SEMI-MONTHLY FISCAL/MONETARY UPDATE – NOT A QUESTION OF “IF”, JUST “WHEN”
There have been numerous ongoing fundamental developments that support our long held view that a day of reckoning is an inevitable consequence of the unimaginable mountain of debt that has been created by Central Banks, worldwide, over the last forty years. As our readers know , we view gold and the gold mining stocks as one of the best hedges against the prospective financial/political/social upheaval that lies (somewhere) ahead. It’s been said that a bet on gold is a bet against Central Bankers’ colored paper. Central Bank credibility continues to be at stake, and we suggest, in summary, that you can’t get out of a hole by continuing to dig.
Several current developments, which we have not recently discussed, support our long term strategy.
First, Central Bankers collectively continue to purchase large quantities of gold bullion. purchasing 333.2 tons, an increase of 39% over the 5-year average in the first half, and about 199.9 tons during Q2. The largest purchases were recorded in Germany, Thailand, Hungary and Brazil. We should note that Russia and China, the most obvious political, economic, and military adversaries of the USA, have consistently added to their gold reserves over the last ten years. China updates their gold holdings only sporadically, supposedly owning only about 2,000 tons, but they are the world’s largest miner, about 400 tons annually, and none of it gets out of China. When pressed as to what event might finally ignite the price of gold, we suggest that China, who has indicated their plans for a digital currency in 2022, will, in one form or another back their currency or their debt with gold bullion. They have encouraged the Chinese public to use gold backed savings accounts and demand for gold jewelry doubled in China in the first half of 2021. Central Banks are voting with their wallets as to whether they prefer fiat paper currencies or gold bullion as the real money over the long haul.
Secondly: The debate continues as to whether all the new money being printed will finally ignite inflation, which (up until the pandemic driven shortages) it hasn’t. Something like $20 trillion has been created by worldwide Central Banks since 2009. However, what happened in the US, for example, is that while the Fed printed money, at the same time they raised the capital and reserve requirements in banks, reducing the “velocity” of the new funds. The Fed bought Treasuries, created money, which wound up in the banks and then was redeposited at the Fed. The money, therefore, never really entered the money supply so wasn’t inflationary. However, in the last twelve months the M-2 money supply was up about 25 per cent last year and could well be the precursor of inflation such as we had in the 1970s (when gold went from $35 to $850/oz.).
You don’t need a PHD in economic. It’s common sense. What if the Central Banks were to create $100 trillion of new currency, with no increase in available goods and services? Prices would be sure to go up, right? Well, $20 trillion didn’t do it over the last ten years but $100 trillion would. Somewhere between $20T and $100T is “ignition” and we suspect it is closer to the former.
We wrote the above commentary a couple of days ago. This evening we read the September 1st commentary of James Grant, publisher of Grant’s Interest Rate Observer, and among the world’s most respected monetary historians. While he would be the first to admit that is timing is often in question, his views over the last forty years have been consistently borne out. We hope he won’t mind if we quote a few sections of the current issue. The underlining is of our choosing.
Grant describes how the suppression of interest rates distorts economic activity, and ends badly:
“Chair Powell last Friday ignored the dollar mountain that figuratively rivals the Grand Tetons. He acknowledged no such thing as the inflation of credit, which leads to the inflation of asset values and thereby promotes overleverage, misdirected investment and financial fragility. He neglected to mention that a zero-percent interest rate in a resurgent economy is one for the monetary record books. And he omitted reference to the thinkers who correctly posit that when the central bank’s policy interest rate is pitched artificially low—e.g., below the expected rate of return on capital—boom and bust surely follow. Everyone living today knows about booms: Credit proliferates, eager financiers swarm venture capitalists, construction cranes ascend and YouTube influencers get their pictures in The Wall Street Journal. But as the boom roars on, the structure of enterprise becomes distorted. Negligible borrowing costs (and the expectation that they will long so remain) bring forth SPACs, NFTs, towering equity valuations, grandiose M&A activity and uninhabited luxury residential towers. The bust starts when credit stops.”
