March 5, 2001


Resolute Persuasion
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Topics in this week's issue of the Global Investment Climate
Why is the gold lease rate contango inverted and what pressure cookers lurk beyond?
The concept of value investing, applied to the current investment climate, and revisited through a trip down memory lane.
A discussion of the egomaniacs that are driving interest rate policy outside of the parameters set by the FOMC.
Can there be deflation in the United States? Inflation versus Deflation argument update.
Rising credit market spreads (risk premiums) + rising national default rates = critical erosion in dollar fundamentals
The nearby direction of the Dollar will be down as consumption peters out again... and it will take the bond with it... could the dollar withstand a zero interest rate policy?
How do recent changes implemented by the Bagel Committee affect the dollar?
Should we buy February's best performing stock sector?


Ready… Set… Go…
Personally, I have been bullish on gold prices ever since the Bank of England announced that it would sell most of its remaining gold, in the spring of 1999. One reason is that while the announcement sent gold prices down to the $250 handle, the sell off wasn't panicky, in nature. There was volume, but it wasn't a long liquidation. There weren't enough (gold) bulls around even then for the announcement to set off a panic.

It was more like the very last gasp of air that a dead bull might snort, just before he keeled over at the hands of his bullfighter…

Gold Gold
10 year gold prices:BOE announcement 2 year gold prices:Nine month wedge?

Within five months, in any case, we were ready to discover why the Bank of England chose to slam the gold market… the major European banks had already sold or leased too much of their gold, and had finally agreed to stop the risky practice by signing the now historic Washington Agreement at month end, September 1999. Though the agreement was downplayed for its significance, perhaps it was necessary if only because the banks did not trust each other to keep to a verbal agreement (maybe even having already failed at that). Is that an idle thought?

Anyhow, with the benefit of hindsight, may we propose that it was helpful to the European banks (the signatories) for the Bank of England to stand on top of the corpse and squeeze every last ounce of life out of it (the market) first? This way, the reversal could take place from a lower price level, allowing two obvious advantages: first it would soften the net financial punishment that the market was ready to deliver in October - upon hearing of the agreement - and second, not unrelated, it would allow the European banks some time to prepare and cull their portfolios a little. In our opinion, this basic scenario is far too plausible to dismiss.

Consequently, maybe it is "not" all that ironic that lurking in the background recently has been the rumor of news that the Bank of England is short physical gold supply with which to settle on its post auction delivery notices...

The view has been offered (by many blue chip analysts…) that the psychological impact of the news that a prestigious central bank cared nothing for its gold holdings, at the time, vastly outweighed the potential market impact of the relatively small amount of gold it held and planned to sell, were it done quietly. But the Bank dismisses this key point as misguided criticism, proposing rather that they broadcast their intentions precisely because they did not want to scare the market. Huh?

You can say that again…
Anyhow, nothing ever happens unless there is a reason for it, right? Of course, we have no proof. We haven't the resources to obtain it. But we can assure you that there are very few speculators or investors who have any more than half the truth at any given point in time… maybe even less than that today.

The reality is that the Bank of England's move was out of place and out of character. It did not reconcile with the view that the European banks shared about gold officially, and it stood entirely against the American position on gold. Folks, this is not conspiracy, it is strategy. We cannot expect that if there exists a potential systemic risk in capital markets large enough that it could crush the global banking system, were it to crystallize, that politicians would tell us all about it. It just does not stand to reason.

More to the point here, adopting our view, it suddenly becomes easy to explain the rise in lease rates prior to the signing of the Washington Agreement, which seemed to puzzle the esteemed Dr. Jessica Cross in her report on the gold derivatives crisis, one year later.

Right, here we go then… those bankers in the know spent the summer unwinding some of their more perilously speculative positions. Who wouldn't? Perhaps, some of the smarter ones had also decided to hoard some physical gold supply, without detection, and maybe even bid for it at the Bank of England's own gold auctions throughout that summer. Ok, if not, how else does one explain the rise in lease rates?

Traders have been trained to anticipate large bullion sales on the rising lease rates. One reason is that it has been traditionally customary for a borrower to sell the gold right away if it was borrowed as a source of financing. The other reason is that when a central bank would sell its gold, it would draw it from the leasing pool to do it.

Yet neither occurred. Rather, there was a nearly obvious accumulation on the charts, at the $250 handle. Well then, somebody must have been accumulating physical gold supply. I suppose it could have been anyone, but consider that such a move might enable the said bankers to contain the post Washington Agreement gold market by supplying the lending pool in order to hold lease rates down and persuade us that there is plenty of supply. Sound familiar?

