Please, click here to read this article in pdf format: september-17-2010

In the last 48 hours, the most relevant event is undoubtedly the decision by Japan’s Ministry of Finance to intervene in the FX market and weaken the JPY vs. the USD. There is a lot of speculation (in fact, this is not new, since the intervention was being heavily speculated since August) as to what should be the right amount of Yen to dump to investors for the intervention to generate results. Some speculate with trillions… There is also research on whether or not the new money should be sterilized, on how it will affect interest rates (the Bank of Japan sells JPY for Treasuries) and there is also a general agreement that under the current macro conditions, no other central bank will coordinate with Japan to help with the intervention. We will not deal with the technicalities of this, for the reader has abundant material available elsewhere.

What we want to draw collective attention to is the bigger picture here. With the intervention, the Yen will be increasingly backed by the sovereign debt of a bankrupt nation. The more successful Japan is in devaluing its currency, the higher the percentage will be, of such debt backing the Yen. This should not surprise anyone but as G. Orwell wrote, sometimes the first duty of intelligent men is the restatement of the obvious. So, let’s restate it: If the Euro is increasingly backed by distressed sovereign debt and liable to banks that finance distressed Euro sovereigns, and if the US dollar is explicitly financing US fiscal deficits, the intervention to weaken the JPY (by also financing US deficits), leaves gold as the last reserve of value. And its price is certainly telling us that this is the case. Some see the Euro as the natural winner here, on a relative value basis (i.e. it has already cheapened), but we doubt reserves will reverse to the Euro zone.

As we wrote in our last letter (and in many others too), the problem the world faces is of a general distortion in relative prices. This distortion causes stagnation, as prices cannot play their role in the allocation resources. Hence, we should not expect productivity increases. We should not expect economic growth. Instead, we will see a massive deterioration in purchasing power in the developed world as a lower amount of goods being produced is chased by a higher amount of debased currency.

The first that comes to our mind is that under this context, even though the ongoing monetary policy is inflationary, stocks should not necessarily protect us from the upcoming monetary/sovereign crisis. The effects of the crisis are not neutral. We will not see asset price appreciations precisely because of the uncertainty of increasing interventionism (at a global scale). The path of least resistance is to take all that amount of debased currencies and exchange it for gold. We’ve seen this happen before, time and time again, in developing economies, when these lose their national currencies. First, their citizens see asset prices rise, but soon stagnation sets in and everyone loses purchasing power. Misery reigns and only those who managed to exchange their savings for a foreign currency can survive by speculating with the price distortions. Of course, they are later blamed for the crisis by politicians. We fear the (developed) world is going to see another round of this pathetic play.

We would like to leave with a very visual chart here: The ratio of gold to oil (Long gold/Short oil) since the beginning of the century (source: Bloomberg). It’s worth more than thousands of words…

Martin Sibileau