The age of negative real interest rates.

Continuing along the themes we’ve established earlier, gold is the proxy for money. It is the best forward-looking indicator of monetary inflation, bar none. Throughout recorded history, golden ages have been ushered in part by keeping money tied to gold, and the very same empires have collapsed when this link has been severed. Karl Marx affirmed these sentiments in Das Kapital, describing gold as the “commodity money par excellence.”

Gold in 1971 was $35/oz. The spot price of gold as of today’s (6/8) close is $1538/oz on the Chicago Mercantile Exchange.

Let’s take a moment and forget about what causes inflation (in other words, what causes the dollar price of gold to rise), and accept the reality that prices across all commodities, both food and energy, have been steadily rising over both the short and long term. If you’re an average American, you work, earn an income, and save. Over time, inflation corrodes the purchasing power of your savings. For this, we are compelled to invest our savings into interest-bearing accounts like CDs or savings accounts. These are the least risky ways of earning a return, and therefore are also the least profitable.

In an ideal world, interest rates should rise and fall commensurate to the rate of inflation. For example, if the cost of living has been rising by 5% annually, we would need to earn a 5% annual rate of return on our savings. Any rate of return below 5% would mean that as time passes, you’re actually growing poorer!

We can take a look at this concept visually.

If we accept the notion that inflation is purely a monetary phenomenon, and that gold is the de facto proxy for money, then by logic it follows that movements in gold best captures future inflation expectations. Taking this a step forward, we can then look at the performance of gold relative to the performance of interest rates as a way to standardize our analysis to reveal whether the rate of inflation is being answered by the rate of interest. The most common indicator of interest rates is the yield of the 10-year US Treasury bond, which is one of the most widely held fixed income securities in the world:

 

The chart is screaming something at you. It’s telling you that the price performance of gold, from 1971 through roughly the year 2000, was being answered by appropriate levels of interest rates.

Critics of this chart will point out that we’re looking at the chart on a linear scale, so recent events skew earlier ones. Fine, let’s look at the chart on a logarithmic scale:

There is only one conclusion to be drawn from this: we are living in an age of negative real interest rates, ushering longterm inflation without appropriate compensation from risk-free instruments like US Treasury bonds, CDs and savings accounts. This means that we are now required to expose our savings to riskier assets like stocks, corporate bonds, and mutual funds, simply to keep up with inflation. If we do not, the purchasing power of our savings will deteriorate over time, just as the chart above portrays.

Either interest rates need to dramatically rise, or we need a new monetary standard; one that doesn’t produce inflation as a solution to virtually every economic problem.

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Treasury Yield Curve is dangerously steep

Everyone will agree it’s important to keep an eye on the Treasury yield curve. Rarely is there ever such a consensus in any discipline, let alone economics, but no one will dispute the yield curve’s importance in understanding the market’s future expectations.

If you’re one of the millions of Americans who have a 401(k), IRA, mutual fund, or government pension, chances are you are holding Treasury bonds ranging from the ultra shortterm 1-month bill to the ultra longterm 30-year bond.

The yield curve, however, reveals the differential between shortterm and longterm maturity Treasury securities. Of course common sense will tell you shortterm bills should have a much lower interest rate compared to their longterm cousins, but the question is, by how much?

Treasury debt is auctioned by the US Treasury Department every couple months, and subsequently, are traded in the open bond markets. Yields, therefore, are determined by the open market.

So far, so good.

Unfortunately for the market, though, the Federal Reserve is also a player in this “open market”, as they directly influence the yield of shortterm securities through open market operations, i.e. by buying and selling shortterm Treasuries to and from the big member banks (Goldman Sachs, Morgan Stanley, Citigroup, etc.) according to monetary policy decisions made by the Federal Open Market Committee (FOMC), whose chairman is the one and only Ben Bernanke.

