Blog 2 Columns

It is widely believed that silver leads gold during bull markets for these metals. I wonder how this belief first arose and persists to this day given that it is contrary to the historical record.

It is partially true that silver outperforms gold during precious-metals bull markets. In particular, it’s true that silver tends to achieve a greater percentage gain than gold from bull-market start to bull-market end. It’s also the case that silver tends to do better during the final year of a cyclical bull market and during the late stages of the intermediate-term rallies that happen within cyclical bull markets. However, the early stages of gold-silver bull markets are characterised by relative strength in gold.

Gold’s leadership in the early stages of bull markets is evidenced by the following long-term chart of the gold/silver ratio. The boxes labeled A, B and C on this chart indicate the first two years of the cyclical precious-metals bull markets of 1971-1974, 1976-1980 and 2001-2011, respectively. Clearly, gold handily outperformed silver during the first two years of each of the last three cyclical precious-metals bull markets that occurred within secular bull markets.

Now, in the same way that all poodles are dogs but not all dogs are poodles, the fact that gold tends to strengthen relative to silver in the early years of a precious-metals bull market doesn’t mean that substantial strength in gold relative to silver is indicative of a precious-metals bull market in its early years. For example, there was relentless strength in gold relative to silver from mid-1983 until early-1991 that took the gold/silver ratio as high as 100, but there was no precious-metals bull market during this period.

Between mid-1983 and early-1991 there was, however, a multi-year period when gold, silver, most other metals and mining stocks offered very profitable trading opportunities on the long side. I’m referring to 1985-1987. We are probably in a similar period today, with the next buying opportunity likely to arrive before the end of this quarter.

The amount of gold mined in a year is only about 1.5% of the total existing stock of gold, which is why changes in gold production have almost no effect on the gold price. It is also why changes in the cost of mining gold do not affect the gold price. In fact, cause and effect works the other way around — the change in the market price of gold determines, with a lag, the average cost of mining gold. To put it another way, the cost of mining gold follows the price of gold.

What happens is that as the gold price rises, mineral deposits or parts of deposits that were previously uneconomic become economic and start being mined. The mining of this lower-grade/higher-cost gold pushes up the average cost of production. And as the gold price falls, lower-grade/higher-cost gold is left in the ground and the average cost of production moves downward. Of course, there are substantial time-lags involved, because it takes years to bring a new mine into production and because mine plans won’t be changed in response to a price trend until the trend has been in progress for long enough to appear sustainable.

Adding to the tendency for the mining cost to follow the price is that after the price has been trending upward for a long period there will be less focus on cost control and more focus on growth, with the opposite being the case after the price has been trending downward for a long period.

Perhaps not surprisingly given that the Bitcoin system was designed to mimic gold in some respects, the relationship between the bitcoin mining cost and the bitcoin price is the same as the relationship between the cost of mining gold and the gold price. That is, the average cost of mining a bitcoin moves up and down with the price. That’s why, several years ago, it was profitable to mine bitcoins when the price was less than $1 and why the average cost of mining a bitcoin has since risen to around US$5,000.

One difference between gold and bitcoin is that the bitcoin mining industry can respond very quickly to changes in price. Whereas it probably will take at least a strong 3-year trend in the gold price to bring about a substantial change in the average cost of mining an ounce of gold, it takes almost no time to put a new bitcoin mining rig into operation and even less time to turn it off.

The way the Bitcoin distributed ledger system is designed, the computational gymnastics that have to be performed to add new blocks to the ‘chain’ and create new bitcoins scale up and down based on the total amount of computing power dedicated to the task. And the amount of computing power dedicated to the task will be dictated by the price. That is, the lower the price the smaller will be the total amount of resource (computing power and electricity) channeled into obtaining the reward of a new bitcoin, thus reducing the difficulty of performing the computations that verify transactions and the associated mining cost.

Therefore, if the price of a bitcoin falls from its current level of around $8,500 to only $100, mining bitcoins will remain a profitable business. It’s just that the quantity of resources being consumed/wasted by the mining process will be a small fraction of what it is today. Alternatively, if the price of a bitcoin skyrockets to $100,000 then the cost of mining bitcoin will also skyrocket, meaning that the quantity of resources being consumed by a process that adds nothing to the general standard of living will be vastly greater than it is today.

