The Heavy Weather Report - 2007
In 2006 I wrote a newsletter to family and friends called 'Heavy Weather - 2006' in which I discussed my analysis of macroeconomic trends, projections for the future (I called the year-end spot gold price on-the nose two years in a row), and strategies for dealing with what I believed to be an impending crisis. Most of what I said there still applies. In this year's newsletter I will further analyze 2006 in hindsight, offer a primer in economic elements and trends, and refine my projections for 2007 based on those trends. This is all from a perspective inside the US economy looking out, with a particular focus on the behavior of precious metals (which I will show is a critical issue to anyone preparing for the future). This series continues in Heavy Weather - 2008
It's been said that "There Ain't No Such Thing As A Free Lunch" (TANSTAAFL). To make sense of the current market behavior you have to understand the corollary: TANSTAAFM (There Ain't No Such Thing As A Free Market). Prior to the November elections, there had always been obvious manipulation of markets in general and the gold market in particular. Manipulation of the publics perception of economic matters by distorting published statistics was also obvious. But by studying fundamentals stripped of reporting bias one could make sense of the movements in currency and commodity markets, and to some extent predict their behavior.
In the months preceding the November election everything changed, defying economic fundamentals, and confounding most of us who thought we understood the underlying processes. A clue to explaining this is the realization that those counter-intuitive differences tended to create a false impression that the economy was in good hands: low inflation, low unemployment, high job creation, moderate but positive GDP, healthy housing and banking sectors, cheap energy, cheap imports, a booming stock market, no recession, a strong dollar. In reality these things could not be further from the truth.
In the months following the November elections many of us expected the rubber band to snap back. This hasn't yet happened. It would seem that either we were wrong about the fundamentals, or wrong about the limited ability of our masters to maintain the market distortions.
In the remainder of this essay, I will attempt to analyze how this distortion has been accomplished, and based on that, make some predictions about the coming year. My son tells me last year's report was “a little light on facts” so I'll try to include more supporting references without drowning you in numbers.
I - 2006 in Hindsight
II - The Natural Interplay of Economic Forces
The Long Term Trends
Between a Rock and a Hard Place
The Current Distortions
The End Game
The Outlook for 2007
Gold in the Coming Year
Deus Ex Machina
References and links
2006 in Hindsight
In my January 2006 Heavy Weather newsletter, I made some predictions about the gold market: "at least $650 by year's end, likely $700, and no more than $800". December gold actually closed at $640, after peaking in May at $735, up 22% on the year. How did the stock market do? The Dow was up 14% in dollar terms, more like 2-4% in inflation-adjusted terms. How did your investments do, adjusting for at inflation? The official inflation figures for 2006 were 3.6%. But net of recent reporting gimmicks, the way it was figured in the 1970's, it was more than 10%. At this rate, your cost of living will double in the next 7 years.
I also made some predictions for the more volatile silver market: “at least $16, and maybe $20 by year's end”. The new year opened with silver at $13, up from $9 in January, so my silver call was pretty far off. The incredible parabolic run-up from September 2005 to April 2006 still looked linear to me in January.
After reviewing my long term analysis and predictions in the 2006 newsletter, there is almost nothing I would change now. The accelerating crisis I saw as 1-2 years away, now looks likely in the second half of this year. But several unpredictable events could move it nearer or further away. More on that below.
In March, April, and May we saw a dramatic spike in gold (up 34%) and silver (up 45%) half of which was given back just as rapidly in the following correction. This was driven by large fund buying and marked a turning point when gold was 'discovered' by the smart money, and the less risk-averse elements of Wall Street after being badmouthed as a 'barbarous relic' by the Keynesians for over 20 years.
The usual fall rally failed to appear. Instead, gold entered an artificial, sideways, range-bound phase that continues at this time with support at 550 and 600, and resistance at 650.
The Natural Interplay of Economic Forces
You can't tell the players without a program. And if you don't know the players, you can't understand the plot. In this section we will review the visible measures of economic activity and how they affect each other. This will give us a basis for understanding trends and how they are manipulated. To some of you, this will be very basic stuff. Please bear with me, it isn't all Economics 101.
M3: This was the official measure of how many dollars were in circulation. Increasing the money supply is called inflation and results in devaluation of all existing dollars. It's one way governments pay for what they can't afford, by taking it unobtrusively from whose who hold dollars. That's primarily you and me and a lot of Chinese and Japanese (1066 Bn and 895 Bn, respectively). This number is now a poorly kept state secret for the obvious reasons. An exponential increase in money supply continues. They're still telling us M2, but M2 doesn't include the repo rate. Repo is buying back T-Bills/Bonds with newly printed money. That's right, check-kiting with ten zeros, pure inflation plus interest. Gosh, these boys must stay up all night thinking this stuff up ... smoking crack.
Increasing M3 reduces USD, increases Euro, Yen, puts upward pressure on Yuan and wages, raises the price of imported and domestic goods, lowers the price of exports, raises the price of equities (Dow), and commodities (gold, oil). When some other country's money supply is increased, it has the opposite effect (on us).
