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Bernanke’s logical fallacies and self contradictions

March 31, 2015

Former Fed chief Ben Bernanke now has a blog. This is mostly good news, because he will certainly do less damage as a blogger than he did as a monetary central planner. However, it means that he is still promoting bad ideas.

I doubt that I’ll be a regular reader of Bernanke’s blog, because his thinking on economics is riddled with logical fallacies. Some of these fallacies were on display in his second post, which was titled “Why are interest rates so low?“. Some examples are discussed below.

In the fourth paragraph Bernanke states: “The Fed’s ability to affect real rates of return, especially longer-term real rates, is transitory and limited. Except in the short run, real interest rates are determined by a wide range of economic factors, including prospects for economic growth — not by the Fed.” However, earlier in the same paragraph he states that the real interest rate is the nominal interest rate minus the inflation rate, that the Fed sets the benchmark nominal short-term interest rate, that the Fed’s policies are the primary determinant of inflation and inflation expectations over the longer term, and that inflation trends affect interest rates. Also, the Fed clearly attempts to influence the prospects for economic growth. So, by Bernanke’s own admission the Fed exerts considerable control over the “real” interest rate. In other words, he contradicts himself.

A bit further down the page he states: “…[the Fed's] task amounts to using its influence over market interest rates to push those rates toward levels consistent with the equilibrium rate, or — more realistically — its best estimate of the equilibrium rate, which is not directly observable.” And: “[the Fed] must try to push market rates toward levels consistent with the underlying equilibrium rate.

So, having said in the fourth paragraph that the Fed has minimal control over the real interest rate and then contradicting himself by saying that the Fed controls or influences pretty much everything that goes into determining the real interest rate, he subsequently says that the Fed’s task is to push the market interest rate towards the “equilibrium rate”, which, by the way, is unobservable. Now, the so-called “equilibrium rate” is the REAL interest rate consistent with optimum usage of resources. In other words, he’s now saying that the Fed’s task is to push the REAL market interest rate as close as possible to an unobservable/unknowable “equilibrium rate”, having started out by claiming that the Fed doesn’t determine the real interest rate. I wish he would at least keep his story straight!

As an aside, the equilibrium rate is the rate that would bring the supply of and demand for money, capital and other resources into balance, which is the real rate that would be sought by the market in the absence of the Fed. In other words, if the Fed did its job to perfection, which is not possible, then it would be constantly adjusting its monetary levers to ensure that the market interest rate was where it would be if the Fed didn’t exist.

Bernanke goes on to say that today’s US interest rates aren’t artificially low, they are naturally low. Apparently, the Fed’s ultra-low interest rate setting is a reflection of a naturally-low interest-rate environment, not the other way around. This prompts the question: Why, then, can’t the Fed just get out of the way? To put it another way, if default-free nominal interest rates would be near zero and real interest rates would be negative in the absence of the Fed’s gigantic boot, then why can’t the Fed allow interest rates to be controlled by market forces?

It seems that Bernanke cleverly anticipated this line of thinking, because in a beautiful example of circular logic he says “The Fed’s actions determine the money supply and thus short-term interest rates; it [therefore] has no choice but to set the short-term interest rate somewhere.” That is, the Fed can’t leave the short-term interest rate alone, because if the Fed exists it will inevitably act in a way that alters the short-term interest rate. Clearly, Ben Bernanke can’t even imagine a world in which there is no central bank.

Ben Bernanke ends his post by putting aside all the talk in paragraphs 5 through 9 about the Fed’s efforts to control the real market interest rate and by reiterating his comment (from paragraph 4) that the Fed doesn’t determine the real interest rate. As a final piece of evidence he notes that interest rates are low throughout the world, not just in the US, but forgets to mention that central banks throughout the world are behaving the same way as the Fed.

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If Keynesians were consistent they’d be Communists

March 30, 2015

If the free market can’t be trusted to set the most important price in the economy (the price of credit) and if government intervention can help the economy work better, then total government control of the economy must be the optimum situation. Therefore, if Keynesians were consistent they’d advocate for either Communism or Fascism.

In practical terms, Keynesian economics, which is the type of economics that dominates policy-making throughout the world today, involves using monetary and fiscal policy to ‘manage’ the economy. The overarching idea is that a free market is inherently unstable and that by modulating interest rates and something called “aggregate demand” the government can keep the economy on a smooth upward path. The fact that the results of putting this idea into practice have typically been the opposite of what was predicted doesn’t, according the Keynesians, indicate a major flaw in the underlying concept; it just means that the right people weren’t in charge.