Returning to gold, a popular argument is that gold is an inefficient form of money due to the high cost of adding a new ounce to the existing stockpile. However, the relatively high cost of mining an ounce of gold is incurred regardless of whether or not gold is money; it is incurred because humans want to own gold and value it highly.

To further explain, well before gold was used as money, people liked to have it in their possession because of its physical characteristics: its look, feel, weight, malleability and extraordinary resistance to deterioration. In fact, it was the widespread desire to own gold that led to gold becoming money. And now that gold is no longer money (due to government command, not market preference), billions of people still desire it enough to cause the price and the mining cost to be relatively high. Allowing gold to be money again would therefore impose no additional cost.

Bitcoin is obviously different, in that its high price and associated high production cost are due solely to the possibility that it will, at some future time, be widely used as a medium of exchange. I think that the probability of this possibility is close to zero and therefore that the price of a bitcoin will eventually drop to near zero, but at the same time I think that the blockchain idea is brilliant.

The changes to US taxes that were approved late last year have drawn acclaim and criticism, but in most cases both those who view the tax changes positively and those who view the tax changes negatively are missing two important points.

Most criticism of the tax changes boils down to one of three issues. The first is that the tax cuts favour the rich. This is true, but any meaningful tax cut will have to favour the people who pay most of the tax. Furthermore, contrary to the Keynesian belief system a tax cut will bring about the greatest long-term benefit to the overall economy if it favours people who are more likely to save/invest the additional income over people who are more likely to immediately spend the additional income on consumer items.

The second criticism is that corporations, the main beneficiaries of the tax changes, will invest only a minor portion of their additional corporate profit in employment-generating business growth. This criticism is valid as far as it goes, because most large, listed corporations will use the additional income for stock re-purchases and dividend payments, while most small businesses will not be presented with new expansion potential by virtue of receiving a boost to their after-tax profits.

The third area of criticism is that the tax cuts will result in a large increase in the government’s debt, in effect meaning that the government is swapping a promise to steal less money from the private sector in the near future for a promise to steal more money from the private sector in the distant future. Again, this is true.

Those who view the tax changes in a positive light assert that corporate America will respond to the lowered taxes by making large additional investments in growth. Also, some supporters of the tax cuts either invoke the fictitious “Laffer Curve” to argue that the tax cuts will lead to higher government tax revenue and thus pay for themselves or argue that government debt is never repaid and therefore that an increase in government debt doesn’t matter.

While it is certainly true that the US government’s debt will never be repaid it doesn’t follow that an increase in government debt doesn’t matter.

The reason that an increase in government debt always matters, regardless of whether the debt ever gets repaid in full or even in part, is that unless the debt investors have access to a virtual printing press then every additional dollar invested in government debt implies a dollar less invested in the private sector. It must be this way because the dollars that are invested in government debt have to come from somewhere. If they aren’t being created out of nothing by the central bank or a commercial bank* then they must be drawn away from alternative investments. For example, if the recently-implemented US tax cuts resulted in $1T being added to the total US government debt burden over the next 5 years then an effect of the tax cuts over this period would be a $1T reduction in investment in the private sector. This $1T reduction in investment would be offset by whatever additional investment was stimulated by the increased incomes of corporations and high-net-worth individuals, but it would be only a partial offset because the beneficiaries of the tax cuts would invest much less than 100% of their additional income.

In other words, deficit-funded tax cuts result in a net reduction in productive investment. This, not the increase in the government debt per se, is an important point that is being missed by almost everyone.

The other important point that is generally being missed is that the US federal government’s tax revenue is likely to be greater in the 2018 than it was in 2017, leading to a reduced government deficit. There are two reasons for this. First, regardless of whether or not retained corporate profits held outside the US are repatriated, corporate America will have to foot a large repatriation tax bill in 2018. This should either fully or mostly offset any tax benefit collectively received by corporations in 2018. Second, the monetary-inflation-fueled economic boom should continue for another two quarters at least, giving a hefty boost to capital-gains tax payments.