The money supply is one of the two main controls used to regulate the economy. Printing more money increases liquidity. The current theory says you can find a sweet spot between inflation and depression by using liquidity to dial economic activity up or down (this is no longer true, if it ever was).
USD: The dollar index, a weighted measure of the exchange rate (relative value) of the dollar vs a 'basket' of representative currencies, primarily Euro and Yen. If it falls, all the things listed above under "Increasing M3" occur. Ultimately, it reflects global demand for dollars, a function of how many there are, how liquid (in actual circulation vs hoarded), and the perceived economic strength and stability of the US. The biggest factor in that demand today is it's status as the world's primary reserve currency, especially in terms of what you must have dollars to buy, like oil. Without this factor, it would have tanked years ago. Demand for the USD is strongly influenced by interest rates, what you can earn by holding them in the form of government bonds (T-Bills/Bonds) or loaning them out in the public sector.
Euro, Yen, Yuan, etc: The indexes of other currencies (exchange rate, perceived strength) vary inversely with the USD. Some, like the Yuan and Rupee, are explicitly or effectively 'pegged' to USD by their government's exchange rate controls. Some, like the Euro and Yen 'float' to whatever exchange rate a seller can get on the free international market. As the exchange rate between two currencies diverges from 1.0, it becomes easier to sell goods in one direction and harder to sell them in the other. The resulting trade imbalance results in a net flow of currency (debt) from one to the other with negative consequences.
Oil: Oil contends with gold for 'king of commodities'. It is currently THE primary force driving geopolitical and economic change on planet earth. Since the dollar went off a gold standard, the role of gold in backing the USD has in some ways been replaced by oil because oil has only been sold for dollars. If the supply goes down or the demand goes up, the price of oil and the prices of most other things will rise, and the USD will fall.
Gold: Gold can behave like a commodity, or a currency, or both at once. It is now in a transition from commodity to currency. Over millenia, it has maintained a roughly constant purchasing power, more constant than anything else, despite short term variations (1 ounce ~ 350 loaves of bread). Most people mistake variations in the dollar price of gold for changes in it's value, when in fact they mostly represent changes in the value of dollars. The best measure of trends in value of an asset is it's price in gold, not in some fiat currency like dollars. This is why things like the DOW/gold ratio are so informative.
There are three things that do change it's buying power, though usually on a temporary basis. One is 'flight to quality' where holders of say dollars exchange them for gold due to perceived weakness or lack of faith in the dollar or its issuer. Another is 'flight to safety' where geopolitical threats to stability like war or natural disaster increase the demand for an asset whose value is more immune to them. Lastly, the demand for gold is reduced when central banks sell or lease it tons at a time. This reduces the (eg) dollar price of gold, making the dollars appear more valuable, a ploy to artificially benefit holders of the currency at the expense of holders of gold. If you can manipulate the price of gold, you implicitly manipulate the price of everything else. Once a conspiracy theory, this activity is now the published policy of central banks, explicitly including the US Fed.
Silver: Like gold, silver can take on the roles of commodity or currency, but its greater industrial utility and lower cost has the result that most silver taken from the ground has been consumed, whereas most of the mined gold is still around. The total dollar value of available silver , (1 Bn ounces) is far less than that of available gold, (4 Bn ounces). Note that this works out to 250 times as much gold as silver in dollar terms. So it's price tends to be more volatile, more sensitive to variations in demand. The silver and gold prices usually but not always move together, and silver prices tend to move twice as far (in percentage terms) as gold.
Dow: The Dow-Jones Industrial Average is an index composed of the sum of the prices of a 'basket' of representative industrial stocks. It is treated like a measure of the fundamental economic health of the manufacturing sector. The factor usually overlooked is that it's measured in dollars, and reflects their value just as much. The Dow usually moves counter to interest rates because it competes with bonds for investment dollars, and high rates make raising capital more expensive, slowing commerce.
Imports: This is stuff we buy from other countries, right? So we have to either trade it for something we make (or do), or give them an IOU (dollars). Since the dollars have no intrinsic value, their putative value to our trading partners is only that they can be later exchanged for something that does have intrinsic value. Question is, now that we no longer manufacture much of anything, what can they redeem their dollars for? Oil, it seems, is about it. If the USD goes up, imports get cheaper, and we buy lots of them. If it goes down, that flat screen TV factory in China has to shut down.
Exports: This is stuff we make (or do) and sell to other countries, right? Like what for instance? Well weapons, movies, wood, grain, er ...
Wages: Used to be wages were closely linked to prices. Globalization changed all that. Now if it can be done in India, China, or Korea it is. So we can have price inflation without (or with less) wage inflation. Bummer. Wages move counter to unemployment. Like just about everything else, they go up with the USD. They go up with exports, and counter to interest rates.