Yet that conclusion is way too controversial to make about her own clients and business associates, and evidently further removed from reality than the idea, proposed by Cross, that the higher lease rates were deliberated by said bankers to generate a little more profit for themselves. Hah! No kidding, that kind of guessing is allowed because it pleases the Queen that her bankers seek to profit in the name of capitalism. The greater insidious truth is that they do it at the expense of capitalism. The critic of our argument might suggest that the lending pool is far too large to lend itself (no pun intended there) to manipulation with such a small quantity of physical gold as could be bought without detection in five months. This critic should read on…

How important are lease rates anyway? According to Dr. Cross, writing for the World Gold Council on the subject of gold derivatives and lending, "the widespread use of derivatives has generated a growing need for lent gold and the concept of participating in the leasing market has been actively marketed (?) to the official sector by the commercial banks."

Since the widespread use of derivatives has grown ever wider since the Washington Agreement was signed, lending markets must have become ever more crucial to the life blood of the contemporary banking system, and lease rates ever more indicative, of something.

But what lending market? According to Jessica Cross, again, "The extent to which the Washington Agreement has effectively sterilized a very large proportion of potential new lending is all too apparent… Should this be the case, the total potential liquidity, post the Washington Agreement, now stands at between 560 and 1000 tons. This compares with figures of over 6000 to over 9000 tons prior to the announcement."

In other words, the regular flow of gold into the lending pool has withered by almost 90%, as a result of the agreement. Well… if this tap has been all but shut off, shouldn't lease rates have risen after the Washington Agreement? Maybe that is what is happening right now. The delayed reaction may be the consequence of two things: First, demand from traditional gold borrowers undoubtedly declined by roughly the same quantity as the new supply, after witnessing what could happen to entire companies who owed the volatile metal. Second, whatever borrowers remained, largely rolled their borrowings right up the maturity contango… meaning that they extended their maturities beyond one year, for a little temporary safety. Another observation made by the Doctor (PhD) in her own report… quoting anonymous banking sources of course.

So if borrowers are borrowing longer term now than one year, that alone probably imparts a slight net drain on the availability of short-term physical gold supply. Moreover, if the currency volatility continues, duh, as if the international currency regime would all of a sudden become stable, then it is increasingly unlikely that the smaller players, like Turkey or India, will be all too willing to join loyal Kuwait in lending their official gold reserves to the hungry tentacles of a giant Fiat Octopus. And if the commercial banks continue to increase their net derivatives exposures then they will be, according to Ms. Cross, generating a growing "need" for lent gold.

So unless Japan or the United Sates enter the picture, there really isn't much of a lease market… and therefore, the published lease rates, especially under one year, have been largely containable, until now perhaps. Since Japan has the lowest proportion of their foreign exchange reserves, among its senior economic peers, vested in gold and since China is planning to become an influential gold trader in the nearby future, it is unlikely to expect Japan on the offer any time soon. If it does, it will be at its own monetary peril, but we believe that the Japanese are increasingly uninterested in supporting dollar policy as an international standard.

Finally, I cannot imagine anything quite so bullish as the American government approving the sale or lease of its own gold. What would be bearish for gold in the short run is for US bullion banks to successfully market the concept of leasing gold to influential Japanese authorities… an unlikely monetary coup for our dollar governors.

But let's consider the bullish case. Maybe there is some truth to this rumor about the Bank of England's supply shortfall. Even as far as a month ago, we began to hear questions like, what if the BOE were to repeal its gold auctions? Well, if that is true, then combined with the other pressure cookers in the lease contango and dollar-denominated capital markets, we are perhaps only seeing the beginning of an enormous supply shortfall in the gold business… especially if investment demand comes back!

And maybe the idea that the Washington Agreement effectively shut down the leasing pool in the same way and maybe for the same reason that the London Gold Pool was shut down in 1969 will be valid. If so, its symbolic significance cannot be understated.

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Continued:Second Excerpt,

Wall Street slashes rates… then wonders, where's the real cut?
Last Monday morning, Lehman Brothers bullish analyst Jeffrey Applegate called for a reduction in the Fed Funds Rate: 150 basis points by June… the same morning, Bear Stearns' Wayne Angell, a former Fed governor, advised key reporters at various news organizations to upgrade the Nasdaq to a strong buy! That morning on the air, Angell struck down his fist and thunder rocked Wall Street. With the conviction of a raging narcissistic bull, he broadcasted, to the entire world that he placed an 80% probability on an intermeeting interest rate cut from the Fed. That was already up from 60% on Friday. The ex Fed governor (make special note of that) gave Wall Street a dose of his pure unadulterated ego… could it also be a form of counterfeit? Follow us…

Both of these analysts were bullish going into Monday morning's new low. Referring to the 3-month S&P chart posted earlier you will recognize that this and the Nasdaq just sliced through critical market support. But, Messrs. Angell and Applegate put everything they had into willing its reversal, so that they wouldn't be wrong. A worthy use of power, wouldn't you agree? Perhaps a note to David Faber at CNBC: both of these men are much older than 30 years. And they are the leaders that younger money managers look up to for direction. A spade is a spade.