Anyhow, the purpose of this post isn’t to argue against Keynesian economic theories, it’s to make the point that completely logical proponents of these theories would recommend a Communist or a Fascist political system. The reason is that these are the political systems that are most consistent with Keynesian economic theory.

As an aside, I’m applying the word “theory” very loosely to what the Keynesians believe, because what they believe is not encompassed by a coherent set of principles. It is more like an endless stream of anecdotes than a theory. Actually, it is a bit like Elliot Wave (EW) analysis. In the same way that EW analysis can always explain what happened in the past but is not useful when it comes to explaining the present or making predictions, Keynesians are always able to come up with an anecdote that explains why historical performance, while seemingly being totally at odds with their theories, fits perfectly into their theoretical construct after the special set of circumstances associated with the time period in question is taken into account. Since there are special circumstances associated with every period, Keynesians will always be able to come up with anecdotal explanations for why things didn’t pan out as expected. There is never any perceived need to question the underlying ideas.

Getting back to my point, consider the control of interest rates by a central planning agency called the Central Bank. All Keynesians (and pretty much everyone apart from the “Austrians”) believe this price-setting power to be not only legitimate and appropriate, but also necessary to facilitate the smooth running of the economy. OK, but given that the price of credit is influenced by a greater number of variables than any other price and would therefore be the most difficult price for a central planner to get right, if central planners can do a better job of setting interest rates than a free market then it stands to reason that central planners could do a better job than the free market of setting all prices. Therefore, anyone who claims that it is right that a central bank controls interest rates would, if they were being consistent, also claim that similar agencies should be established to control all other prices.

Now consider the Keynesian notion that the government should modulate “aggregate demand” to create a more stable economy. The thinking here is that 1) a free-market-economy periodically gets ahead of itself and then plunges into an abyss, 2) dramatic economic oscillations are caused by largely unfathomable changes in “aggregate demand”, with the devastating downswing the result of a mysterious collapse in “aggregate demand”, and 3) by adding and removing demand via its own spending, the government can smooth the transition from one boom to the next. In effect, the economy is treated as if it were a swimming pool that sometimes, for no well-defined reason, loses a lot of water, while the government is treated as if it were an institution capable of replenishing the water, even though in the real world the government has no water of its own.

If the economy really were like an amorphous mass of liquid that could be manipulated, via changes in government spending, in whatever direction was needed at the time to create the optimum outcome, then total government control of the economy would definitely work.

The upshot is that if uber-Keynesian Paul Krugman went on television and argued in favour of a Soviet-style system, he would be taking his economic principles to their natural political conclusions. In doing so he would be totally logical. He would be totally consistent. And he would be totally discredited.

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Why were the Commercials so wrong about the euro?

March 27, 2015

This post is a slightly-modified excerpt from a recent TSI commentary.

The following chart shows that Commercial traders, as a group, were heavily net-long euro futures almost all of the way down (the blue bars indicate the net-position of the Commercials). Since the Commercials are reputedly the “smart money”, how could they have been so wrong?

The answer is that they weren’t wrong. Here’s why.

First, if large speculators and small traders are lumped together under a category labeled “speculators”, then the commercial net-position is simply the mathematical offset of the speculative net-position. If speculators, as a group, are net long to the tune of X contracts, then commercials, as a group, will be net short to the tune of X contracts. Second, in the currency market and also in the gold market (gold trades like a currency), speculators drive short-term price moves. This is evidenced by the fact that speculators (as a group) become increasingly ‘long’ as the price rises and then become increasingly less long, or short, as the price declines.

Due to the fact that every long position in the futures market must be associated with a short position (it’s a zero-sum game), speculators cannot increase their long exposure in the futures market unless commercials increase their short exposure by exactly the same amount. To put it another way, it would not be possible for speculators to drive the price upward by going ‘long’ if there weren’t commercials prepared to take the other side of the trade and ‘go short’, and it would not be possible for speculators to go short or liquidate their long positions unless commercials were prepared to go long or exit their short positions.

Looking at it from a different angle, it would not be possible for commercials to hedge their long exposure in the cash market by going short in the futures market unless speculators were prepared to do the opposite (go long) in the futures market, and it would not be possible for commercials to hedge their short exposure in the cash market by going long in the futures market unless speculators were prepared to do the opposite.

Both commercials and speculators are needed to establish a liquid futures market. The speculators create the opportunity for commercials to do what they do, which is to hedge by selling into strength and buying into weakness, and the commercials create the opportunity for speculators to do what they do — speculate on price direction.

