Here is a brief excerpt, with updated charts, from a recent commentary posted at TSI.

If you read some gold-focused web sites you could come away with the belief that movements in the gold price are almost completely random, depending more on the whims/abilities of evil manipulators and the news of the day than on genuine fundamental drivers. The following two charts can be viewed as cures for this wrongheaded belief.

The first chart compares the performance of the US$ gold price with the performance of the bond/dollar ratio (the T-Bond price divided by the Dollar Index). The charts are almost identical, which means that the gold price has been moving in line with a quantity that takes into account changes in interest rates, inflation expectations and currency exchange rates. The second chart shows that the US$ gold price has had a strong positive correlation with the Yen/US$ exchange rate. As we’ve explained in the past, gold tends to have a stronger relationship with the Yen than with any other currency because the Yen carry trade makes the Yen behave like a safe haven.

There are two possible explanations for the relationships depicted above. One is that the currency and bond markets, both of which are orders of magnitude bigger than the gold market, are being manipulated in a way that is designed to conceal the manipulation of a market that hardly anyone cares about. The other is that the gold price generally does what it should do given the performances of other financial markets. Only one of these explanations makes sense.

There’s an old saying in the financial markets that the trend is your friend, meaning that you will do well as long as you position your trades in line with the current price trend. This sounds good. The only problem is that you can never know what the current trend is; you can only know what the trend was during some prior period. How is it possible for something you can never know to be your friend?

Market ‘technicians’ often make comments such as “the trend for Market X is up” and “Market Y is in a downward trend” as if they were stating facts. They are not stating facts, they are stating assumptions that have as much chance of being wrong as being right.

A statement such as “Market X’s trend is up” would more correctly be worded as “I’m going to assume that Market X’s trend is up unless proven otherwise”. The proving otherwise will generally involve the price moving above or below a certain level, but the selection of this level is yet another assumption and the price moving above/below any particular level will provide no factual information about the current trend.

To further explain, let’s say that a market made a sequence of higher highs and higher lows over a 3-month period. It can be said that during this period the market’s trend was up. That’s a fact, since the definition of an upward trend is a sequence of rising highs and lows. However, even if this market has just made a new high it is not a fact that the current trend is up, because the high that was just made could turn out to be the ultimate high prior to the start of a downward trend. Nobody knows whether it will or won’t be the ultimate high, but some traders will assume that it was — or was very close to — the ultimate high and sell, while other traders will assume that the trend is still up. The members of the first group have approximately the same probability of being right as the members of the second group, but many members of the second group (the trend-followers) will unequivocally state “the trend is up”.

In the above hypothetical case, let’s assume that the first group was right and that the price immediately started to trend downward. Most members of the second group will have in mind price levels at which they will stop assuming that the trend is up, but the point at which their assumption changes could turn out to be the bottom. In other words, having wrongly assumed that the trend was still up after the price had just peaked, they might subsequently make the incorrect assumption that the trend has changed from up to down at the time that it is actually changing from down to up.

The impossibility of knowing the direction of the trend in real time is one of the reasons that the majority of trend-following traders end up losing money. Looking from a different angle, if it were possible to KNOW the direction of the trend in real time then every half-decent trend-follower would generate good returns, but very few of them do generate good returns over the long haul.

As an aside, the majority of non-trend-following traders also end up losing money. The fact is that regardless of what method is used, trading success over the long haul is primarily about risk management.

So, just be aware that when you read comments along the lines of “the trend is up”, the author is not stating a fact. He is, instead, announcing an opinion (making an assumption) that could be wrong.

Some analysts argue that the US economy is strong enough to handle some rate-hiking by the Fed. Others argue that with the economy growing slowly the Fed should err on the side of caution and continue to postpone its next rate hike. Still others argue that the economy is so weak that the Fed not only shouldn’t hike its targeted interest rate, it should be seriously considering a rate CUT and other stimulus measures. All of these arguments are based on a false premise.

The false premise is that the economy is boosted by forcing interest rates to be lower than they would otherwise be. It should be obvious — although apparently it isn’t — that an economy can’t be helped by falsifying the most important of all price signals.

When a central bank intervenes to make interest rates lower than they would be in a free market, a number of things happen and none of these things are beneficial to the overall economy.

First, there will be a forced wealth transfer from savers to borrowers, leading to less saving. To understand why this is an economic problem in addition to being an ethical problem, think of savings as the economy’s seed corn. Consume enough of the seed corn and there will be no future crop.

Second, construction, mining and other projects that would not be economically viable in a less artificial monetary environment are temporarily made to look viable. A result is that a lot of real resources are directed towards projects that end up failing.