Interest Rates: This is the cost of borrowing money. In theory this depends on the prime rate set by the Federal Reserve. In fact supply/demand factors can intervene. Along with the money supply (M3) this is one of the two biggest levers the Fed has to regulate the economy. The current theory says you can (and should) find a sweet spot between inflation and depression by using liquidity to dial economic activity up or down. Increasing interest rates decreases liquidity. It is also the main way that the exchange rate of the dollar is regulated. If interest rates are boosted, demand for dollars increases because it pays more to loan them out.
The Prime Rate is the lowest rate charged by the kind of bank you are likely to encounter. In theory it is set by your lender. In fact they all move pretty much together. The Prime is effectively based on the Federal Funds Rate. The FFR is that ordinary banks charge each other for overnight loans, mainly to cover federally mandated minimum reserve requirements. It is loosely and indirectly regulated by the Feds control of the T-Bill/T-Bond supply. The Federal Discount Rate is the rate charged by Federal Reserve banks to other banks, directly set by the Fed. Higher than the FFR, it's the credit of last resort for common banks. T-Bills and Bonds are at the top of the credit (and hence the interest rate) food chain. Their interest rates are established at auctions but effective regulated by the Feds supply and repo activity.
There is an implicit tug-of-war between interest rates and money creation. They pull the dollar index in opposite directions. There is another tug-of-war at a higher level as interest rates in different currencies tug exchange rates in opposite directions, likewise for money creation.
T-Bills and Bonds: After printing more money, issuing Treasury Paper is the other way government pays for things it can't afford. Like fiat money, it's an IOU. But unlike fiat money, it's honest about it, and it it pays you to hold it, whereas fiat money costs you to hold it (through inflation). Still, it's just another way for government to go deeper into debt. Treasury Bills (short term) and Bonds (longer term) are the ultimate source of credit in the US economy. They are sold at auction to big institutions and hence into the secondary market. Foreign central banks often convert their dollar reserves into more explicit US government debt by purchasing them.
Credit: Industry used to be the engine of the US economy. Today credit provides the motive force. Credit extended to the government by foreigners buying Treasuries. Credit extended by the Federal Reserve to 'regular' banks. Credit extended by those banks in the form of mortgages, plastic, and other loans. Over 4 trillion dollars (4,000,000,000,000) in credit was created by the US in 2006, an all-time record and a world record.
It all works like this: The Fed (Federal Reserve, a private organization which in fact has no reserves) prints up money, some in paper form, most just created by digital bookkeeping. The Treasury Department, which is a government agency, prints up some T-Bills/Bonds (IOUs). the Fed gives the government some of this so-called money in exchange for the IOUs, which they then sell. In a bizarre sort of perpetual motion machine, this 'pays' for the 'money' the Fed loaned to Treasury. The government can now use this 'money' to pay for operations. Here's the hook: The government now owes the Fed for the loan of the money (created from thin air) plus interest! Nice work if you can get it, yes?
The Fed now holds so much government debt that this private organization in a way owns the government. The original T-Bills/Bonds end up sold to individuals, domestic and foreign banks, corporations, big-time FOREX traders working arbitrage in the Japanese Yen 'carry trade', and so on. They represent debt that must be paid to the bearer at maturity at a rate of interest manipulated by the Fed via regulation of supply. By dialing this process up or down, the Fed controls the money supply. They can grow it slowly or rapidly. Another way the Fed regulates liquidity is by changing the Reserve Requirement, how many dollars a bank may loan for every dollar of real assets it owns. This acts as an amplifier of the M3 money pump.
Member banks in the federal reserve system get credit from the Fed at the Federal Discount Rate. Then they can make loans to you. But get this: they don't actually have to have all the money they loan you. This is called Fractional Reserve Banking. These days if a bank has $100 in cash, it is allowed lo loan out something like $1,000 (it varies). The difference is created out of thin air by the same kind of digital bookkeeping magic used by the Fed. They just flip some bits in your checking account and wham, you've got a loan. When you pay it back, they just reverse the trick. Difference is, now they have some interest left over. Faith-based banking. Nice work if you can get it, yes?
Now, imagine what would happen if 10% of depositors tried to withdraw their money at once. Not only does the bank not have the physical cash to hand out, they actually don't have the assets to pay these people what they are owed. If this happens, the Fed steps in and loans the funny money required at the Federal Discount Rate. If this happens all over the country they close the banks and things get weird (Roosevelt did this in 1933).
The Housing Market: When the money supply is pumped up, it has to go somewhere. In the 90's it poured into the stock market, inflating equity values, promoting wild speculation and high risk investment, and creating a giant bubble that popped in 2000. Vast amounts of artificially created pseudo-wealth was artificially destroyed as a result. To limit the damage and trigger a recovery the money creation machine was dialed up even higher (another 6%) and interest rates were cut drastically from 9.5 to 4%.