The increase in the government’s tax revenue during the first year of the new tax regime will undoubtedly prompt the fans of the Laffer Curve to give themselves public pats on the back, but it’s likely that 2018′s reduced government deficit will be followed by an explosive rise in the deficit during 2019-2020 as revenues collapse in response to the combination of lower tax rates and an economic recession.

*The outcome would be different if the dollars invested in government debt were created out of nothing. Instead of the increased investment in government debt being ‘funded’ by reduced investment in the private sector (corporate bonds, etc.), the new money would cause price distortions and promote bubble activities. The short-term consequences would be superficially positive, but the long-term consequences would be dire.

A press release from Apple last week generated a lot of excitement about the new investments in the US that will be stimulated by Trump’s tax cuts, but it seems to me that apart from paying $38B of extra tax Apple is not planning to do anything that it wouldn’t have done in the absence of the tax cuts. This is what I gleaned from dissecting the above-linked press release:

1) Apple estimates that the new investment it plans to make over the next 5 years will ‘create’ an additional 20,000 US jobs, but what Apple counts as job creation is hugely different from Apple’s direct employment. Specifically, the company employs 84,000 people in the US but estimates that it is responsible for creating 2 million US jobs. The non-Apple employees involved in developing new iOS apps account for about 80% of this 2 million jobs number.

2) Additional job ‘creation’ of 20K amounts to only a 1% increase, but how much of this 1% increase is related to the tax cuts? As discussed below, possibly none of it.

3) Apple and other US companies with profits held outside the US are required to pay a one-off repatriation tax regardless of whether or not the profits are repatriated. Apple has stated that it will be making a repatriation tax payment of $38B, but has not stated that it will be bringing any of its overseas money back to the US.

4) Regardless of whether or not Apple shifts some of its foreign-held money to the US it is unlikely that this shift will result in additional capital investment in the US. The reason is that at no time over the past several years were Apple’s US investment plans constrained in any way by inadequate access to cheap financing. In other words, there is unlikely to be a significant change in Apple’s US capital investment plans due to the tax changes.

5) The concluding sentence in the above point is supported by the figures contained in last week’s press release from the company. The press release trumpets “350B contribution to the US economy over the next 5 years”, but goes on to mention that in addition to new investments this $350B includes Apple’s current rate of spending. The current rate of spending is $55B/year, which amounts to $275B over 5 years assuming no “inflation”. Allowing for a small amount of “inflation” would bring the amount up to around $300B. The $350B also includes the $38B repatriation tax, so we can quickly account for about $338B of the planned $350B without allowing anything for ‘new’ investments.

Apple is a great company and it will almost certainly invest heavily in the US economy over the next 5 years, but no more heavily than it would have invested in the absence of the “tax reform”.

Kudos to Apple management for creating the false impression, via a cleverly worded press release, that massive new investment would result from the tax changes. Politically, this was a smart move.

[This post is an excerpt from a commentary posted at TSI about two weeks ago]

Some commentators have made a big deal over the Yuan-denominated oil futures contract that will soon begin trading in Shanghai, but in terms of effect on the global currency market this appears to be a very small deal.

With or without a Yuan-denominated oil futures market there is nothing preventing the suppliers of oil to China from accepting payment in Yuan. In fact, some of the oil imported by China is already paid for in Yuan. Having a Yuan-denominated oil futures contract may encourage some additional oil trading to be done in China’s currency because it would enable suppliers to reduce their risk via hedging, but the main issue is that the Yuan is not a useful currency outside China. Unless an international oil exporter was interested in making a large investment in China, getting paid in Yuan would create a problem of what to do with the Yuan.

In any case, the monetary value of the world’s daily oil consumption is less than 0.1% of daily trading volume on the foreign exchange market, and the foreign exchange market is dominated by the US$. Despite the popular (in some quarters) notion that the US$ is in danger of losing its leading role within the monetary system, at last count the US$ was on one side of 88% of all international transactions. The euro, the world’s other senior fiat currency, was at around 30% (and falling). The Yuan’s share of the global currency market is very small (less than 3%), and according to the following chart could be in a declining trend.