As a result, Fed policy directly influences the Treasury yield curve. If the yield curve is too shallow, it discourages longterm investments. If the curve is too flat, it doesn’t reward longterm investments at all. If the curve is inverted, it signals that there’s a dangerous disconnect between credit supply and demand. If the curve is too steep, it rewards creditors (lenders) at the expense of debtors (borrowers).

The current yield curve looks like this:

In nominal terms, this doesn’t tell us much. We need to understand how this yield curve stacks up relative to the past. Thankfully, with an abundance of historical data, we can calculate Treasury yield curve “steepness”, or lack thereof. After hours of crunching all the numbers, here’s what I found:

The methodology I used for calculating the steepness is simple: the average percentage difference between each Treasury bond at each point in time. Needless to say, the curve today is alarmingly steep relative to the last sixty years.

Let’s zoom into the past 15 years. We see the same thing:

Once again, we’re in unchartered territory. Some critics of yield curve steepness measurements argue that it is too susceptible to shortterm Fed policy decisions, and as such renders the steepness calculation as meaningless. Fine, lets exclude the 3-month bills, which are currently yielding a pathetic 0.06%. We still get this result:

The differential between shortterm and longterm maturity Treasuries is absolutely staggering.

In nominal terms, sure, we’ve seen shortterm and longterm interest rates much higher than what we have today, but nominal terms are about as useful to know as what you pay for rent. What matters more is relative thinking, i.e. what your rent is as a percentage of your monthly income.

Let’s take a look at one more chart: the multiple of the 20-year yield to the 1-year:

Never before in history have we seen such a steep yield curve. This means that lenders get to borrow at extremely low interest rates from the Federal Reserve’s discount window and lend out that money at extremely high interest rates to borrowers.

The unbelievably steep yield curve tells us one thing: the big banks are having a good ole time right now, courtesy of the Fed’s easy money policy of the past two years, but really of the last decade. As mentioned in previous posts, we’re in completely unprecedented, unchartered territory, and the Federal Reserve once again is at the center of it all.

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Correction in silver justified; the bullish case.

The news that’s been dominating the financial markets these past couple weeks is the widespread fallout of commodities all across the board over the past month:

(Performance from May 2 thru May 20, 2011):

Crude Oil: -14.62%
Natural gas: -9.12%
Gold: -5.00%

But silver has had the roughest time, taking nearly a 30% haircut since May 2, 2011.

If you’re an investor in silver, I’d look past the noise and assess whether the fundamental value of silver as both an industrial and precious metal has changed in the past few weeks.

The Chicago Mercantile Exchange raised margin requirements 4-5 times, which means there are far fewer “speculators” in the silver futures market. What that really means is that there are far fewer people buying silver on margin, i.e. buying silver using borrowed money.

But if you look at the historical relationship between gold, the bonafide proxy for money and future inflationary expectation, and silver, you’ll quickly realize nothing crazy is happening:

This chart only shows the Silver/Gold ratio up through April, 2011, so May’s numbers aren’t reflected yet. But you can see silver prices relative to gold had been repressed towards the lower end of the trading band since the 2008 crisis, and subsequently skyrocketed relative to gold thus far in 2011.

But after these past few weeks’ commodities selloff, let’s look at where the Silver/Gold ratio is now:

Silver (SIN11 Jul’11): $35.08
Gold (GCM11 Jun’11): $1508.9

Silver/Gold Ratio: 2.32%. That falls squarely within the normal trading range of silver/gold over the past 15 years in the above chart.

Nothing to see here, folks. Silver isn’t overvalued nor is it undervalued. It’s right where it needs to be.

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Fed has forced a “double-edged sword” scenario.

I couldn’t help but to break from my established trend of introducing timeless fundamental laws and theory of economics and shift to a news event, but I really think this is noteworthy to devote an entire blog post to. Folks, we’re living through some truly fascinating, albeit alarming, times.

Just today, co-founder and President of the Pacific Investment Management Company, better known as PIMCO, Bill Gross, made a pretty startling announcement. PIMCO manages the world’s largest mutual fund, the PIMCO Total Return Fund, with assets under management (AUM) of over $240 billion.