Capital then fled from stocks into the housing market in great big gobs. Home valuations rocketed, doubling since 2000. People bought homes they couldn't really afford. 90% of refinancing home owners extracted their newly inflated equity, using the money for boats and vacations and flat screen TVs. Real estate speculation and 'flipping' was rampant. This was all caused by liquidity, easy credit.
In 2006 the real estate bubble reached a top and began to subside. There's a lot of denial about this but it's true. How far and how fast will it fall? That's a good question. Next question please.
What would happen if suddenly lots of people could not pay their mortgages? Like if for example we were hit with a serious recession? Well, it works like this: You take out a mortgage with your local bank. They don't look too closely at you because they won't be keeping it very long, days or weeks. They sell it to Fanny Mae/Freddy Mac, the national mega-mortgage machines sponsored by the US gov. Fanny and Freddy don't keep it either. They lump it together with lots of others and package them into a derivative, a mortgage bond, and sell it yet again, this time to banks, big pension funds, and other institutional investors. In this form, the quality and risks of the component mortgages are disguised. The money is recycled into new mortgages.
If the economy tanks, people can't keep up their over sized mortgages. They default. The devalued property can't be sold for enough to clear the mortgage if it can be sold at all. The loss dominoes through Fanny and Freddy, the pension funds, the investment banks. The mortgage market is now so heavily leveraged through these derivatives that a truly gargantuan amount of money is at risk. We are talking about a 300 trillion dollar overhang in the derivatives market. This inconceivable number dwarfs the national debt, and just about any other number you don't hear from an astronomer. A real collapse in the housing sector would likely take the rest of the US economy down with it, if not the entire planet. It's less than likely but more than possible.
The housing market is very sensitive to interest rates, not only in terms of new mortgages, but more seriously because of the prevalence or ARMs (Adjustable Rate Mortgages) that many homeowners will not be able to afford if interest rates rise. High rates are an inevitable phase of the recovery from our current economic predicament.
The Long Term Trends
Given the way all these forces naturally interact, how would we expect things to play out over the next few years? (Keep in mind that these things will not be allowed to follow their natural course in the short term).
M3: The money supply has been on an exponential rise for more than 20 years. We can expect this to continue, as this is the only way our Ponzi economy can be maintained.
USD: The rapidly increasing supply of dollars should force the USD index (exchange rate) ever lower, eventually to 30-40% of it's current level of 85.
Euro: All other things being the same, the Euro should become stronger vs the dollar as the dollar sinks.
Yen: Japan has been and is now a major source of almost free credit. The yen carry trade will probably continue despite toothless threats by the BOJ of rate increases because it promotes foreign investment in US treasuries and defends the dollar, of which the Japanese hold lots (895 Bn). There are also powerful internal political pressures to keep their rates low. I haven't a clue how long this will last.
Yuan: The Chinese currency (also called renminbi) will continue to slowly strengthen vs the dollar. In mid 2005 its peg to the USD was ended but upward revaluation has been glacial. A weak Yuan stimulates highly profitable (to the Chinese) trade but the resulting trade imbalance will grow leaving them with more and more weakening dollars. They continue to buy T-bills/Bonds with these dollars putting our government heavily in debt to theirs. They are now in a 1 trillion dollar position to dictate some terms to us and this will worsen.
Oil: Supplies are flat or declining. Demand is increasing from the glutinous US and the emerging industrial economies, especially China and India. Obviously the price has to go up, and faster than it already has (from $11 to $50+ since 1998).
Gold: A weakening dollar means a rising dollar price for gold. The trend in central bank sales of gold reserves is reversing. Dollars and dollar-denominated assets will continue to lose value. Geopolitical instability will increase. In result gold will gain actual value both as an investment, a safe-haven, and eventually as money. It will continue to rise at least 20-30% a year as it has for the last 5 years. At some point it may experience a bubble hairier than the one in 1980, peaking at $3000, $4000, or more.
Silver: Pretty much the same story as gold, but more volatile and harder to predict.
Commodities: Historically there have been 40 year cycles with capital swinging between equities and commodities. 2001 appears to have been the turning point into a 15-20 year phase of falling stocks and rising commodities. Add to this the downward pressure of inflation on paper assets, and the rising demand for raw materials by the growing industrial economies of India and China. This is a recipe for a record-breaking commodities boom which will gather more momentum in 2007-2008. This will show up most dramatically in energy, base, and precious metals.
The Dow: The other side of a commodities boom is an equities bust. Add in recession and the trend to export manufacturing and jobs. It's not a pretty picture. If we are lucky, the Dow will bottom out at 3000-4000 at some point in the next decade, then recover.
Imports: The current high flow of imported goods will likely be significantly reduced by the middle of 2007, certainly by the end. Either the foreign and domestic credit fueling it will begin to dry up, or the American consumer will finally wake up and smell the crap, or a falling dollar will make imports way more expensive.
Exports: They will continue to shrink as we continue to give away jobs and manufacturing capacity, and sink into recession. This will be only slightly offset by the weakening dollar.