That’s why the relentless complaining in some quarters about commercial short selling of gold futures and other precious-metals futures is so silly. Complaining about a large commercial net-short position is the same as complaining about a large speculative net-long position, because they are two sides of the same coin — you can’t have one without the other. Limit the extent to which the commercials can go short and you also limit the extent to which speculators can go long.

Getting back to the euro futures market, it’s not correct to say that the commercials have been wrong, because a substantial commercial net-long position in the futures market does not imply that the commercials are betting on a rising euro. In general, the commercials don’t bet on price direction; that’s what speculators do.

In the euro futures market the commercials weren’t wrong, but it’s fair to say that speculators, as a group, were very right all the way down. That’s unusual. The Commitments of Traders (COT) situation is nothing more than a sentiment indicator, and it’s rare for speculative sentiment to reach either a bullish or a bearish extreme and for the price to continue in the direction expected by speculators with almost no interruption for many months thereafter. So rare, in fact, that I can’t recall ever seeing it before.

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Expensive Copper

March 25, 2015

Considering the overall commodity backdrop, the recent sharp rebounds in base metal prices and the copper price in particular are both interesting and incongruous.

Under the heading “Copper Bottom” in a TSI commentary a few days ago I discussed last week’s upward reversals in the copper price and the Industrial Metals Index (GYX). I assumed, at the time, that last week’s price gains were partly due to the risk that supply would be disrupted by the blockade of Freeport’s massive Grasberg copper mine in Indonesia, and therefore that the removal of this risk at the end of last week would result in some of the price gains being given back this week. Strangely, however, the copper price spiked higher at the beginning of this week and briefly challenged the bottom of the major $2.90-$3.00 resistance range before pulling back to the high-$2.70s (a few cents above last week’s closing level). It seems that games are being played by large-scale participants in this market.

I plan to write some more about copper later this week at TSI, but at this time I wanted to point out that the bearish participants in the copper market have relative valuation on their side. As illustrated by the following charts, the copper price is presently at a multi-decade high relative to the CRB Index and at its highest level since 1998 relative to oil.



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Gold’s price should be consistent with the prices of other things

March 23, 2015

A recent Mineweb article comments: “…it does seem to be odd that given the huge undisputed flows of physical gold from West to East that the gold price has performed so badly over the past few years.” Actually, no, it doesn’t seem odd at all, since the flow of gold from sellers in one part of the world to buyers in another part of the world suggests nothing about the price. A net flow of gold from “West” to “East” is not inherently bullish and a net flow of gold from “East” to “West” would not be inherently bearish. Through bull markets and bear markets, some individuals, parts of the market and regions of the world will be net buyers and other individuals, parts of the market and regions of the world will be net sellers. Anyhow, the main purpose of this post isn’t to rehash the concept that the volume of gold being transferred between sellers and buyers contains no information about the past or likely future change in the gold price, it’s to make the point that gold’s price must bear some resemblance to the prices of other useful commodities.

Due to its nature, including its traditional role as a store of value, gold is capable of trending upward in price while most other commodities are trending downward in price. However, there are limits that have been defined by the historical record.

One of these limits is 26 barrels of oil. The historical record tells us that gold is very expensive relative to oil when the gold/oil ratio moves above 26. Even at the crescendo of the 2008-2009 Global Financial Crisis, when the fundamental backdrop was as bullish as it ever gets for gold relative to oil, the gold/oil ratio didn’t rise above 28. And yet, in January of this year the ratio got as high as 29. This was the highest since 1988 and not far from a 40-year high.

In other words, gold was so expensive relative to oil earlier this year that it would have made no sense to expect significant additional gains in the US$ gold price without a substantial recovery in the US$ oil price.

It’s a similar situation with many other commodities. For example, the following two charts show that a proxy for agricultural commodities and a proxy for commodities in general came within spitting distance of their respective 2008-2009 financial-crisis lows last week. Given that gold is presently trading about 70% above its 2008-2009 low, the appropriate question isn’t “why has gold performed so badly?” it’s “why has gold held up so well?”. I think it’s because there are plenty of well-heeled people in the world who are aware of the eventual consequences of the current monetary experiments and are buying gold as a form of insurance.

My point is that although some of gold’s most important fundamental price drivers are unique to gold, the gold price should never become completely divorced from the prices of other useful commodities. Considering the prices of other commodities, it would make no sense for the gold price to be substantially higher than it is today.