Check out today’s headliner:

PIMCO’s Bill Gross Shorts Treasuries As Experts Eye Inflation

http://blogs.forbes.com/afontevecchia/2011/04/11/pimcos-bill-gross-shorts-treasuries-as-experts-eye-inflation/

Anyone familiar with Bill Gross knows his economic worldview largely coincides with many of the principles and ideas discussed here on this blog, so this shouldn’t be surprising one bit. It connects back to our earlier themes discussed here on Marginal Thought about the boom/bust cycle ushered by the Fed’s continuous cycle of credit tightening and easing.

We’re treading through a truly dangerous time right now. There can only be two outcomes to our current situation:

1) The Fed allows QEII program to expire this June and chooses not to begin a third round of Treasury purchases. This would undoubtedly prompt interest rates on Treasuries of all maturities to rise, as bond prices have soared over the past two years since the QE program first began in 2009. The Fed is currently the largest holder of US debt, and when your biggest customer stops buying, and no one else is there to pick up the slack, you’re in trouble. Why? Because rising interest rates means the US Government will have to allocate more of its annual budget from years 2012 through 2020 to making interest payments in order to cover the ever-growing cost of the massive Entitlements programs, defense and military spending, discretionary programs, and off-budget items. This would put a fiscal debt crisis a real possibility, given what we know to be record-high federal debt and deficits even today with record low interest rates. Fiscal insolvency similar to the situations we saw in Greece, Portugal, and Ireland all of a sudden falls within the realm of possibilities.

After all, look at the obvious correlation between rising interest rates and the Debt/GDP ratio:

2) The Fed chooses to avoid the chaos of the above scenario and initiates QEIII. This would mean more Treasury purchases, a continuation of record low interest rates, and more credit liquidity into the banking system. Given what we know to be true under any quantitative easing program, asset prices, including food and energy commodities, would continue their march upwards:

Gas prices and groceries bills seeing all-time highs would become a real possibility. We’ve already seen gold and silver achieve all-time highs, and crude oil, sugar, and wheat have seen substantial increases. A QEIII program, even if its smaller than its two predecessors, would trigger hyperinflation with M3 as a percentage of GDP would see all-time highs. Too much money chasing too few goods is never a good thing for average middle class Americans. Only this situation would be a global phenomenon, as the US dollar is the world’s reserve currency. It has already hit emerging markets and third world countries pretty hard.

Neither outcome is good. The only difference is that the first scenario expedites our bankruptcy and gets it over with quicker. The latter kicks the can down the road for a couple more years. You take your pick. This is why I believe we’re due for some unbelievable developments in the coming months.

Bill Gross and I have taken our stances.

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The lie detector of prosperity.

The antagonist says, “If total production is growing, purchasing power is by definition growing. The more we produce, the more income we generate.” Seems like awfully simple and straightforward logic.

Unfortunately, its not so. Take, for example, the current war in Libya. It is reported that Coalition forces have been using Tomahawk cruise missiles to attack targets believed to be Qaddafi-loyalists. These missiles are produced by Raytheon, a defense contracting company whose primary client (if not only client) is the United States Government.

Raytheon employs tens of thousands of employees and generates roughly $25 billion annually. Needless to say, Ratheon plays a vital role in the economy by providing an opportunity for individuals to build and grow their personal wealth with a dynamic career at this influential company.

When US-led forces use one of its Tomahawk missiles on a Libyan target, it can be said that the US economy was just boosted by $600,000 (that is the reported cost of one missile). As the war effort continues, millions, maybe billions, has been utilized from the stockpile of missiles, which the Government will have to replenish at some point in time. The Government then places an order at Raytheon to supply them with 100 more missiles, at a cost of roughly $60 million.

Thus, when Raytheon reports its annual income statement, it will say they generated at least $60 million in sales that year over and above the previous year. The economy just grew by $60 million, and we can safely say we have bolstered the livelihoods of all the employees of Raytheon, including new hirees that might have resulted by this massive new order placed by the Government.