Third, investors seeking an income stream are forced to take bigger risks to meet their requirements and/or obligations. In effect, conservative investors are forced to become aggressive speculators. This inevitably leads to massive and widespread losses down the track.

Fourth, debt becomes irresistibly attractive and starts being used in counter-productive ways. The best example from the recent past is the trend of US corporations taking-on increasing amounts of debt for the sole purpose of buying back their own equity. Going down this path is a much quicker way of boosting earnings per share than investing in the growth of the business, so, naturally, the increasing popularity of debt-financed share buy-backs has gone hand-in-hand with reduced capital spending.

Fifth, “defined benefit” pension funds end up with huge deficits.

The reality is that the economy cannot possibly be helped by centrally forcing interest rates to be either lower or higher than they would be if ‘the market’ were allowed to work. The whole debate about whether the US economy is strong enough to handle another Fed rate hike is therefore off base.

The right question is: How much more of the Fed’s interest-rate manipulation can the US economy tolerate?

I saw a press release today that boggled my mind. The press release is from Gold Road Resources (GOR.AX), a company in the process of exploring/developing a large gold deposit in Western Australia, and is linked HERE.

According to the press release, GOR is pleased with itself for having short-sold 50K ounces of gold and having given itself the option of short-selling an additional 100K ounces of gold.

Now, it’s one thing for a current gold producer to forward-sell part of the coming year’s production in order to ensure a certain cash-flow, but GOR is not a current producer. It doesn’t even have a completed Feasibility Study and is therefore years away from having any production. In fact, there is no guarantee that it will ever have any production.

What GOR is doing cannot be called hedging. It is an outright bet against a further rise in the A$-denominated gold price. Moreover, the bet is subject to margin calls, so GOR shareholders better hope that the gold price doesn’t skyrocket over the next 12 months.

It’s quite possible that GOR won’t be hurt by its bearish gold bet. It’s also quite possible that I won’t be hurt if I play Russian roulette, but that doesn’t mean it’s a good idea for me to play.

but possibly not in your lifetime.

As I mentioned in a blog post back in April of last year, I have never been in the camp that exclaims “buy gold because the US is headed for hyperinflation!”. Instead, at every step along the way since the inauguration of the TSI web site in 2000 my view was that the probability of the US experiencing hyperinflation within the next 2 years — on matters such as this there is no point trying to look ahead more than 2 years — is close to zero. That remains my view today. In other words, I think that the US has a roughly 0% probability of experiencing hyperinflation within the next 2 years.

I also think that the US has a 100% probability of eventually experiencing hyperinflation, but this belief currently has no practical consequences. There is no good reason to start preparing for something that a) is an absolute minimum of two years away, b) could be generations away, and c) is never going to happen with no warning. With regard to point c), we will never go to bed one day with prices rising on average by a few percent per year, 10-year government bond yields below 2% and the money supply rising at around 8% per year and wake up the next day with hyperinflation.

It takes a considerable amount of time (years, not days or weeks) to go from the point when the vast majority is comfortable with and has confidence in the most commonly used medium of exchange (money) to the point when there is a widespread collapse in the desire to hold money. Furthermore, many policy errors will have to be made and there will be many signs of declining confidence along the way.

The current batch of policy-makers in central banking and government as well as their likely replacements appear to be sufficiently ignorant or power-hungry to make the required errors, but even if the pace of destructive policy-making were to accelerate it would still take at least a few years to reach the point where hyperinflation was a realistic short-term threat in the US.

In broad terms, the two prerequisites for hyperinflation are a rapid and unrelenting expansion of the money supply and a large decline in the desire to hold money. Both are necessary.

To further explain, at a time when high debt levels and taxation underpin the demand for money, a collapse in the desire to hold money could not occur in the absence of a massive increase in the money supply. By the same token, a massive increase in the money supply would not bring about hyperinflation unless it led to a collapse in the desire to hold money.

Over the past three years the annual rate of growth in the US money supply has been close to 8%. While this is above the long-term average it is well shy of the rate that would be needed to make hyperinflation a realistic threat within the ensuing two years. Furthermore, high debt levels in the US and counter-productive policy-making in Europe will ensure that there is no substantial decline in the desire to hold/obtain US dollars for the foreseeable future.

The upshot is that there are many things to worry about, but at this time US hyperinflation is not one of them.

People are naturally attracted to viewpoints that are similar to their own and to information that supports what they already believe. In fact, most people go out of their way to find articles and newsletters that are biased towards their pre-existing views of the world. However, they should do the opposite.