After Greenspan's congressional testimony by Wednesday, Angell was compelled to withdraw his comments altogether, though I don't know why. Mr. Greenspan was probably just throwing a wrench into the lunacy. How is an interest rate cut supposed to even work when expectations move so far ahead of it? Hello… McFly… remember crowd behavior 101?

But since that was all the credibility required, that day, to motivate Wall Street's trigger-happy bond dealers to corner the market on fed funds futures contracts (I don't think that is even theoretically possible by the way), interest rates effectively declined throughout the entire curve, and new liquidity was created. Bets have now been placed in anticipation of the Greenspan nod, which if it comes can do nothing short of collapsing the long end of the treasury market, where inflation expectations, which have been ratcheted down with this kind of counterfeit leadership, have to flare up and finally drive up the bloody risk premium… how's that for ego.

IRX: short yields Bond Yields
Short Term Yield Index 6-months 30-year US Treasury Yield Index 1-year

Our well paid, broadly respected, and infinitely capitalized bond market shepherds, and I am thinking specifically of PIMCO's Bill Gross here, maintain that interest rates are going to go to 3%. In order to make a call like that, you need to have a brutal conviction that the dollar will hold up. Yet, nowhere in his entire argument does he discuss the impact on the dollar of an interest rate cut to 3%. But I see that productivity works for him because he has more time to spend on TV than he does reading a basic book on monetary analysis.

Look here, if monetary policy becomes ineffective in promoting the now customarily expected high rates of return on US dollar-denominated investment, and we're not talking about long-term foreign direct investment either, then the inflation which he, and many other regal analysts including the fist pounding wonder-kid at the Economic Cycle Research Institute, do not see, will become quickly visible.

Bond Prices US Dollar
30 Year US Treasury Index 1-year US Dollar Index 3-years

There cannot be deflation in the United States
It's the truth. By definition, we are Inflationists, determined to counter deflationary forces with more inflation. It is as simple as that. I don't think that we could fit more truth into a smaller sentence than that, unless you can count the letter "V." The governors of our credit money system might shout that the whole idea of credit money is that the mechanism of credit best self regulates the money supply against inflation… by canceling both sides of the ledger during a contraction in the demand for credit, the money supply should also contract, in theory. In other words, if debts get cancelled, then so do credits, and thus the money supply contracts rather than expands.

Is there a better way to explain the logic that underlies our preoccupation with the deflationary aspects of a credit cycle bust?

Yet, our private sector banking system has rapidly erected, and theoretically insured, a complex array of financial intermediaries in order to rationalize the monetization of those very credits, no doubt so that they can be used more broadly, as money. But there is no need to go into that here. Doug Noland writes on the topic every week in the Credit-Bubble-Bulletin, which we post at SafeHaven as a must read in order to understand the rapidly changing developments in US and global credit markets.

Thus, over the past six years, foreign investors have been enormous net buyers of this money, whose value is really only supported in so far as their (foreign interests) own will desires more dollar denominated CRAPITAL. Still, the point is that the cancellation of credits now involves decisions by foreign interests, and thus must impact on the exchange rate of the dollar against other currencies. Unfortunately for the dollar, since the United States is now the largest global net debtor and since the global financial system has monetized more US dollar-denominated debt than any other foreign debt, the prospect for a massive inflationary breakdown stemming from too many liquid (dollar) credits ranks high, in our opinion.

Adding to that problem of course is the fact that all the world's paper currencies have been falling against the value of important world commodities… we have passed the point of no return, for to reverse this trend now would require an interest rate hike, rather than a cut, by all the world's central banks.

Global Stock Market Deflation

Paris Bourse German Stock Index
Toronto Stock Market Index Nasdaq 100: Large Cap
French CAC; German DAX; TSE 300 Composite; and Nasdaq 100: 3-years

So let us ask you, if the FOMC were to cut interest rates by 150 basis points, which stocks would you buy under such conditions, if you had to buy stocks? Why not start with Monday's best performers, since they are the ones that responded to the rate cut. In this case, the XAU also happens to be February's best performing stock sector:

US Gold share index
February's Best Performers
XAU: American Gold Share Index

What stocks wouldn't you buy?

Citigroup GE: Blue Chip Barometer
Citigroup common stock: 3 years General Electric common: 3 years

This week (or maybe next) we are looking for…

  • Gold markets to roll over the shorts on improving technicals
  • The Dow to crystallize our call to break 9000, likely to be led by the financials and a failure of the Transports to follow through… C'mon boys, get it over with already
  • The long bond to break out of its holding pattern, on the downside
  • A break in the Dollar, against both the Yen and Euro.

A Note to Applegate at Lehman Brothers: You will get these outcomes before a 150-basis point cut in the fed funds rate… and we're gonna bet on it!

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Edmond J. Bugos

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