Wages: Expect little change in the rate of wages paid for a particular job. If anything they will gradually fall to the pressure of globalization. Expect the average wage and the total wages paid in the US to continue to fall, as real unemployment grows and skilled/professional jobs are replaced with lower paid, unskilled ones.
Interest Rates: In the very short term they probably won't change much if at all. We are headed into stagflation. Increase rates and recession gets worse. Decrease rates and inflation gets worse. Predicting the short term rate decisions of the Fed is a crap-shoot. Eventually they will have to rise into the teens to defend the failing dollar, into the twenties if the cure is put off long enough. This has always been a necessary component of recovery from fiscal irresponsibility.
T-Bills/Bonds: As the dollar fades, the twin deficits and total debt rises, US Treasury paper will lose its appeal to investors. Yields will be forced higher to finance the deficits and service the debt (or at least its interest).
De-dollarization: We are in a phase transition from a single world reserve currency based on the USD, to a multi-currency reserve system as dollars flood the planet and they lose value. When this is complete, the US will no longer be a superpower. The shift of reserves in foreign central banks away from the dollar that began last year is spreading and gathering momentum. Central banks in Sweden, Russia, Italy, the UAE, Kuwait, Venezuela, and China have made or announced a shift in reserves away from the dollar, citing devaluation and deficits as reasons. Oil is increasingly sold in Euros and Rubles as the US loses it's grip on the market and new markets accepting other currencies emerge. This is a self-reinforcing feedback loop. In the short term it will be orderly and gradual. Over time the pace will increase. At some point a panic is more than possible. In the long term this process may result in currency exchange controls imposed on US citizens and businesses.
Gold is playing an increasing role in this process as some central banks, as well as private investors increase the gold percentage in their portfolios, dumping dollars. In the long term this may result in heavy regulation or an outright ban on the private gold market in the US, as happened in 1933.
On the positive side, it is possible that the fundamental economic strengths of the US economy will mobilize to save the dollar from this fate, or at least mediate it. These include vast natural resources, excellent infrastructure, a skilled and educated workforce, and a tradition of innovation and initiative. In times of adversity Americans have shown that they can be ingenious, pragmatic, and hard-working. Looks like they will soon get another opportunity to prove it.
Between a Rock and a Hard Place
Inflation, recession, interest rates, money supply, budget and trade deficits, foreign investment. The US is caught in a trap constructed of these factors from which there is no escape. A tsunami of entitlement spending is now in sight. There is massive military spending on multiple war fronts. Huge trade deficits rack up more and more debt. Government is spending far more (300 Bn per year) than it collects. The difference has to be made up somehow. How can they deal with it? Let me count the ways:
They can raise taxes. This is political suicide in the short term so it won't really happen until the public perceives a dire emergency. In the long term it has always been a necessary component of recovery from fiscal irresponsibility.
They can borrow it by printing money and issuing T-Bills and Bonds. The first consequence is price inflation, first in imported goods, later in everything. The second is reduced foreign investment in government bonds by those already burned through dollar devaluation. Buyers must now be enticed with high interest rates. The final consequence is depression as business grinds to a halt from lack of capital and the housing sector tanks.
They can take it by naked force, either by military action (like we are seeing today), or from their own citizens by various means (confiscation, capital and exchange controls, wage/price controls) at literal or implicit gunpoint.
All of these avenues lead to the same place: depression, unemployment, poverty, and tyranny.
Is there no way out of this predicament? Sure there is, and it's quite simple. We all know how to apply it in our private lives (though many of us seem to have forgotten how). The answer is this: Reduce spending to less than income, then pay down debt, then save against future needs. It remains only to convince our leaders to do this. Unfortunately most of us continue to vote for more government gifts, not realizing that it has to come out of our pockets before coming back, considerably smaller after the round trip.
So, it's simple but not easy. We are behaving like children, refusing to face these simple facts: There is no free lunch. Chickens always come home to roost. Accepting government handouts is making a deal with the devil. The longer you put off dealing with it, the worse it will be. And it's already going to be pretty bad.
The Current Distortions
As it happens, these economic forces will not be allowed to interact freely and naturally. Most of the big boys believe that economies can and should be 'managed'. Others seem bent on looting the system for what they can get, then letting the sticks fall where they may. There is a dominant culture of denial of the obvious, delay of the inevitable, and concealment of the facts. We will now examine some of the ways the system is manipulated to behave counter-intuitively, and what results.
The M3 Pump:The Fed chairman has vowed to throw money from helicopters if that's what it takes to prevent deflation (read depression). This is already happening (at 11% per year and rising), just not in your neighborhood. This flood of liquidity stimulates the economy, masks recession, and inflates the stock market, making it appear healthy. It also devalues the dollar which ought to show up as a falling USD index, were it not for ...