The point we were trying to make in the above paragraph is that a change in how any country pays for its oil imports will not have a big effect on the global currency market. Actually, the cause-effect works the other way around. The pricing of oil in US dollars is not, or at least is no longer, even a small part of the reason that the US$ dominates the global currency system, but the fact that the US$ dominates the global currency system causes most international oil exporters to demand payment in US dollars.

The US$ sometimes rises and sometimes falls in value relative to other currencies, but it always dominates global money flows. Like it or not, that’s the nature of today’s monetary system.

The current monetary system is US$-based and in all likelihood will remain so until it collapses and gets replaced by something different. In other words, it’s unlikely — we almost would go as far as to say impossible — for the current system to persist while another currency gradually superseded the US$. The reason is that there is no viable alternative to the US$ among today’s other major fiat currencies.

We don’t have a strong opinion on what the post-collapse “something different” will be. One possibility is a system based on gold, but there could also be an attempt to create a global fiat currency. The world’s political leadership and financial establishment would certainly favour the latter possibility, but we fail to see how it could work as it would essentially be the botched euro experiment on a much grander scale.

1. According to news reports, unnamed senior government officials in China have recommended slowing or halting the purchase of US Treasury securities.

2. If China’s government really was planning to reduce its investment or rate of investment in US government debt, why would it announce the change beforehand given that doing so would potentially lower the market value of its holdings?

3. The only reason to make the announcement is if there is no intention to implement a change but there is something to be gained by making the threat.

4. Clearly, the announcement is part of a negotiation strategy regarding China-US trade.

5. The reality is that China’s government buys and sells Treasury securities and other international reserve assets as part of its effort to manage (that is, manipulate) the Yuan’s exchange rate. When the Yuan is strengthening, international reserves will be bought — using newly-created local currency — to slow or stop the advance. When the Yuan is weakening, international reserves will be sold to slow the decline. That’s why China’s stash of US Treasury debt trended upward for many years prior to 2014 (when the Yuan was strengthening relative to the US$), trended downward during 2014-2016 (when the Yuan was weakening relative to the US$), and trended upward over the past 12 months (when the Yuan was strengthening relative to the US$).

6. China’s total investment in US Treasury securities was significantly greater 4 years ago than it is today. This is evidenced by the following chart, which shows that the combined Treasury holdings of China and Belgium (Belgium must be added to get the complete picture because that’s where China’s government keeps its custodial accounts) dropped from about 1.65 trillion in early-2014 to 1.2 trillion in May-2017. It’s likely that the holding is now about $100B larger, which implies that China’s government has been a net seller of about $350B of Treasury debt over the past four years.

7. China’s government will continue to do what it has been doing — buy US Treasury debt when it feels the need to weaken the Yuan and sell US Treasury debt when it feels the need to strengthen/support the Yuan.

8. There are good reasons to expect that yields on US T-Bonds and T-Notes will be significantly higher in 6 months’ time, but the recent deliberately-misleading news emanating from China is not one of them.

In a recent newsletter John Mauldin wrote: “It is monetary policy madness to raise rates and undertake quantitative tightening at the same time.” However, this is exactly what the Fed plans to do in 2018. Has the Fed gone mad?

If mad is defined as diverging in an irrational way from normal practice then the answer to the above question is no. The Fed is following the same rule book it has always followed.

It should first be understood that earlier rate-hiking campaigns were always accompanied by quantitative tightening (QT). Otherwise, how could the Fed have caused its targeted interest rate (the Fed Funds rate) to rise? The Fed is powerful, but not powerful enough to command the interest rate to perform in a certain way. Instead, it has always manipulated the rate upward by reducing the supply of reserves to the banking system via a process that also reduces the money supply within the economy; that is, via QT. In other words, far from there being something unusual about the Fed simultaneously raising rates and undertaking QT, it is standard procedure.

What’s unusual about the current cycle is the scale. Having created orders of magnitude more money and bank reserves than normal during the easing part of the cycle the Fed must now implement QT on a much larger scale than ever before. At least, that’s what the Fed must do if it follows its rule book.

