Wednesday, December 10, 2008

The Fed Still Manipulates Gold and the Markets

In a dynamic duo of articles published last weekend, I predicted the fall of the Dollar via a Gold-based perspective, and a US Treasury-based perspective. I want to round off and perhaps even reinforce my theory with a few more opinions and thoughts, which of course may be faulty as the major decisions are still at the mercy and discretion of the Fed, whom I have learned to never underestimate. To be a real "expert" in economics today requires one to be an "expert" in predicting government interventions, so it is all guesswork unless one is an insider. I am highly interested if there are any crucial facts I am missing by the way, please leave any counterarguments below.

I own some gold and if gold goes down I'll buy some more and if gold goes up I'll buy some more. Gold during the course of the bull market, which has several more years to go, will go much higher. – Jim Rogers, famed commodities trader, last week

I have written previously how the Fed creates and destroys money, but the example I used of open market operations (OMOs) has changed dramatically in 2008. The Fed is, on a daily basis, still altering its Treasury holdings, but more importantly propping up other assets by buying them, such as mortgage-based securities, Citigroup (C), AIG, etc. The Fed balance sheets have plunged from its historical levels of ~95% Treasury securities to less than 32% Treasuries, which hampers OMOs since the assets purchased will likely find no willing buyer on the market.

It may seem like the Fed is creating lots of money (and they are) but remember that $7.76 trillion, $8.5 trillion, WHATEVER the new number will be by the end of this week, pales in comparison to the amount of financial derivatives in existence, which per the BIS at last count (and just over-the-counter!) was $684 trillion. I am not sure if I ever wrote this phrase in this column before, but I’ve always viewed the financial crisis as a "Triple-D" crisis. Dollar. Debt. Derivatives.

There is another method of money destruction that I have not overlooked and want to mention. In an economic "disintegration" or a monster of a recession, money can also be destroyed by corporate, government and private bankruptcies.

In the debt-based world we live in, I think money destruction could be seen in shocking scales far exceeding the imaginations of the Keynesian-economics-based minds of the Fed and other central bankers. For instance, comparatively there has been much less noise in the commercial mortgage markets. However, if a lot of businesses fail, which has been known to happen in any recession, how do you suppose those mortgages will be repaid to the banks? In such a scenario, central bankers have just two options: create replacement money to re-inflate supply, or revalue the currency to an asset (very likely gold, after all central bankers do not hold at least some gold for their collective health, the yellow stuff is nice life insurance for fiat currency, ain't it?).

In this eye-popping December 4 essay by James Conrad, he reasons the central bankers will revalue to some sort of a gold standard to escape oblivion, and the price of gold will go from $750 per ounce to $7500-9000. [Remember the "price" is not REALLY going up, after all 1 ounce of gold is the same from day to day. What it really means is that all fiat currencies are going to be massively devalued as the worthless scraps of paper and electrons they really are!]

There is a legal requirement that, in every futures contract that promises to deliver a physical commodity, the short seller must be 90% covered by either a stockpile of the commodity or appropriate forward contracts with primary producers… Things, however, are changing fast. As previously stated, the first major mini-panic among COMEX gold short sellers happened last Friday. As of Wednesday morning, about 11,500 delivery demands for 100 ounce ingots were made at COMEX, which represents about 5% of the previous open interest. Another 2,000 contracts are still open, and a large percentage of those will probably demand delivery. These demands compare to the usual ½ to 1% of all contracts.

Time for Captain Calculator! On December 5, the open interest was 264,796 contracts (at 100 troy ounces per bar). This equates to 823 tonnes, a very significant amount equal to about 10% of the total gold reserves claimed by the United States, the world’s largest holder. There are 26.5 million ounces in contracts and only 2.9 million ounces in COMEX warehouses to cover deliveries as Dr. Fekete notes here. Over 40% of the warehouse totals will be delivered before January 1.

Where is the gold to cover the rest of the contracts? In the ground? In central bank vaults? At the GLD London vault? I do not know the answer, but I agree with Fekete’s comment on gold’s recent backwardation and Conrad, the traders requesting delivery are skeptical there is enough.

Conrad then proceeds to outline a very convincing (to me) proof that ends with:

It is only a matter of time before gold is allowed to rise to its natural level. Assuming that about half of the current increase in Fed credit is eventually neutralized, the monetized value of gold should be allowed to rise to between $7,500 and $9,000 per ounce as the world goes back to some type of gold standard. In the nearer term, gold will rise to about $2,000 per ounce, as the Fed abandons a hopeless campaign to support COMEX short sellers, in favor of saving the other, more productive, functions of the various banks and insurers.

Revaluation of gold, and a return to the gold standard, is the only way that hyperinflation can be avoided while large numbers of paper currency units are released into the economy. This is because most of the rise in prices can be filtered into gold. As the asset value of gold rises, it will soak up excess dollars, euros, pounds, etc., while the appearance of an increased number of currency units will stimulate investor psychology, and lending and economic output will increase, all over the world. Ben Bernanke and the other members of the FOMC Committee must know this, because it is basic economics.

Hyperinflation is nasty stuff. I first wrote about it in my July article "Calling All Wheelbarrows: Hyperinflation in America? (Part 2/2)" and a fellow Nolan Chart columnist, Republicae, with far more experience than I wrote "The Hyper-Inflationary Trigger."

Jim Sinclair, precious metals expert, comments here:

I recently completed the same mathematics that helped me so much in 1980 to determine the price that would be required to balance the international balance sheet of the US.

Balancing the international balance sheet is gold’s mission in times of crisis.

I recently did the math again and was sadly shocked to see what the price of gold would have to be to balance the international balance sheet of the USA today. That price for gold is more than twice Alf’s projected maximum gold price.

Alf Field’s maximum projection is $6,000 per troy ounce. Wow, guess Captain Calculator can take a vacation! On that note I would like to end with a reminder to the republican, Republican, and the third person who is reading this:

"We renew our allegiance to the principle of the gold standard and declare our confidence in the wisdom of the legislation of the Fifty-sixth Congress, by which the parity of all our money and the stability of our currency upon a gold basis has been secured."

– Republican National Platform, 1900

"We believe it to be the duty of the Republican Party to uphold the gold standard and the integrity and value of our national currency."

– Republican National Platform, 1904

"The Republican Party established and will continue to uphold the gold standard and will oppose any measure, which will undermine the government’s credit or impair the integrity of our national currency. Relief by currency inflation is unsound and dishonest in results."

– Republican National Platform, 1932 [Above are sourced from H.L. Mencken, A New Dictionary of Quotations on Historical Principles from Ancient and Modern Sources (1985, p. 471)

"We must make military medicine the gold standard for advances in prosthetics and the treatment of trauma and eye injuries."

– the only mention of gold in the Republican National Platform, 2008. Try searching for ‘gold’ or ‘dollar’ here.

Well, the Gold Standard ended in the US in 1914 when the first unbacked and "unsound" Federal Reserve Notes were printed. Ok, I hate the Fed, but fellow columnist Gene DeNardo phrased it best in his intriguing article "MV=PT A Classic Equation and Monetary Policy":

When the economy grows in a healthy way, we all share in the profit as our currency becomes stronger and is able to purchase more.

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