Advance signs of a global slump in economic activity emerged in 2015.
Furthermore, the dollar's strength, coupled with widening credit spreads
confirms a global tendency for dollar-denominated debt to contract. These
developments typically precede an economic and financial crisis that could
manifest itself in 2016, partially confirmed by the disappointing performance
of equity markets. If so, demand for physical gold can be expected to
escalate rapidly as a financial crisis unfolds.
Introduction
Gold has now been in a bear market since September 2011. Major central
banks in the advanced economies have implemented policies that have covertly
suppressed the gold price, while they have overtly inflated asset prices.
This has led to valuation extremes in all asset markets, including gold, that
would never be seen in free markets backed with sound money. We can be
certain that today's unprecedented build-up of price distortions will be
corrected eventually by market forces, probably in the coming months. The
commencement of a crisis has already been evidenced by the collapse in energy
and industrial-commodity prices, causing major problems for nations and
international companies with US dollar obligations and suddenly finding they
lack the revenue to service them. The scale of commodity-related losses is
not generally understood, but cannot be ignored for much longer.
The rapid expansion of central bank balance sheets since the Lehman crisis
is the ultimate phase of a process that can be traced back to at least the
1980s. Starting in London, US and European banks at that time took control of
securities markets. Since then, they have increasingly directed bank credit
at the expansion of those securities markets, principally through the
development of over-the-counter (OTC) derivatives, but also by dominating
bond and equity markets, and regulated derivatives.
The expansion of bank credit aimed towards financial activities has had
the triple effect of inflating financial assets, suppressing commodity prices
below where they would otherwise be, and enhancing international demand for
the US dollar as the main pricing currency. The result has been an
unprecedented peace-time expansion of global debt, while confidence in the
reserve currency has been maintained. However, there are indications that
this period of expansion is now at an end. According to the Bank for
International Settlements' statistical releases, the gross value of bank-held
derivatives has been contracting since 2013. Notional amounts of outstanding
OTC contracts peaked at end-2013 at $711 trillion, and by June 2015 had declined
to $553 trillion.
This is an important point, because an unseen bubble at the heart of the
financial system is deflating with unknown consequences. When bubbles
deflate, and here we are talking about one in the hundreds of trillions, bad
debts are usually exposed. Even though much of the reduction in outstanding
OTC derivatives is due to consolidation of positions following the Frank Dodd
Act, much of it is not.
When free markets reassert themselves, and they always do, the disruption
promises to be substantial. We appear to be in the early stages of this
event.
Dollar and European dangers
As noted above, the rising value of the dollar measured against
commodities is a major problem. In the short-term the dollar is extremely
over-bought against record levels of commodity short positions. Most notable
is the dollar price of oil, with West Texas Intermediate having fallen from
$105 in June 2013 to $32 today. While much of the fall can be attributed to
lower demand from a slowing global economy, some of it is undoubtedly due to
the strength of the dollar itself. Bad and potential bad debts, many
commodity-related and denominated in dollars, are a global issue, and the US
banks are trying to control their international loan exposure. Consequently,
international borrowers with dollar-denominated debt are being forced to sell
down local currencies to buy dollars in order to cover their dollar
obligations. The problem has been aggravated further by speculators bidding
up the dollar against these distressed buyers.
The dollar's overvaluation is also supported by the belief that the US
economy is healthy and performing relatively well. With official unemployment
down to 5%, demand for domestic credit, while patchy, is basically sound and
growing at a moderate pace. However, nominal GDP growth is entirely due to
monetary stimulus being not yet offset by lagging price inflation, and is not
the well-founded economic recovery generally supposed. But for dollar bulls,
the apparent strength of the US economy is another reason to believe the
dollar will remain strong, given the prospect of a rising interest rate
trend. There are considerable dangers to this bullish view for the dollar,
not least the degree to which it is already discounted in current prices.
A second global problem is the financial and economic condition of the
Eurozone. 2015 saw the Greek crisis deferred, but for 2016 we have the
prospect of trouble from Spain and Portugal, with government debt as a
percentage of GDP estimated at 100% and 130% respectively. In the Spanish
general election in December an anti-austerity combination of the left-wing
Podemas and PSOE political parties won 159 seats against the ruling party's
123. Negotiations are now underway, but it looks like an anti-austerity
coalition will form the next government. Greece was difficult enough, but
Spain is many times greater in terms of its economic impact and the amount of
government debt involved. Also, Portugal, whose economy is about the same
size as that of Greece, had its general election in October, and the ruling
party lost its overall majority, suggesting that anti-austerity pressures
will increase in Lisbon as well. And Greece has not gone away.
Greece in 2015 was the warm-up act for what's ahead in the Eurozone.