A plausible argument can be made that the Fed should now deviate from its rule book, but the argument isn’t that the economy is too weak to cope with tighter monetary policy. The correct argument is that the damage in the form of misdirected investment and resource wastage was done by the earlier quantitative easing (QE) programs and this damage cannot be undone or even mitigated by deflating the money supply. In effect, the incredibly loose monetary policy of 2008-2014 has made a painful economic denouement inevitable. At this point, reducing the money supply — as opposed to stopping the inflation of the money supply, which would be beneficial as it would prevent new mal-investment from being added to the pile — would exacerbate the pain for no good reason.

In other words, the damage done by monetary inflation cannot be subsequently undone by monetary deflation.

A plausible argument can also be made that for the first time ever the Fed now has the option of hiking interest rates without doing any QT. This is due to its ability to pay interest on bank reserves. This ability was acquired about 9 years ago solely for the purpose of enabling the Fed to hike its targeted interest rate while leaving the banking system inundated with “excess reserves” (refer to my March-2015 blog post for more detail). That is, this ability was acquired so that the Fed would not be forced to undertake QT at the same time as it was hiking rates.

However, the Fed is not going to deviate from its rule book. This is mainly because the Fed’s leadership believes that a new QE program will be required in the future.

To explain, a Fed decision not to implement QT would create an expectations-management problem in the future. Specifically, an announcement by the Fed that it was going to maintain its balance sheet at the current bloated level would be a tacit admission that QE involved a permanent addition to the money supply rather than a temporary exchange of money for securities. If the Fed were to admit this then the next time a QE program was announced there would be a surge in inflation expectations.

There has been monetary policy madness in spades over the past two decades, but within this context there is nothing especially mad about the Fed’s plan to raise rates and undertake quantitative tightening at the same time.

It is appropriate to think of Keynesian economics as superficial economics*, because this school of thought generally considers what’s seen and ignores what’s unseen. To put it another way, Keynesianism focuses on the readily-observable situation and the immediate/direct effects of a policy while paying little or no attention to why the current situation came about and the indirect (not immediately obvious) consequences of a policy. This leads to nonsensical conclusions, such as that the economy can sometimes be helped by the destruction of wealth (the idea being that after assets are destroyed people can be ‘gainfully’ employed rebuilding them).

To further explain, when a shop window is broken the typical Keynesian would account for the additional work and income of the glazier hired to fix the window but would make no effort to understand how the shopkeeper would have allocated his scarce resources if his window had remained intact. And in a case where resources are ‘idle’, the Keynesian would focus exclusively on the direct effect of using increased government spending or central bank money-printing to put these resources to work. He would pay scant attention to why the resources were idle in the first place and would ignore the longer-term effects of creating artificial demand for some resources and forcing the private sector to fund projects that it would otherwise choose not to fund**.

Due to its shallow nature, Keynesian economics is not useful when attempting to understand the real-world drivers of production and consumption. However, it can be put to good use when attempting to understand and predict the actions of policy-makers.

Aside from the fact that almost all politicians are economically illiterate, if your overriding goal is to win the next election then what you want are policy-related effects that are short-term, obvious and direct. What you want is to be able to point to a bunch of guys in hard hats hammering away on a government-funded project, and say: “Without the bill I sponsored, these guys would not have jobs”. The longer-term economic negatives aren’t relevant because not one voter in a thousand will see the link between these negatives and the “stimulus” bill.

There will come a day when Keynesian economics has been totally discredited again***, but until that day there will be many opportunities to make money by betting on policy-makers acting stupidly.

    *In a blog post in May-2015 I suggested that Keynesian Economics should be renamed ASS (Ad-hoc, Superficial and Shortsighted) Economics.

    **The “idle resources” fallacy that underlies the justifications for various government stimulus programs was debunked by William Hutt in a book published way back in 1939 and was more more briefly — but still thoroughly — debunked by Robert Murphy in a January-2009 article.

    ***Keynesian economics was discredited during the 1970s but subsequently managed to claw its way back to a position of great influence. It is resilient because it seemingly gives politicians the scientific justification for doing what they already want to do, which is make themselves appear benevolent — and thus garner the support of more than 50% of the voters — by spending the money of some people to provide short-term benefits to other people.