Competitive Currency Devaluation: This is a game wherein other countries print money as fast as we do so their currency is inflated (devalued) as fast as ours. The reason is to prevent a situation where we don't buy as much of their stuff because it got too expensive in dollars because of changing exchange rates. This serves the interests of the US too because it hides the economic bad news about dollar inflation. Taken too far, it clobbers what's left of our own industry by making our stuff too expensive to sell elsewhere.
This is currently the case with China and the artificially weak Yuan. There is much posturing in congress these days about protectionist retaliatory measures. This will not happen because they hold a bigger stick: over a trillion dollars in US Government debt and cash reserves, a stick big enough to destroy the US.
A US economic A-team just returned from negotiations with Beijing. Some sort of secret deal has been struck with the Chinese over this, the nature of which I speculate thus: We will continue to permit free trade. The Yuan will remain at a ruinous (to us) exchange rate. They will continue to eat the trade deficit, holding our dollars and in effect extending us credit. We get to buy their stuff real cheap. They promise not to nuke our economy by dumping the dollars. For now.
Competitive devaluation lets us get away with secretly inflating our own currency, creating bubbles that eventually pop. Then in steps ...
The Plunge Protection Team: This is a collaboration between US Government and the most powerful investment bankers in the US for the purpose of preventing a stock market crash. To put it baldly, in a crisis the government prints up and loans great gobs of money to prop up tottering financial institutions and pull the stock prices back up. This was done following the 1987 market crash, and the 2000 pop of the NASDAQ bubble to bring free-falling prices under control and initiate a recovery. It's just another form of the M3 Pump. Sounds like a conspiracy theory doesn't it? But it's a real entity with public visibility, meetings and minutes and everything. Its official title is the Presidents Working Group on Financial Markets . A related agent performing a similar function with respect to the currency is the Exchange Stabilization Fund, an entity within the Treasury Department. Its official charter is limited to various kinds of currency operations. But there is evidence that its activities extend (logically) into gold price manipulation.
Since there is no free lunch, economic manipulation is just a giant game of whack-a-mole. Push trouble down in one place and it pops up in another, like the gold market, necessitating ...
The Great Gold Smackdown: Smart money knows that gold is a better measure of value than fiat currencies. So it watches the dollar price of gold rather than the dollar index (aggregate exchange rate) to assess the strength of the dollar. But smarter money knows that the gold price has been artificially depressed for decades by central banks who have a lot to lose if it's left to seek its own level. Now they are starting to lose that control. They will continue to fight it every step of the way because a rising gold price means a falling dollar. Gold sales, leases and increasingly their derivatives are used to smack down the price of gold when it seeks to rally. How much gold central banks have left to continue this game is a closely held secret on which there is much fevered speculation. The IMF has just announced they will require central banks to report gold sold or leased separately from reserve gold assets around the end of 2007. The smackdown will be harder to get away with once it must be done in public. This is viewed as extremely bullish by the gold market. Since that market has a strong forward component, we can expect this news to add to the other upward pressures on gold in the coming year.
It works like this: Central banks lease tons of gold to bullion banks. It's a charade because they will never get it back and they know it. Still they get to claim it on their books as an asset because it is never actually sold. The bullion banks are in the business of selling the gold they borrowed (!) and investing the proceeds at a higher rate of return than the interest on their gold loans. It's not hard to make money this way, the central banks loan their gold out at .1 to .15 %, the worlds sweetest sweetheart deal. Nice work if you can get it, yes? Eventually the gold lease comes due and the central bank just rolls it over without ever setting eyes on the gold again.
Now imagine what happens if the price of gold goes up by 20 or 30%, like it has averaged every year for the last five years. The bullion bank owes umpty tons of gold to the central bank but must now pay more to get it than they made from the deal. They are bankrupt, a secret well worth protecting since this is the top of the food chain on which the entire world economy is based. The situation just keeps getting worse. And the cure, dumping more gold on the market to suppress the price, in the long run just adds to the disease. Go lemmings go.
There is another commodity besides gold whose price gains threaten the dollar, giving rise to a deal that is ...
Light, Sweet, and Crude: In some ways, the dollar is now backed by oil instead of gold, so it's quite sensitive to changes in the oil price. Just about everything is because ultimately it takes oil to make, deliver, or operate just about everything we buy. Rising oil prices are a strain the US economy can't bear on top of everything else clobbering it. So the US has struck a deal with the Saudis to lower the price and block attempts by OPEC to cut back output. I can't prove that, but it's 'common knowledge'. What are they getting in return? Check it out for yourself, it's no big secret. You won't believe me if I just tell you. This little bit of chicanery prevents the recession and dollar fade that would otherwise occur did the oil price float. No telling how long it will last though.
The dollar defenders fight a losing battle through this and the other measures. While Rome burns, the Fed does ...
The Interest Rate Tapdance:This is the very public Keynesian game of “Raise rates to prevent inflation, lower them to prevent depression” (admittedly an over-simplification). This no longer works (if it ever did). The inflation and depression parts of the interest rate curve now overlap in a “stagflation zone” where we now are, and there is no rate where you have neither. Still if things go to far in one direction or the other, they will jerk on the same old lever, hoping to make a difference, or at least delay the inevitable for one last profitable tango.
