Please, click here to read this article in pdf format: october-8-2010 Today, we want to briefly discuss a few points: 1. Since the past week, we see a much clearer landscape supporting gold than stocks, because the rise in gold is based on the discoordination of monetary policies, which generate relative price changes and affect [...]
Please, click here to read this article in pdf format: october-8-2010
Today, we want to briefly discuss a few points:
1. Since the past week, we see a much clearer landscape supporting gold than stocks, because the rise in gold is based on the discoordination of monetary policies, which generate relative price changes and affect stocks in different ways (refer: “The Yen intervention supports gold”, on Sept 17th: www.sibileau.com/martin/2010/09/17 ).
We first brought up the issue of policy coordination on April 17th, 2009, when we actually proposed this thesis:
“…when there is global coordination of inflationary monetary policies, gold cannot be a safe and lucrative asset. When inflationary monetary policies are not globally coordinated, gold is a safe and lucrative asset…”
(For those interested in this relationship, which we see stronger by the day, Don Patinkin (1922-1995) was the first to imply it in his famous article “The Indeterminacy of Absolute Prices in Classical Economic Theory”, 1949, Econometrica.. We merely adapted the concept to a global economy)
2. The Bank of Japan also announced they will consider quantitative easing of their own to depreciate the Yen. We had proposed this earlier, because buying only USDs is a losing proposition for Japan (and we explained why). We expect that the Yen will depreciate only as fast as this policy is implemented. On September 23rd, we wrote:
“…What would we have done to weaken the Yen, had we been asked? We would have not intervened the FX market. We would have simply issued bills to the BOJ and with the Yen, we would have bought the most toxic Japanese assets out there, making sure they are really, really, uglier than Greek debt or US subprime mortgages!…” (www.sibileau.com/martin/2010/09/23 )
Is this behind the recent speculation to buy protection (short cds) on Japan’s sovereign risk?
3. Beware of QE2 (quantitative easing II). If it takes off, it will be structurally very different from QE1. Here’s why:
Under QE1, the Fed funded what economists call “stocks” (i.e. mortgages, a finite amount of Treasuries), but under QE2, the Fed will be funding what economists call flows (i.e. deficits) (refer: http://en.wikipedia.org/wiki/Stock_and_flow ).
Flows can only be known at the end of a period. An example of a flow is consumption. Consumption is measured monthly or quarterly or annually. We can only know then what was consumed at the end of each chosen term. However, a stock, is measured at a certain point in time. An example is mortgages held by a bank. We can know how many dollars are in a bank’s balance sheet, with certainty, at a specific time. When a central bank buys these mortgages, it’s quantity is known. The mortgages were originated, closed, “prior” to the transaction. But when a central bank states that the supply of money will be driven by their purchases of Treasuries and such purchases will depend on the level of unemployment, which is a flow, the certainty is lost. What will be the level of unemployment? How does that translate in demand for money? How does the Fed address the excess or fall of that demand? What Treasuries will be bought?
We commented on this difference at the peak of the European Union currency crisis and note here that the Fed would actually engage in a more aggressive move. Unlike the ECB, it certainly doesn’t intend to sterilize its actions. Here’s then something to start thinking about: If banks currently have a decent amount of deposits and there isn’t enough lending, what would happen when inflation accelerates and deposits begin to shrink? People will need the cash sitting in their savings accounts to offset the loss in purchasing power of their wages.
4. Finally, we’ve read a few comments expressing fear that central banks may sell gold, meaningfully impacting the bullish trend. Although a sell-off is possible if not likely in the short-term, to examine this point, we must ask ourselves what would the gold being sold be exchanged for.
Broadly speaking, with gold being an asset of central banks, the sale of gold may trigger either:
a) a change in the composition of the asset side of their balance sheet or
b) a decrease in their liabilities.
If central banks had meaningful equity, gold could also be used to “buy it back”, but that is not the case. Let’s examine the first possibility, namely, a change in the composition of the asset side of their balance sheet. The main asset classes central banks carry are: Foreign exchange, government debt, loans to other banks, gold and lately, corporate debt. Gold therefore could possibly be sold to increase the component of any of these other asset classes.
If gold was to be sold to increase foreign exchange holdings, the sale could not be executed in the FX market, which trades currencies. In order to be neutral to the liquidity markets, it would have to take the form of a swap. This means that central bank A would sell gold to central bank B, in exchange of currency from country B. But if that is the case, gold would still be held by a central bank and the transaction would not affect the market and hence the price of gold. If the sale was not neutral, it would take the central bank’s currency out of circulation, gold would be sold in the market and money would flows back to central banks. This would require immediate sterilization, to return to the original level of liquidity. Otherwise, interest rates would increase, which is the opposite of what central banks are currently aiming at.
If the currency taken out of circulation is used to purchase back government bonds or corporate bonds, it would have the same effect as quantitative easing. But as the market sees the final outcome (i.e. less gold and more debt), the currency of that central bank would be sold off and the price of gold and bonds would continue to rise (sounds familiar?). Would this always occur? No, not if the nation in question fights a credible battle to eliminate fiscal deficits. It is also more difficult to see in net creditor countries like China, which shows that such a move could not be coordinated with other central banks.
Having run out of options to change the composition of the asset side of the balance sheet, let’s next consider a decrease in liabilities (=if gold (=asset) is sold, liabilities have to fall too, in the absence of meaningful equity).
Central banks could simply sell gold and keep the money collected out of circulation. But as we noted, this would go against the common notion that interest rates must remain low for an extended period. The world cannot afford an increase in interest rates. The other component of liabilities of central banks is the banks’ reserves held at the central banks. Gold could be debited and these reserves credited. But that would amount to an explicit subsidy by the government to the banks, which is politically unacceptable. If banks want to back their deposits with gold, they should go to the market, rather than get it from the taxpayer at a “special” price.
For all the reasons mentioned above, which simply go back to the same issue (i.e. no reduction of fiscal deficits), we do not believe that central banks will engage in a coordinated sale of gold without losing the battle.