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Ignore per-ounce valuations for gold deposits

March 18, 2015

During 2001-2011, buying exploration-stage gold stocks with large in-ground resources at low per-ounce valuations worked well. It worked well because ‘the market’ was often more concerned about leverage and quantity than economic viability and quality. Since 2012, however, buying an exploration-stage gold-mining stock on the sole basis that owning the stock gave you relatively low-cost exposure to a lot of in-ground gold has generally not worked well, to put it mildly. For the past three years, one of the most important rules to be followed by value-oriented speculators in gold-mining stocks has been: if it ain’t economic, it ain’t worth anything. This rule will probably apply for at least two more years.

Here’s a specific example to illustrate how the per-ounce market value of an exploration-stage gold-mining stock can be very misleading.

At the closing stock prices on Tuesday 17th March, I estimate that the 1M ounces of Measured-and-Indicated (M&I) in-ground gold owned by Dalradian Resources (DNA.TO) were being valued by the market at around US$80/ounce and that the 15.7M ounces of M&I in-ground gold owned by International Tower Hill Mines (THM, ITH.TO) were being valued by the market at around US$2/oz (taking into account the net cash of the companies). This simple comparison suggests that THM offers much better value than DNA.TO, but this isn’t the case.

Based on the economic studies that have been completed to date by each company, I think that DNA offers the better value. The reason is that DNA’s deposit is economically robust at $1200/oz whereas THM’s deposit would require a gold price of more than $2000/oz just to become economically viable. Any gold deposit that currently needs a gold price of at least $2000/oz to become viable will never be worth anything, because by the time gold rises to $2000/oz, which it very likely will within the next 5 years, the deposit that needed a price of $2000/oz to be viable in early-2015 will probably need a gold price of $2500-$3000/oz to be viable.

Now, it’s certainly possible that THM will come up with a totally different mine design that enables the project to become viable at a much lower gold price. However, that’s a long shot. Based on what’s known today about the economics of THM’s Livengood project, the project’s appropriate per-ounce valuation is zero.

I’m not saying that buyers of THM won’t make money. THM and other gold stocks with blatantly uneconomic deposits will be bought during gold rallies and are capable of delivering large percentage gains in quick time. For example, THM’s stock price more than tripled from its Q4-2013 bottom to its Q1-2014 peak and almost doubled from its December-2014 bottom to its January-2015 peak. That is, stocks like this can still work well as short-term trades, despite the reality that their mining assets aren’t worth anything.

The important thing is not to kid yourself that an extremely low per-ounce valuation necessarily means that you are getting an excellent deal.

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Interesting US oil-production and price-inflation charts

March 16, 2015

An article by Wolf Richter contains some interesting charts showing the response of the US oil industry to the huge decline in the oil price. Two of these charts are displayed below.

The first chart shows that there has been a collapse in the rig count (the number of drilling rigs in operation), which is not surprising considering the magnitude of the price decline. It also shows that the daily oil production rate has continued to climb and has just hit a new all-time high, which is a little surprising.

The second chart shows that with flagging oil demand and the on-going upward trend in oil supply, the amount of oil in storage in the US has moved sharply higher and is now about 21% above the year-ago level.

Can the oil price bottom while supply/demand fundamentals are becoming increasingly bearish? The answer is yes, because the market is always trying to look ahead. However, at this time there is no evidence in the price action of a bottom.



A WSJ blog post by Josh Zumbrun contains charts suggesting that an upward reversal in US consumer prices is underway. The evidence is in data compiled by the “Billion Prices Project”, which “scrapes the Internet daily to capture changing prices online and has often foreshadowed subsequent changes in official price indexes.

Here is one of several interesting charts from the above-linked post. The “PriceStats” index is calculated by the Billion Prices Project. Based on past performance, the turn that’s showing up in the PriceStats daily index probably won’t be captured by official measures of “inflation” until reports in late April.

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Danger, data-mining ahead!

March 14, 2015

Depending on how it is manipulated, presented or interpreted, a set of data can be used to validate almost any theory or conclusion. For example, as I explained HERE, by changing the starting assumption the intraday London gold price data can be used to ‘prove’ either long-term suppression of the gold price or long-term elevation of the gold price. For another example, as I showed HERE, by cherry-picking the timescale of the data it is possible to demonstrate a relationship (in this case a relationship between the gold price and the US federal-debt/GDP ratio) that wouldn’t be apparent if a different timescale were chosen. I’ll now discuss a new example that was part of a 12th March article at

I agree with the gist of the above-linked Marketwatch article, which is that the US stock market is stretched to the upside in a big way. However, the chart used in the article to make this point is a great example of data mining. Here is the chart.