Grant talks about the unprecedented recent growth in the money supply, with the likelihood that inflation will follow:
“In the two years to May 2021 M-3 broad money rose by 35%, by far the highest number for such a short period since the Second World War. On the basis of the money supply developments, we have argued that the annual rate of U.S. consumer inflation will lie between 5% and 10% until at least the end of 2022. Views are shifting, but our forecast remains far above the prevailing consensus.” Milton Friedman was sometimes wrong, but perhaps now, when his monetary-policy legacy is either forgotten or derided, and when the money-supply data certainly look alarming, he could be a little right.”
Grant describes the unbelievable leverage involved in the Fed’s “business model”, how dangerous it is, and how uncontrolled market forces (i.e. when “bond vigilantes” will say “basta” and require a much higher return to invest in US debt) will eventually end the party:
“Systemwide, the Fed shows assets of $8.33 trillion versus capital of $39.8 billion, for a leverage ratio of 209:1. If the average conscientious Federal Reserve bank examiner encountered such a balance sheet as this one, he or she might dial 911. However, the New York Fed, with assets of $4.156 trillion and capital of $13.3 billion, exhibits a leverage ratio of 311.6:1. For perspective, on June 30, JPMorgan Chase showed a ratio of assets to stockholders’ equity of 12.9:1. What makes the New York Fed so confident that it can manage a balance sheet almost nine times more distended than the one that almost took down Morgan Stanley in 2008? Footnote 15 on page 7 of form H.4.1—the weekly Federal Reserve balance sheet emission— dated Jan. 6, 2011, has the answer. It discloses that future losses at the central bank will be treated as a negative journal entry to the Treasury rather than a reduction in the Fed’s capital and surplus account. In the ordinary course of business, the Fed remits its operating income to the Treasury—the New York Fed, just this past week, journaled $728 million over to Janet Yellen. In case of a substantial loss, for example, an inflation-induced markdown to bond prices, the central bank would effectively draw a government loan. Fearless in the face of its extreme leverage, the Fed is a kind of financial free agent. It formally answers to Congress and may one day soon have to answer to Mr. Market.”
Back to a conclusion, our way:
Just as Grant described, huge distortions in financial markets are taking place. Around the world, $15.9 trillion’s worth of bonds are priced to yield less than zero, though not in the US (yet). An illustrative example of this absurdity is that the Greek government zeros of 2026, for example, are priced to yield negative 0.08% versus the positive 0.77% from five-year Treasuries and that is why US Treasuries, surely safer than Greek debt, are a relative bargain. This is the definition of “the best house in a terrible neighborhood”. Another description goes “a race to the bottom”.
Step back for a moment. The US Treasury needs more capital to finance the $3-4 trillion annual deficit, so sells bonds to the Fed, which prints it out of thin air and lends it to the US government at a minimal interest rate. There is no limit to how much currency can be created so there is no limit to how much money the US politicians can piss away. The interest (even at the low rate) earned by the Fed is periodically rebated (after the Fed’s billions of administrative overhead) back to the US government, reducing the deficit just a little from what it would have been. The interest on the debt has therefore been recycled (after paying the salaries of hundreds of economic PHDs and thousands in staff) and the principal borrowed (forgetting about the wasteful spending) doesn’t ever need to be repaid, except by newly created Fed currency. This is how the Fed’s balance sheet has gone from $1T ten years ago to over $8T today and the annual US deficit, which was $100B in 1980 is $3-4T today.
Does this “scheme” seem sustainable to you? Well, sort of, except that a 1913 dollar is worth $.02, and a $1971 dollar is worth about $0.15. In the history of the planet, there has never been an unbacked “fiat” currency that has survived. It is just a question of how long it will take the politicians of the day to destroy it and nobody would suggest that today’s politicians are any different. An important caveat, however, is that a deflationary bust could interrupt the inflationary party, ala’ the deflationary 1930s, before a new monetary system (with at least some temporary restrictions) takes shape. This brings us back to gold related assets, that have proven over the centuries to protect purchasing power in both inflationary and deflationary times.