There’s an old theory that addresses this economic fallacy. 19th century French classical liberal economist Frederic Bastiat called it the ‘broken window fallacy‘ in an essay he wrote in 1850.

John Maynard Keynes believed governments can spend money to create jobs and boost individual purchasing power, but knew it cannot do this without financing such activity through the creation of credit, i.e. selling bonds to raise money to pay for these new programs and initiatives. What Lord Keynes overlooked in this scenario, is that the immediate short run benefits of deficit spending will come at the cost of longterm growth and production, because the only way it can pay its debts is by taxing the economy by the same amount it borrowed.

To simplify: if the Government spent $60 million on ordering 100 new Tomahawk missiles for the Libya conflict, it will have to tax the economy $60 million in the future to pay for it.

What’s equally, if not even worse than raising taxes, is when the government chooses not to tax the economy $60 million, but instead inflate the currency by printing $60 million new dollars and using that to pay down the accumulated debt. This means the central bank ‘monetizes’ the debt by converting debt securities into liquid cash, which the government then uses to pay its creditors that it borrowed the $60 million from in the first place.

The free market is rational and efficient. It is the collective conscience of all individuals in the marketplace, and reflects the aggregate wisdom of market participants. Market mechanisms efficiently adjust to distortions caused by monetary and fiscal policy such as the Libya war example above.

That isn’t to say the immediate benefit caused by government spending isn’t real. There could be a serious threat to our national security, in which its in all our interests that the Armed Forces protect and defend our homeland. However, the greatest judge of the needs of the Electorate is the Electorate itself, and it presents its approval rating of public policy in the financial markets.

In this sense, there is a lie detector of economic prosperity: Gold.

Gold is the oldest, most consistent store of value and exchange. Gold, over the long run, never loses its value. Holding gold doesn’t make one wealthier, either. It holds its purchasing power to a degree greater than any other means of exchange.

To this degree, all one needs to pay attention to is the long term trend of gold prices.

There are only 4 possible outcomes:

1) Stocks are falling and gold is falling;

This is the classic example of deflation. The economy is strangled by the central bank taking money and credit out of the market, prompting rising interest rates. With less credit available, creditors (lenders) are rewarded at the expense of the debtors (borrowers). The marginal supplier needs to supply more goods in exchange for bonds than he had to before. The economy contracts.

2) Stocks are rising and gold is falling;

In a period where the value of the private sector is rising and the paper value of gold is falling, you have true, organic growth. Governments are not distorting growth with the ‘broken window’ and central banks as such are not monetizing debt. Wealth grows and purchasing power grows. This is a best case scenario.
3) Stocks are falling and gold is rising;

This is the classic example of inflation. The purchasing power of the currency plummets, money buys less goods, and money flows outward into other economies. This occurs when the Fed undershoots its target interest rate to the downside. Debtors are rewarded at the expense of creditors, and commodities surge. This is a worst-case scenario.
4) Stocks are rising and gold is rising.

This situation is a hybrid of #1 and #3 above. We have a period of economic growth orchestrated by artificially created credit by Fed ‘easing’ and simultaneously a monetization of debt. Commodities surge, paper currency depreciations, thereby driving up asset prices to reflect the new monetary base. Rising asset prices create the appearance of rising wealth, when in fact its the currency losing value.

Let’s take a 30-year history of the stock market and gold, and do some quick analysis.

This isn’t the best looking chart in the world, but it tells you one thing: the current run up in asset prices has been at least partially fueled by the broken window and inflation. We are currently in a very dangerous Situation #3, comparable to the late 1970s. Only this time, we’re drowning in a federal deficit of $2 trillion, or 15% of total GDP.

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Price stability? What’s that?

The Federal Reserve System is a collection of “central” bankers responsible for managing the money supply of the United States and ensuring financial institutions have access to sufficient liquidity to seamlessly create credit.