Meanwhile, €3 trillion of government bonds in Europe now trade with negative
yields, an unprecedented situation, which illustrates how overvalued European
government bonds in general have become, particularly when taking into
account the parlous condition of some major governments' finances. The
Eurozone banks are also financially precarious, having an average Tier 1
capital ratio to tangible assets of 5.1%, dropping to 4.1% when off-balance
sheet items are included. Furthermore, the netting off of credit default
swaps permitted under new Basel Committee rules has allowed the banks to
conceal their true loan risk. The combination of European banks gaming the
system, average core balance sheet leverage (including off-balance sheet
obligations) of 24:1, and their balance sheets laden with wildly overvalued
government bonds, has the makings of a crisis in search of a trigger.
A European banking crisis could escalate very rapidly if and when it
starts, and would be an event beyond the direct control of an alarmingly
undercapitalised ECB. The initial effect might be to drive the dollar higher
in the foreign exchanges, particularly against the euro, and instigate a
further markdown of commodity prices, as markets try to discount the economic
implications of a systemic problem in the Eurozone. If an event such as this
occurs, it would be impossible to limit it to a single geographical area. The
major central banks would be forced into a coordinated rescue programme,
involving a major expansion of all their balance sheets, on top of the post-Lehman
crisis expansion.
Once initial uncertainties are out of the way, the prospect of escalating
systemic risk should be very positive for gold, which is the only certain
hedge against these events. To determine the potential for the gold price,
its current value should be assessed by looking at the long-run inflation of
fiat dollars relative to the increase of above-ground gold stocks, and
adjusting the dollar price of gold accordingly.
FMQ and gold
The fiat money quantity represents the total fiat money that has been
produced by the US banking system. It includes fiat currency not in
circulation, being mainly bank reserves sitting on the Fed's balance sheet.
The chart below shows the monthly accumulation of US dollar FMQ since 1959.
Following the Lehman crisis, the dollar-price of gold fell initially
before recovering and gaining all-time highs in September 2011. With the
benefit of hindsight, we can surmise that the immediate effect of the Lehman
crisis was to trigger a flight into the dollar, before it became evident that
the Fed's actions aimed at stabilising the financial sector were succeeding
at the expense of monetary inflation. This also provides an explanation as to
why, in order to maintain confidence in the dollar, the gold price had to be
subsequently suppressed. Judging by all the circumstantial evidence following
the Cyprus crisis, the most notable suppression exercise was in April 2013,
and close study of market actions and volumes reveals that other less
dramatic price suppressions have from time to time also taken place.
Given this experience, it would be wrong to rule out another attempt by
the western central banks to suppress the price of gold in the event of a
crisis. However, it is becoming clear that they can only suppress the price
through the paper markets, given the relative scarcity of physical bullion in
western central bank vaults, and the reluctance of individual central banks
to compromise their bullion holdings any further. These short-term
uncertainties cannot be quantified, but we can have a clear idea as to gold's
current true value, expressed in US dollars. This is the subject of our next
chart.
The chart shows the price of gold deflated by both the increase in FMQ
over the years and by the expansion of above-ground gold stocks, since the
price was fixed at $35 in 1934 by President Roosevelt. Adjusted by these two
factors, gold at end-December 2015 was priced at the equivalent of $3.25 in
1934 dollars, less than 10% of the 1934 price. The only occasion the adjusted
price has been lower was in 1971, just months before the Nixon shock, when
the Bretton Woods system finally collapsed. The adjusted price stood at $3.13
in March that year.
The next chart shows the same price adjustments applied to the gold price,
this time from August 2008, when the Lehman crisis broke and the nominal gold
price was $918.
The adjusted price, reflecting the expansion of both the FMQ and
above-ground gold stocks, now stands at $402, a decline of 56% in real terms
since Lehman.
On value considerations, we can therefore conclude the following:
• Gold is cheaper than it has ever been against the world's reserve currency,
with the single exception of the time when it was so under-priced that the US
Government was forced to scrap its peg at $35 and abandon the Bretton Woods Agreement.
• Compared with the situation at the time of the Lehman crisis, gold is
significantly cheaper today, which is wholly at odds with the continuing
systemic risk to fiat currencies from undercapitalised banks, unprepared for
the prospect of markets normalising.
Many contemporary financial analysts would argue that gold is not relevant
to these issues, because gold is no longer money. This line of reasoning
ignores the fact that ordinary people in the west do not get this message and
are accumulating gold coins and small bullion bars at increasing rates. And
more importantly, economic power is shifting from countries where this
Keynesian view is prevalent to countries where it is not. The next section
looks at the geostrategic implications of the shift in the ownership and
pricing of gold from west to east.