The chart uses a 6-year rate of change (ROC) to suggest that the US stock market is almost as extended to the upside as it was at the top of the late-1990s mania, but why a 6-year ROC? Why not a 7-year or a 5-year ROC?

The answer is that only a 6-year ROC creates the impression that the author wants. A chart showing a 7-year ROC, for example, would actually appear to support an opposing view — that the market is not remotely stretched to the upside. As evidence I present the following chart of the Dow’s 7-year ROC. It makes the market look cheap!


The reason that the 6-year ROC works so well to support the view that the market is dramatically extended to the upside is that the bottom of the major 2007-2009 bear market occurred exactly 6 years ago. What you are seeing in the past year’s spectacular rise in the market’s 6-year ROC is the reverse of the 2008-2009 crash. Even if the US stock market had traded sideways over the past year, the extraordinary market collapse of 2008-2009 would have ensured a moonshot in the 6-year ROC.

To put it another way, the near-vertical rise in the 6-year ROC over the past 12 months reflects the waterfall decline that happened many years ago. It does not reflect a manic upside blow-off in the current market.

If the market trades sideways from here then a year from now the 7-year ROC will show the moonshot that the 6-year ROC currently shows.

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Debunking the “London Bias” gold manipulation story

March 10, 2015

Some commentators who claim that the gold price has been relentlessly and successfully suppressed over many decades cite something they call the “London Bias” to support their claim. For example, a recent article by Ed Steer puts the London Bias forward as evidence of long-term price suppression. However, what the so-called “London Bias” actually proves is that some pundits who want to present evidence of unidirectional price manipulation are not above using data manipulation. As I’ve previously said, by carefully mining the data you can ‘validate’ almost any theory, even the most cockamamie one.

The idea behind the London Bias is that there is a tendency for the London PM gold fix to be lower than the London AM gold fix. The result is that you would have lost money almost every year, through gold bull markets and gold bear markets, by simply buying a position at the London gold AM Fix every day and selling the position at the London PM Fix the same day. More specifically, here’s how it’s described in the above-linked article:

…if you invested $100 at the London a.m. gold fix on January 2, 1970, sold your position at the London p.m. gold fix the same day, then reinvested the proceeds the next day at the London a.m. fix and sold at the p.m. fix once again — and did that every business day for 45 years in a row — you’d have had the magnificent sum of $12.13 in your trading account at the close of business on February 27, 2015.

…from January 2, 1975 going forward and with the exception of only a couple of years between 1975 and 1980, the yearly London price bias in gold has been negative ever since — for more than two generations. In other words, since January 2, 1975 — and with the very odd exception in the interim — the gold price has closed for a loss between the London a.m. and p.m. gold fixes for 40 years in a row regardless of what was happening in the overall gold market.

The blue line on the following chart illustrates how someone would have fared if they had started with $100 and then bought/sold at the daily fixes as described above. The yellow line on the chart is the US$ gold price.

Can anyone spot the problem with the assertion that the “London Bias” proves long-term downward manipulation of the gold price?

There’s more than one problem, but the main one is that exactly the same data could be used to prove long-term UPWARD manipulation of the gold price. Here’s why:

The assumption underlying the claim that the London Bias shows relentless downward manipulation is that the London AM Fix is the right price and that downward manipulation regularly occurs between the two fixes, leading to the London PM Fix consistently being lower than it should be. This assumption is groundless. An equally valid (meaning: equally groundless) assumption would be that the London PM Fix is the right price and that upward manipulation occurs between the two fixes, leading to the London AM Fix consistently being higher than it should be. In this case the logic would be that the manipulators get to work boosting the gold price during the relatively thin trading hours, leading to an artificially high London AM fix, and that the price settles back to its correct level during the higher-volume trading hours.

Based on the second assumption, a chart could be constructed to illustrate the financial extent of the upward manipulation. The chart would assume that $100 was invested at the London PM gold fix on January 2, 1970, and sold at the London AM gold fix the following day, with the proceeds then reinvested later that day at the London PM fix, and so on, for every business day for 45 years in a row. The chart would show a huge return on investment thanks to the positive “London Bias”.

The point is that depending on your starting assumption, the same London gold-price data could be used to illustrate long-term price suppression or long-term price elevation. That is, you could assume that there is a negative bias in the PM Fix or you could just as validly/invalidly assume that there is a positive bias in the AM Fix. Alternatively, you could assume that the data is indicative of a market characteristic that has nothing to do with manipulation in either direction.

Clearly, there are people analysing the gold market who have a very strong belief that a successful, long-term price suppression scheme has been operated in this market. These people are eager to interpret data in a way that supports their belief. This is a bias that YOU should be aware of.