If you seek-out information that supports what you already think you know and exclusively read authors whose opinions match your own, you will never learn anything. All you will do is increase your comfort in, and therefore entrench, views that may or may not be correct. You will never find out if your views are incorrect because you are refusing to objectively consider any alternatives.

Even when a particular belief leads to a decision that, in turn, leads to a devastating loss, you probably won’t accept the possibility that the premise behind your decision was wrong. Instead, you will assume that the decision was soundly based but that unforeseeable external factors intervened to bring about the bad result. Rather than acknowledge that your premise was wrong you might, for example, conclude that a nefarious force manipulated events such that a logically prudent course of action on your part was made to look ill-conceived.

Seeking out and focusing on information, analyses and opinions that mesh with your existing beliefs is called confirmation bias. An antidote is to go out of your way to read articles and other pieces of literature that challenge your dearly-held beliefs.

For example, if you strongly believe that financial Armageddon lies around the next corner then the last thing you should do is devote a lot of your finance-related reading time to the Zero Hedge web site. Instead, you should seek-out sites that present less-bearish analyses and conclusions. This way you can make decisions based on a wider range of information, not just information that has been carefully selected to support one particular outcome.

If you can keep an open mind while reading articles and assessing information that does not agree with your current beliefs, then you have a chance of learning something and avoiding pitfalls. After all, it ain’t what you don’t know that gets you into trouble; it’s what you know for sure that just ain’t so*.

*A Mark Twain quote

This post is a brief excerpt from a recent commentary posted at TSI.

In the late stages of every long-term bull market there has been a widely-believed, simple story for why prices will continue to rise despite high valuations.

In the early-1970s the story was the “nifty fifty”. The belief was that a group of 50 popular large-cap NYSE-traded stocks could be bought at any price because the quality and the growth-rates of the underlying companies virtually guaranteed that stock prices would maintain their upward trends. The “nifty fifty” not only collapsed with the overall market during 1973-1974, most members of the group under-performed the overall market from 1973 to 1982.

In 1999-2000 the story was the “technology-driven productivity miracle”. The belief was that due to accelerating technological progress and the internet it was reasonable to value almost any company with a web site at hundreds of millions of dollars and it was reasonable to pay at least 50-times annual revenue for any company with a decent high-tech product. Most of our readers will remember how that worked out.

In 2006-2007 there were three popular stories that combined to explain why prices would continue to rise, one being “the great moderation”, the second being the brilliance of the current batch of central bankers (these monetary maestros would make sure that nothing bad happened), and the third being the unstoppable rapid growth of the emerging markets. Reality was then revealed by the events of 2008.

The story is always different, but it always has two characteristics: It always seems plausible while prices are rising and it always turns out to be completely bogus.

The most popular story used these days to explain why the US equity bull market is bound to continue despite high valuations is often called “TINA”, which stands for “There Is No Alternative”. The belief is that with interest rates near zero and likely to remain there for a long time to come it is reasonable to pay what would otherwise be considered an extremely high price for almost any stock that offers a dividend yield. There is simply no alternative!

We can be sure that the TINA story will turn out to be bogus and that the high-priced dividend plays of today will go the way of the “nifty fifty”. We just don’t know when.

There are certain phrases or ways of using/displaying words in written English that I find annoying. Here is an incomplete list of these minor annoyances:

1) Saying “literally” when what is really meant is “figuratively”

For example: “When Jim’s boss found out that the report was a week late, he literally exploded.” No, he didn’t literally explode (the room didn’t end up being covered in the boss’s blood and body parts); he got very angry. For another example: “Jane was literally swept off her feet by the charming man.” No, the man didn’t assault Jane with a broom; he used words to figuratively sweep her off her feet.

2) Saying “could” when “couldn’t” is what’s really meant

This is something that people from North America tend to do, most often in the “could/couldn’t care less” context.

When someone says “I could care less” they are saying that they care at least a little bit, which is the opposite of what they mean. The correct wording is: “I couldn’t care less”.

3) Writing “the proof is in the pudding”

This makes no sense. The correct saying is “the proof of the pudding is in the eating”.

4) Writing “personally, I”

Although it is probably not grammatically incorrect, I find it slightly irritating when someone writes “Personally, I…” or anything else that involves putting the word “personally” before or after “I” or “me”. As soon as you use “I” or “me”, the “personally” is implied.

5) Writing “she” to mean “he/she”

Writing “he/she” is a little clumsy. The correct alternative is to write “he”. Using “she” as the abbreviation for “he/she” is a blatant attempt by the author to be politically correct, and political correctness in all of its guises is annoying.

