggregates. Indeed, the components of M3 that are contracting can no more be regarded as money as even worthy leading indicators. But the same cannot be remarked of our Austrian School measure below. Note how neatly it "predicted" the 2001-02 bust, the subsequent boom, the 2007-08 bust, as well as the PIIGS crisis (the growth rate in euro money fell even more sharply ahead of the crisis). M3 typically lags.
M3 is NOT Money
Lest we get ahead of ourselves, however, note in the chart here first that the Austrian School measure of money supply currently contradicts M3, and is pushing ahead at about 10% year over year. The banks are in fact creating deposit liabilities (a.k.a. money) as fast as ever, with the help of the Fed.
For a concise elaboration on why M3 is a bad measure of money, see Frank Shostak's blog here: http://blog.mises.org/12845/a-visible-fall-in-us-money-m3-worries-some-analysts/
Frank is an Austrian School scholar in our eyes, and chief economist at Man Financial in Australia. You might notice that Frank's monetary measure looks slightly different than ours. That is because he treats savings deposits not as demand deposits, but rather as loans to the bank, based on a clause that allows the banks to defer settlement of the demand for up to 30 days in certain circumstances. This is a technical point, and suffice that it is the only point on which we disagree with Frank.
Our argument is that technological innovation (debit) and changes to the way we use a savings deposit (and the terms on which they are issued) make them equivalent to demand deposits today in every respect. Irrespective, most Austrian School economists now include savings deposits, and Frank's measure is turning up anyway.
Importantly, the school is unanimous in its view that M3 is a poor measure of money -because it includes time deposits and money market mutual fund accounts, which introduces the problem of double counting.
[Feel free to call on us for more elaboration on that if Shostak's article doesn't clear it up.]
The Key Point... We Repeat
Notice the fly in the ointment in the deflation case. At each point where a deflationary crisis could have occurred - 9/11, Bear Stearns collapse, AIG, and now the PIIGS crisis - what did the actual money supply really do?
Did it collapse like the deflation camp projected? Of course not, because while deflation is what needs to happen to get the rot out of the system, the Fed won't let it happen. And this is the key point. In the absence of the gold standard to check the central bank and government the question becomes a matter of political will.
The deflation camp continues to misconstrue the whole situation as a Fisher-Minsky debt spiral, or a Kondratieff winter, where there is nothing the central bank can do to prevent the destruction of money brought about by debt liquidation. They fail to accept that the Fed can inflate indefinitely, in part because they confuse credit and money.
Since credit is characteristically and catalactically different than money (still can't use a Tbill to buy a barbecue at Wal-Mart -it has to be sold for cash first), it does not play a direct part in the formation of prices, and does not contribute to the general rise in prices... but to the extent that it is involved in the creation or destruction of money.
For the sake of brevity we're trying to avoid getting too academic but the salient point is that an expansion in credit, like a contraction, need not impact the supply of money, and we see proof of this today. What matters is that the Fed stands ready to monetize any and all the potential deflation of the outstanding deposit liabilities of the commercial banking system (the outstanding money supply).
These amount to a little under $6 trillion today, a pittance compared to the many more trillions in credit outstanding -both private and public. Since money comes into existence through the fractional reserve banking system, many people think it is destroyed when credit is destroyed. But this is not always true. Credit and money do not always die together, if, for instance, the defaulter has already spent the money he borrowed. The bank takes a hit, which in turn may affect its leverage ratios and willingness to take the same risk again but it does not destroy a deposit directly... nor does it result in deflation if the central bank is offsetting it, which is why at each point where deflation was supposed to have occurred in the past, money supply has been expanded instead. Suffice it to say that the Fed has already created enough reserves to offset a 20% contraction in the "money" stock, and indications suggest it stands ready to monetize whatever it takes. The key point is that in the absence of a gold standard there is nothing to stop the central bank from inflating the money supply, and ultimately the banking system, except political will.
Time and again the deflation camp has been on the wrong side of the trade because it fails to grasp this insight.
Each time the crisis is more severe, for reasons both sides generally agree on, and each time the inflationary intervention is also more intense... starting with LTCM, then the tech bubble, then the real estate bubble that has led to the crisis we face today... and now the government bond bubble, which may be bursting. The crises are getting larger, and so is the Fed's response. The correct thing to fear is more inflation in our view.
Needless, it is the very fear of deflation that is at the heart of the Fed's inflation policy.
Enough of that! We've said it all before. We'll only add that we're not saying deflation is impossible. It very much is possible if there were enough political will behind the idea of abandoning the inflationary policy... letting interest rates find their own levels (to encourage savings and realign saving and consumption patterns), and of allowing the broad liquidation of unsound activities which currently burden the true wealth generating capacities of the economy.
Deflation and depression are the processes (made inevitable by the creation of unsustainable booms) by which a market system realigns and cleanses itself of the wasteful and all too visible hand (support) of the government. It would not be pleasant, we agree, for there are a lot of resources devoted to the pursuit of bubble activities today.
But while it is the only way to get the economy on a sustainable growth path, clearly the world is not ready.
The political will to withstand a temporary monetary deflation, and major government retracement, is not there yet.
If it were, we'd consider siding with the deflation camp.
Near Term Risks to the Bull Case for Gold
Of more concern to the case for gold, in our opinion, is therefore whether the Fed and Treasury roll out a follow up version of its stimulus efforts in the short term, let's call it QE v.2, or hold back out of fear of the inflationary impetus.
If they hesitate, there is a chance the credit contraction worsens, and even stops the growth rate of money, which as we have already shown is continuing at a good pace in the US. However, the Greek tragedy has no doubt tilted the debate in recent months in favor of announcing more inflationary measures, especially if stocks keep sinking.
And we expect this cycle will not go away... if anything, it will become increasingly vicious.
We believe that ultimately the market will see that the Fed has no exit strategy, and neither do other central banks.
Also of some concern to the bullish case for gold could be that sentiment is relatively bullish. Should stock prices turn up, say, because the inflation trade returns and people flee from cash, gold prices could correct (we realize this is counterintuitive)... even if the USD turns down again. This would be temporary as the inflation trade is ultimately bullish for gold prices. But right now, at the margin, gold has been garnering a safehaven premium, which happens to be contributing to possibly unsustainable spreads between gold and other commodity values. Thus our outlook for the immediate short term remains relatively uncertain, but fundamentally, and we don't mean in jewelry demand, we expect more inflation, and suspect that the future underperformance of equities and debt will continue to drive investors into gold, as will the future financial crises guaranteed by the inflationary policies pursued today. And as we progress down this path the argument that gold is the soundest reserve asset will continue to gain momentum.