You can obviously choose to believe whatever you want, but if you choose to believe that powerful forces have both the motivation and the ability to suppress the gold price over the long term then it would be irrational of you to be involved in the gold market on the ‘long’ side. So, why are you?

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Tightening without tightening (or why the Fed pays interest on bank reserves)

March 9, 2015

When the Fed gave itself the ability to pay interest on bank reserves, it gave itself the ability to hike its targeted short-term interest rate (the Fed Funds rate) without tightening monetary conditions. In other words, it gave itself the ability to tighten monetary policy in the eyes of the world without actually tightening monetary policy. That’s one reason why it’s absurd that almost everyone involved in the financial markets is intensely focused on the timing of the Fed’s first 0.25% upward adjustment in the Funds Rate. It’s not only that a 0.25% increase is trivial, but also that, thanks to the payment of interest on bank reserves, it will almost certainly be implemented without making the monetary backdrop any less ‘accommodative’.

I’ve dealt with this topic a number of times at TSI, most recently last week. Here’s what I wrote last week under the heading “Why the Fed pays interest on bank reserves”:

“The Fed’s reason for paying interest on bank reserves has been addressed in previous TSI commentaries, but it’s an important issue and worthy of additional commentary space. That’s especially so because there is so much confusion surrounding the issue. In particular, the actual reason for the interest payments is at odds with the beliefs/assumptions of many journalists, newsletter writers and other commentators on financial matters.

Before getting to the real reason we’ll deal with the two most common false beliefs. The first of these is that the Fed started paying interest on bank reserves to prevent the commercial banks from rapidly expanding their loan books in reaction to the Fed-generated ballooning of reserves from Q4-2008 onwards. The second is that the main purpose of the interest payments is to provide financial support to the banks.

There is no truth to the first belief, because the interest payments on reserves have no effect on either the ability or the willingness of banks to make loans. The facts are that a) reserves cannot be loaned into the economy, b) there has been no relationship between US bank reserves and US bank lending for decades, and c) even if the amount of bank lending were influenced by the level of reserves as wrongly explained in outdated economics textbooks, an increase in a bank’s lending would not affect the amount of interest earned by the bank on its reserves. This last point is due to the fact that an increase in a bank’s loan book could shift reserves from the “excess” to the “required” category, but wouldn’t affect its total reserves. The Fed, however, pays interest on ALL reserves, not just “excess” reserves.

There is some truth to the second belief in that the payment of interest on reserves does provide some additional income to the banks. However, even with today’s massive reserve levels the financial impact on the banks is trivial (at the current interest rate we are talking about $6B/year of reserve-related interest payments across the entire banking industry, which is a veritable drop in the ocean).

The real reason that the Fed began paying interest on bank reserves in late-2008 was to enable it to maintain control of the Fed Funds Rate (the overnight interest rate on reserves in the inter-bank market and the primary rate targeted by Fed monetary policy) while it pumped huge volumes of dollars into the economy and into the reserve accounts of banks.

To further explain, prior to the extraordinary measures taken by the Fed in late-2008 in reaction to the global financial crisis, the Fed Funds Rate (FFR) could be adjusted by making small changes to reserves. However, after the Fed began pumping hundreds of billions of dollars of reserves into the banks, the central bank was in danger of losing its ability to control the FFR. With the commercial banks inundated with reserves and with plans in place for additional rapid monetary expansion, it became clear to the Fed that even maintaining an extremely low FFR of 0.25% was going to be impossible. Furthermore, the Fed was thinking ahead to the time when it would have to start hiking the FFR. With reserve levels way in excess of what they needed to be to set the FFR at 0.25%, even the superficially minor task of pushing the FFR back up to 0.50% would, under the Fed’s traditional way of operating, necessitate a large-enough contraction of bank reserves and the money supply to bring about another financial crisis.

Think of it this way: In October of 2008 the FFR was at 1% and the total level of US bank reserves was $315B. This suggests that $315B was consistent with an FFR of 1%. Today, the total level of bank reserves is about $2.5T. The implication is that to get the FFR back up to 1% the Fed would have to remove about $2.2T of covered money ($2.2T of money ‘backed’ by $2.2T of bank reserves) from the US economy, but there is no way that it could remove that amount without crashing the financial markets and the economy. Actually, we doubt that it could even remove a quarter of that sum without precipitating a stock market collapse and a severe recession.