China, India and the rest of Asia
China and India, together with all the other countries in mainland Asia,
have been draining the west's vaults of above-ground gold stocks for far
longer than most people in western capital markets realise. China first
delegated the management of gold policy to the Peoples Bank by regulations
adopted in 1983, in a move that followed the post-Mao reforms of 1979/82. The
intention behind these regulations was for the state to acquire substantial
amounts of gold, to develop gold mining, and to control all processing and
refining activities. At that time the west was doing its best to suppress
gold in order to enhance the credibility of paper currencies, by releasing
large quantities of vaulted bullion through leasing and outright sales. This
is why the timing is important: it was an opportunity for China, with its
one-billion plus population in the throes of rapid economic reform, to
diversify growing foreign currency surpluses, in the same way as the Arab
nations did earlier and contemporaneously between 1973-1990 following the oil
price boom.
When China set up the Shanghai Gold Exchange in 2002 and encouraged its
private sector to accumulate gold, the state had obviously acquired enough
bullion for its own strategic purposes. We cannot know how much the state has
actually accumulated, or indeed to what extent the gold she has mined has
been taken into state ownership since, but the amount is likely to be very
substantial. We do know that gross deliveries into public hands since 2002,
satisfied mainly by imports from western vaults, exceed 11,000 tonnes to
date. It is therefore quite possible that China and its citizens now have
more gold than all the other central banks put together, given that some
official gold is currently leased by western central banks and some has been
secretly sold to suppress the price.
The monthly statements about China's gold reserve additions are therefore
meaningless. However, Russia is now accumulating official reserves as well,
and the Indian state is trying to acquire her citizen's gold by stealth,
having been frozen out of the market through lack of supply. The bulk of Asia
is, or will be, bound together through the Shanghai Cooperation Organisation,
an economic partnership dominated by China and Russia, encompassing more than
half the world's population, and which accepts physical gold as the ultimate
form of money. And what clearly emerged in 2015 is that the dominant trade
currency in this bloc will unquestionably be the Chinese yuan, the currency
of the country that has now cornered the world's physical gold market.
The future for the world's money is rapidly developing, as will become
increasingly apparent in 2016. The era of dollar supremacy is coming to an
end, no doubt hastened by the Fed's ultimately destructive monetary policies.
The threat to the dollar's primacy is also a threat to the other great paper
currencies: the euro, the yen and sterling. Whether or not these fail before,
with or after the dollar, is only a matter for timing. China must have
foreseen this possible outcome, otherwise she would not have embarked on a
policy of accumulating gold as long ago as 1983, invested substantial
resources into gold mining and refining, actively encouraged her citizens to
own it, and is today promoting use of her currency for global trade and the
pricing of gold.
Western market observers seem to be unaware of how advanced China's
currency policy is today. Instead, they expect a full-blown credit crisis,
the result of the credit expansion of recent years being undermined by a
rapidly slowing economy. Furthermore, they argue that Chinese labour costs
have increased and require a much lower yuan exchange rate to become
competitive again. Based on western-style macroeconomic analysis, they
naturally conclude that China will require a substantial currency devaluation
to contain these problems.
While it is a mistake to gloss over the considerable economic
difficulties, this analysis is flawed on two counts. Firstly, the state owns
the banks, so a credit crisis stops with the debtors. And secondly, under the
thirteenth five-year plan, China is embarking on a redirection of economic
resources from being the cheap manufacturer for the rest of the world to
serving its growing middle class and developing trans-Asian infrastructure.
China's unemployment rate is estimated to be about 5%, so workers employed on
current production lines will need to be redeployed, if the state's economic
strategy is to progress. A substantial devaluation is therefore
counterproductive, though the central bank does move the yuan's peg against
the dollar from time to time.
The purpose behind China's accumulation of gold can only be to eventually
make the yuan a reliable store of value. China will need to see a higher gold
price in yuan, probably at a time dictated by external events, which she will
patiently await. This is why, having developed the Shanghai Gold Exchange
into the world's most important physical gold market, China plans to price
gold in yuan, with the objective that the yuan-gold peg will eventually supersede
yuan-dollar peg.
We will surely end 2016 with a wider appreciation that the dollar is no
longer king, and that the future for money lies in Asia, the yuan, and gold.
Conclusion
In the near-term, paper gold is extremely oversold, reflecting the expression
of western establishment sentiment in the paper markets. Futures and forward
markets are short of paper gold to an extraordinary degree. Whether or not
this leaves open the possibility of further falls in the dollar price of gold
in the next few months is a moot point. More importantly, on longer-term
considerations, gold has not been this undervalued since the events leading
to the collapse of the Bretton Woods agreement. If current events lead to a
systemic crisis in western capital markets in 2016, which given the global
slump in economic activity looks increasingly likely, a further expansion of
central bank balance sheets on top of the post-Lehman expansion seems
certain. If this happens, it is unlikely the purchasing power of the dollar
and the other major currencies will remain at current levels. And if the
dollar loses purchasing-power, price inflation will rise along with nominal
interest rates, and a wider debt liquidation in western capital markets
becomes a real possibility.
China and her SCO partners have taken steps to be protected from this
outcome and have cornered the gold market. A wise person should take note and
think seriously about the implications.
Enjoy 2016.
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