The End Game
Eventually all these manipulations will fail and it will be time to pay the piper. Doom-sayers have been predicting this for decades and it still hasn't happened. But it really, really looks different this time. This could be it, the big blow-off. Somewhere near the end, in some order, most of these things will happen:
The many dollar defenses measures weaken. The slow growth of the gold price goes into stage III mania, everybody's an expert, everybody is buying whatever the price, then a parabolic spike occurs, to $3000 and beyond. If we're lucky, it's followed by an almost instant 50% correction, otherwise ...
The dollar defenses collapse. Foreign central banks write off their losses and let the dollar fall. If we're lucky, the dollar only looses 50-60% of it's value. If not, we go into a less likely phase of Wiemar Republic-like 'wheelbarrow money' you don't even want to think about.
Either way, trade is reduced, limited to what we can exchange actual manufactured goods for. The M3 Pump stops working, the Dow falls into the 3000 zone, and the dollar index drops through 40. Purchases of T-Bills/Bonds dry up and interest rates zoom in an attempt to restore them. Unemployment escalates to a level that can no longer be hidden by creative accounting. Adjustable mortgages default en-mass. Housing prices fall for lack of buyers under a glut of foreclosures. The repercussions domino through the mortgage industry and spread into pension funds and investment banks, many of which fail.
We can no longer support a large expensive high-tech military, so OPEC restores a more realistic oil price. Most Americans park their SUVs and take the bus.
Central banks dump all dollars for gold, it's dollar price shoots still higher. Since national economies are so interdependent, the dollar crisis dominoes around the globe and the gold price eventually goes up in all freely traded currencies. Some stop allowing free exchange, starting with the dollar.
In an echo of 1933, private ownership of gold by US citizens is banned and gold clauses in all contracts, public and private, are void by decree. US-based Digital Gold Currencies like E-gold are forced to close out their client accounts with dollars at forced low rates of exchange. Banks close, some temporarily, some not. Access to safe deposit boxes is supervised and all weapons and precious metals they contain are confiscated. Exchange controls force the dollar to have at least some nonzero value within US borders. Wage and price controls are put in place. Some things are rationed. Credit is nearly unobtainable. The commodity boom tops and slides as uncontrolled worldwide economic growth, no longer fueled by insane amounts of credit, is scaled back.
By 2015, the bottom is reached and the pendulum starts to swing the other way. Over the following ten years, sanity and a degree of prosperity are gradually restored. Stock markets recover into a regime of healthy growth rates on their way to the next bubble, sometime around 2030.
Wow. What an Orwellian nightmare. Unfortunately much of it is likely, a matter of when not if. All of it is plausible. All of it has happened before either to us or to other states which tried to use fiat money. Regardless of how pessimistic this turns out to be or how lucky or wise we are, the reality will fall somewhere along this spectrum of events. Of course, all this is speculation, my speculation. Do your own homework and decide how much of it to believe.
My advice: Liquidate all your assets and buy gold. Physical gold. All you can. And store it somewhere personal property rights are likely to be respected in an emergency (not in the USA). Exactly where might that be? Good question. Next question, please.
The Outlook for 2007 (I dust off the crystal ball)
You can take most of this with a pound of salt, I don't really have a crystal ball. But any careful student of trends and patterns can make predictions with better than random results, that's what brains are evolved (or designed if you prefer) for. Besides, I read a lot of Science Fiction and that uniquely qualifies me to predict the future. Furthermore I've had a little luck doing this in the past and it's made me cocky.
The stock market boom will appear to continue, at least for the first half of the year. The dollar index will struggle to fall through the resistance at 80, succeeding by mid-year. Stagflation will become more and more obvious until official denial is pointless. Housing sales will fall off dramatically but prices will only fall in areas where they were the most inflated. Oil prices will remain relatively low for the first half year but will close the year between 70 and 80, barring acts of lunacy. By year's end it will be obvious to most that the five year old commodity bull is not over and equities are going to suck most vigorously. The TV financial news pundits will continue telling us to just keep trading, and “stay the course” like they did in 1998-2000. Go lemmings go.
Some time this year will be recognized in hindsight to be a major tipping point into economic crisis, though not immediately.
Son-of-Bush will become more radical, more isolated, and more at odds with congress and the public. It will become obvious that congress is unable or unwilling to reign him in despite much posturing. The erosion of privacy and civil liberties will continue, perhaps accelerate. Only a minority will object. Talk of impeachment will continue and increase but I don't hold out much hope.
Opposition to the forever war (on drugs, terror, the Constitution, and your wallet) will gradually grow without reaching Viet Nam levels. It will be largely ignored by the administration. More presidential hopefuls will appear. Other than Ron Paul, none will have an effective plan to take the tough measures required to head off disaster. Like a deer in the headlights, the US public will continue watching 'American Idol', 'Survivor', and 'CSI Miami' (Ron who?). Boy do I want to be wrong about this.