This problem was obvious to Bernanke, and his solution was to pay interest on reserves. With this new tool in its kit the Fed gained the ability to set the FFR at whatever level it wanted without adjusting bank reserves and the economy-wide money supply. For example, if the Fed decides in the future that it wants the FFR at 1%, it could achieve this target by simply changing the interest rate on reserves to 1% while leaving reserve and money-supply quantities untouched.

A likely ramification of the Fed’s ability to control the FFR via the interest rate on bank reserves is that the Fed’s balance sheet has reached a permanently high plateau. There will be no traditional tightening of monetary policy in the foreseeable future.”

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Price manipulation is not inherently wrong

March 6, 2015

The Wall Street Journal recently broke the story that there is evidence of banks attempting to manipulate the prices of gold and other precious metals. In other breaking news, evidence has emerged that the Earth revolves around the sun, that the Pope is Catholic, and that bears sometimes defecate in the woods.

Kid Dynamite is happy that regulators are finally taking note, as he has studiously documented evidence of upward manipulation of the gold price for years, to seemingly no avail. Actually, what he has done is show that the same sorts of price/volume changes in the gold futures market that are routinely put forward to ‘prove’ downward manipulation can also be used to ‘prove’ upward manipulation. By carefully mining the data it is possible to validate almost any theory, even a ridiculous one.

In any case, my purpose in writing this post is not to delve into the murky world of gold-market manipulation theories, but to point out that “manipulation” is often a poorly chosen word. To manipulate is to skillfully influence or change to one’s advantage. As such, manipulation could be a legitimate business practice. In the financial markets, for example, there is generally nothing ethically wrong with a private (meaning: non-government) trader buying or selling with the aim of influencing the price. Trading with the express purpose of driving the price up or down will usually not lead to a profit, but one person’s reasons for buying or selling are not the business of anyone else.

“Manipulation” therefore doesn’t imply “wrong” or “unfair”. Other words must consequently be used to distinguish between the manipulation that could form part of legitimate business practice and the manipulation that involves a violation of property rights and/or a breach of fiduciary duty. Fraud is a good word. For example, if banks siphon money from their customers to themselves by front-running their customers’ orders or by misusing information given to them in confidence by their customers, as was alleged in a lawsuit filed by a jewellery firm last November, then the banks are engaging in fraud, not just manipulation.

Manipulation is not inherently wrong. Fraud, by definition, is.

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Total guesswork regarding China’s gold holdings

March 3, 2015

Last year I noticed an article by Alasdair Macleod containing an estimate that China (meaning: China’s government) had accumulated 25,000 tonnes of gold between 1983 and 2002. I would say that this estimate was based on rank speculation, but that would be doing an injustice to rank speculation. It is more like total guesswork. It is largely based on assumptions that are either obviously wrong or that have no supporting evidence. I bring this up now because it looks like the 25,000-tonne figure that was plucked out of the air by Mr. Macleod last year is on its way to becoming an accepted fact in some quarters. For example, it forms the basis of a new estimate that China’s government now has 30,000 tonnes of gold.

Here’s the supply/demand table from Mr. Macleod’s article. The top section of the table purports to show the total amount of gold supply that was created during 1983-2002 and the bottom part of the table shows guesses on how this supply was distributed around the world. If the top section contains figures that are either based on false logic or completely lacking in evidentiary support, which is definitely the case, then the figures in the bottom section are irrelevant. That’s because the figures in the bottom section have been chosen so that they add up to the figures in the top section.

Gold Supply 31102014.jpg

The most obvious error is the assumption that because gold was in a secular bearish trend during 1983-2002, there was no net buying of gold within the Western world over this entire period. Instead, it is assumed that not a single ounce of the 42,000 tonnes of gold that was produced by the global mining industry during this period was bought by anyone in Europe or North America. It is also assumed that the “West” reduced its collective gold holdings by 15,000 tonnes during the period.

This takes me back to a point I’ve made many times in the past in relation to similar misguided analyses of the gold market. The point is that the quantity of gold (or anything else, for that matter) transferred from sellers to buyers says nothing about price. The corollary is that price says nothing about how much was transferred.

The fact that the price of gold was making lower-highs and lower-lows during 1983-2002 does not imply that less gold was bought in the “West”. In fact, it’s just as likely that the opposite was the case — that sellers, including gold miners, had to lower their asking prices to account for the reduced eagerness to own gold and sell what they wanted to sell. It’s therefore quite possible that there was no net “Western” divestment of gold and that all of the gold produced during 1983-2002 was sold in the “West”.

I’m not claiming that all of the gold produced by the mining industry during 1983-2002 was sold to Western buyers, but such a claim would be no more ridiculous than Mr. Macleod’s guess that none of the newly mined gold was sold to Western buyers.