They have been entrusted with two primary objectives, better known as the Dual-Mandate:

1) Maintain full employment (<5% unemployment rate)
2) Maintain stable prices

The Fed has a number of sophisticated tools to achieve this, but in a nutshell, they engage in asset purchases (mostly Treasuries, but also other assets like mortgage-backed securities) during times of economic stress, which helps banks by providing more liquidity to create credit (loans). It also seeks to help individuals by driving down interest rates, making it cheaper to take out loans. Their rationale for doing this is best summarized by two words: demand management. By forcing interest rates to come down, they attempt to make debt more attractive for individuals. As people, enticed by lower interest rates, take on more debt, the economy, in theory, recovers because people are buying more. Then, as the economy “heats up”, the Fed begins to undo what they started by slowly selling some of those Treasuries and other securities they were buying up, causing interest rates to rise up again.

The cycle continues, as it always has, since the Fed was chartered in 1913.

Sounds fair enough, right?

To put the Fed’s performance under review, let’s look at some critical components to everyday living, transport, and working:

Wheat, soybeans and oats comprise of an infinite array of daily food products around the world. Since 1971 (in future blog posts, I’ll get into why 1971 was a game changing year. If you can’t wait that long, google Bretton-Woods System), they have surged 400%, 250%, and 500%, respectively.

Let’s look at copper, an important indicator of industrial activity (I wish I had more historical data here!):

Even crazier here, surging 700% over an even shorter time period.
But let’s get to everyone’s favorite: crude oil.

This one is so popular, I could easily find a super long-term chart of crude oil prices:

You’ll notice crude oil prices were doing virtually nothing from the 1920s all the way through the mid 1970s. Now you’re seeing why the 70s were such an amazing time. If only I could show wheat, soybeans, and oats spot prices that go back pre-1971, you’d see something very similar to this chart of crude oil.

The Fed doesn’t like to use energy and agricultural commodities as indicators of rising prices, since they are too “volatile” and influenced by speculation. Unfortunately for them, this refusal to accept rising prices in gold, silver, energy, and food prices puts them far behind the curve, as all their measures of inflation (Core CPI, PPI, CPI-U, and GDP deflator) are after-the-fact indicators. In other words, wheat could be surging, but until General Mills starts raising their prices for a box of Wheaties, the Fed will remain oblivious to inflation pressure.

So lets pretend we didn’t see all those charts of surging food and energy prices. Let’s instead take one of the Fed’s own measures for inflation, the GDP Implicit Price Deflator. That’s fancy lingo for being able to look at how expensive things were X years ago relative to how expensive they are today:

Anyone reading this blog can see that the Fed has given us anything but price stability over the many years they’ve been in operation. Forget this blog; anyone who lives a blue collar life has felt the pressure of rising cost of living.

My final question: are we better off with the Fed’s macromanaging of our money and credit?

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Stocks, money and gold.

It’s no secret stocks have been rockin’ on over the past 24 months, since the epic lows we witnessed in March of 2009. We’ve seen a lot of changes made since then, and at first glance, whatever it is those folks in DC did, it’s been working very good.

Well, that is if you consider a surging stock market and corporate earnings as the primary goal and best case scenario.

There’s a small caveat to this, of course. Lesser known, but definitely not overlooked by a certain school of economic thought, is how inflation preempts rising asset values.

Let’s cut to the chase. Say we go back to the first millenia of recorded history.  Hell, why not just go back to even 50 years ago. Actually, forget all that. Just think of present terms. What’s unit of value is universally accepted as ‘money’? Gold. From the beginning of recorded history to today, gold is understood across all peoples to be valuable, even divine or auspicious in some cultures.

They say a single ounce gold coin could buy you a really sexy toga back in ancient Greece. A one ounce gold coin today would net you a Burberry suit. Coincidence? Maybe.

But let’s look into this a bit further. If gold, historically, has been used as a medium of exchange (i.e. money), then let’s look at the stock market in terms of gold over the past 10 years:

Yikes.

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