Gold in the Coming Year
In 2007, we can expect increasing activity from professional investment managers, culminating in the start of a spike that begins when the amateurs finally take notice. Where and when that will end is anyone's guess, either a drastic but partial correction or (slightly less likely) hyperinflation leading to a crash-and-depression. The peak of this is probably somewhere between 6 months and two years off.
Last year, I said 2006 would be harder to call than 2005, but I still called it very close both years. In 2007 I expect the increase in volatility to continue. $100 swings over two month spans will not be unusual. If there is no spike, I expect gold to close the year in the 800-850 range.
If there is a spike, it will likely be preceded by at least one 'false spike' to 1500 or more. The true spike will peak in the 2500-3500 range. Tops are notoriously hard to call, so if you want to bail out, wholly or partially, you might want to break this up and scatter it along the curve.
For the scoop on silver, just multiply the gold percentage changes by 2X and apply them to silver. That gives you something like a December spot of $20-22. A spike could run to 88-130. One cash-averse strategy is to hold silver on the way up and gold on the way down.
Deus Ex Machina
It's likely that we will get one or more 'surprises' this year. Here are the possibilities I can think of:
Manic Spike: This would be a replay of the 1980 gold spike, with the same stages and symptoms but a more compressed time frame. I consider this inevitable, more a question of when than if. For 2007, it's something like a 40% probability. See the discussion above.
9-11-II: Another 9-11-like attack would just be too, too, convenient this year for some. We've already whipped the Islamic lunatic fringe into a foaming frenzy. Whatever that fool in the White House does next could drive them over the edge. And I wouldn't put it past him to fake it for purposes of gathering more war powers and renewing popular support. It wouldn't be the first time (read your history) This would be worth a $200 jump in gold all by itself. A 25% probability.
Iran War: A 60-70% probability by many accounts. Look for the current US naval buildup in the gulf to culminate in a massive air attack, after which the Israelis fly in and hit underground facilities with tactical nukes. Unless we have some gee-whiz new non-nuclear option up our sleeves, nothing else will do the job. We won't have to dirty our hands by using our own nukes (again). The Israelis will view it as a matter of national survival and won't care what anyone else thinks. Gulf shipping will halt. Oil will shoot over $100 a barrel. Gold will jump 100's of dollars, The USD will drop. It will accelerate and deepen any economic crisis. This is the worst possible scenario, and except for the nuke part the most likely. Bummer.
Dollar Crash: A 20% probability. The present orderly disassembly of the USD world reserve currency system reaches a tipping point and turns into a rout, with everyone racing to not be the last caught holding near-worthless dollars. Many things could trigger it. There would be little warning. It could all take place over a few days or weeks. In a worst-case scenario, the price of gold in dollar terms might become almost meaningless, 5000, 10000. It's more likely though that the dollar would lose 50-60% of it's value but not crash completely. There are too many assets in the US for it's currency to become completely worthless.
I'm supposed to summarize everything I've already said at this point, but I'm not going to do so. If you didn't get it the first time, read it again. Read it again anyway, you can't absorb this much information in one pass. Heavy weather is coming. The worst thing you can do is nothing at all. I probably made some stupid mistake or six. Don't discount it all for that reason. It's a big planet and there are many who are far more knowledgeable about these things than I. They will have their blind spots, biases and agendas, just as I do. Free your mind.
Wavyhill – January 2007
References and links
Gold Market Lending, An inside look
World gold supply and demand
Five year gold chart
USD foreign exchange reserves
Exponential money supply
John Snow's sweet-spot managed economy
The stagflation dilemma
The USD basket
It's good to be the reserve currency
Oil, the queen of commodities
Oil now backs the dollar
Gold, the king of commodities
The Dow/gold ratio
Central Banks tip their hand
The silver supply
The gold supply
The Dow basket
Fed credit creation
The 1933 bank holiday
Money creation after the dotcom crash
Interest rate cuts after the dotcom crash
The real estate bubble
The home mortgage as ATM
The real estate party ends
The secondary mortgage market
Those bad boys Freddy and Fanny
The dollar prognosis
The Yen carry trade
Dollar foreign debt
Future oil supply
Future oil demand
The 1980 gold bubble
The commodity super-cycle
Future commodity demand
We export our manufacturing capacity
We export our white-collar jobs
The average wage trend
The transition away from a USD reserve currency
Reserve diversification spreads
Non-USD oil markets spread
Central banks increase gold reserves
Boomers break the bank
Wars break the bank
How 'Helicopter Bernanke' got his name
The artificially weak Yuan
We go begging to Beijing
The Plunge Protection Team
The Exchange Stabilization Fund
Gold price suppression
The IMF to make central banks honest
The IMF accounting report
The Saudi Deal
The false flag ploy
The current gulf naval buildup