I’ll end this discussion by reiterating that even if you have enough information to do the additions accurately (which nobody ever will, by the way), there is no point adding up the amounts of gold being transferred between sellers and buyers in different geographical regions or different parts of the market. At least, there’s no point if explanations of past price movements and clues regarding future price movements are what you want. There could, however, be a point if your aim is to find a justification for being bullish no matter what’s happening in the world.

I should probably do a separate blog post titled “Total guesswork regarding China’s gold strategy”.

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Revisiting the global boom/bust indicator

March 2, 2015

This post is a slightly-modified excerpt from a recent TSI commentary.

Gold tends to fare relatively poorly during the booms, which are periods when confidence in central banks and the economy rises at the same time as mal-investment is setting the stage for a future period of great hardship, and fare relatively well during the busts, which are periods when the investing mistakes of the past come to the fore. Be aware, though, that the word “relatively” is critical to understanding gold’s relationship to the boom/bust cycle, because the relationship often doesn’t apply to gold’s performance in US$ terms.

To show what I mean I’ll begin with a chart of the US$ gold price covering the past 20 years. There were booms and busts during this period that are not evident on this chart. In particular, 2001-2011 contained huge booms and busts, and yet the gold price trended steadily upward throughout. How could this be?

Armed with the 20/20 vision called hindsight, analysts who did not expect the large 2001-2011 rise in the US$ gold price and who were completely baffled by it while it was happening eventually came up with explanations/rationalisations for it. Some of the most popular explanations involved identifying other things that trended relentlessly upward during the 2001-2011 period and assuming that the rise in this other ‘thing’ caused the rise in the gold price.

For one example, prior to the past two years it was possible to create a chart that demonstrated a strong positive correlation between the gold price and the US federal-debt/GDP ratio, provided that you started your chart in the early-2000s (starting the chart much earlier would reveal that there was actually no consistent relationship between gold and the debt-GDP ratio*). For a second example, prior to the past two years it was also possible to create a chart that demonstrated a strong positive correlation between the gold price and the US Monetary Base, again provided that you started your chart in the early-2000s (as is the case with the supposed relationship between the gold price and the debt/GDP ratio, the relationship between gold and the US Monetary Base disappears when a longer-term view is taken**). For a third example, some analysts belatedly linked the 2001-2011 upward trend and subsequent downward reversal in the gold price to the goings-on in the “emerging” economies. This explanation is a top contender for the “grasping at straws” award, since, unlike the linking of gold to the debt/GDP ratio or the Monetary Base, it has absolutely no logical basis. Not only that, but the net buying of gold by India, China and Russia, the three most important “emerging” markets, was greater when the gold price was trending downward during 2012-2014 than when the gold price was trending upward during 2009-2011.

As intimated in the opening paragraph, the overarching driver of the gold price (the boom/bust cycle) only becomes clear when gold’s RELATIVE performance is viewed. More specifically, understanding why gold did what it did over a long period requires looking at how it performed relative to industrial metals.

The fact is that the gold market is generally weak relative to the industrial metals markets during the boom phase of the inflation-fueled, central-bank-sponsored boom/bust cycle and strong relative to the industrial metals markets during the bust phase of the cycle. In other words, the gold/GYX ratio (gold relative to the Industrial Metals Index) tends to fall during the booms and rise during the busts. This is due to gold’s historical role as a store of purchasing power and a hedge against uncertainty.

By shading the bust periods in grey, I’ve indicated the global booms and busts on the following chart of the gold/GYX ratio. During the 20-year period covered by this chart there were four busts: the multiple crises of 1997-1998 (the Asian financial crisis, the Russian debt default and the LTCM blowup), the recession of 2001-2002 that followed the bursting of the NASDAQ bubble, the global financial crisis and “great recession” of 2007-2009, and the euro-zone sovereign debt and banking crisis of 2011-2012. On a relative basis gold was clearly very strong during the busts and generally drifted lower during the intervening periods when confidence was rising.

Note that monetary-inflation-fueled booms tend to fall apart more quickly than they build up, which is why the rising trends in the gold/GYX ratio tend to be shorter and steeper than the falling trends.

When gold/GYX made a new multi-year low last October it indicated that the global boom was going to extend into 2015, which it has certainly done. However, gold/GYX’s sharp rise from its November-2014 low to its January-2015 high could be an early warning that the boom is on its last legs.

Gold/GYX has pulled back far enough from its January peak that a solid break above that peak would now be a clear signal that the boom has ended or is about to end.

*Refer to for additional information

**Refer to for additional information

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