6) Replacing letters with asterisks

I have no problem with swearing. Words are just sequences of sounds and no sequence of sounds is inherently more offensive than any other sequence of sounds. Also, social conventions are constantly changing such that words that were considered profane in the past are no longer considered so and words that are considered profane today will not be considered so in the future. For example, the terms “dark meat” and “white meat” in reference to parts of a chicken or turkey started being used in Victorian times because in that period the words “breast” and “thigh” were widely viewed as vulgar.

That being said, many people are offended by swear words. That’s why I never swear in blog posts and rarely swear in my private life. However, some people apparently believe that they can swear without really swearing by simply replacing some of the letters in the ostensibly offensive word with asterisks. But if the word that is being ‘concealed’ with asterisks is still obvious, which it always is, then how is using the asterisks anything other than an insult to the reader’s intelligence?

Either swear properly or don’t swear at all. Don’t insult my intelligence by inserting asterisks in part of what you believe to be an offensive word.

An increase in the amount of gold bullion held by GLD (the SPDR Gold Shares) and other bullion ETFs does not cause the gold price to rise. The cause-effect works the other way around and in any case the amount of gold that moves in/out of the ETFs is always trivial compared to the metal’s total trading volume. However, it is reasonable to view the change in GLD’s gold inventory as a sentiment indicator.

Ironically, an increase in the amount of physical gold held by GLD and the other gold ETFs is indicative of increasing speculative demand for “paper gold”, not physical gold. As I’ve explained in the past (for example, HERE), physical gold only ever gets added to GLD’s inventory when the price of a GLD share (a form of “paper gold”) outperforms the price of gold bullion. It happens as a result of an arbitrage trade that has the effect of bringing GLD’s market price back into line with its net asset value (NAV). Furthermore, the greater the demand for paper claims to gold (in the form of ETF shares) relative to physical gold, the greater the quantity of physical gold that gets added to GLD’s inventory to keep the GLD price in line with its NAV.

Speculators in GLD shares and other forms of “paper gold” (most notably gold futures) tend to become increasingly optimistic as the price rises and increasingly pessimistic as the price declines. That’s the explanation for the positive correlation between the gold price and GLD’s physical gold inventory illustrated by the following chart.

Now, speculation in “paper gold” is both an effect of the gold price and an important short-term driver of the gold price. It is therefore fair to say that although changes in GLD’s gold inventory don’t cause anything, they often reflect changes in speculative sentiment that at least on a short-term basis do have a significant influence on the gold price. At the same time it is also fair to say that the influence of speculative buying/selling in the futures market is vastly greater (probably at least an order of magnitude greater) than the influence of speculative buying/selling of GLD shares. Refer to “The scale of the gold market” for details on relative size an influence.

The speculative demand for “paper gold” has certainly ramped up over the past several months. This is partly reflected by the increase in the GLD inventory shown on the above chart, but it is primarily reflected by the rise to an all-time high in futures-related speculation. This is illustrated below.

Chart source: http://www.goldchartsrus.com/

The extent to which short-term speculators are bullish on gold is a risk. An unusually-elevated level of speculative enthusiasm will never be the cause of a reversal in the price trend from up to down, but it will exacerbate the decline that happens after the price-trend reverses for some other reason.

James Altucher wrote a blog post several years ago that has stuck with me. The gist of the post was that the best way to deal with crappy people is to not engage with them in any way under any circumstances. Do not argue with them, do not attempt to give them advice, and do not make any effort to get them to like you. Just ignore them.

Altucher’s message has saved me a lot of aggravation over the years. Once in a while I fall into the trap of interacting with someone I should ignore, but I’m usually successful at preventing crappy people from disrupting my peace of mind — by essentially blotting them out.

I don’t have any crappy people in my personal life. At least, I don’t at the moment. However, as someone who publishes stuff on the internet I regularly attract emails from crappy people I don’t know. In the distant past these emails would sometimes annoy or disturb me and occasionally I would get sucked into a ‘tit for tat’ exchange, but no longer. I’ve learnt that there is no point trying to mud-wrestle a pig, because you both end up dirty and the pig enjoys it.

Just to be clear, I have no problem with polite criticism. In fact, when I write something that is logically or factually incorrect I am grateful if someone takes the trouble to explain where I went wrong. Crappy people, however, do not disagree in a polite and well-reasoned manner; instead, they launch insults.

Nowadays when I receive an email from a crappy person, I never respond. As soon as I realise the nature of the email, I delete it and add the sender’s address to my “blocked senders” list, thus ensuring that I will never hear from them again.

The best emails sent to me by crappy people are the ones that have an insult in the subject line, because I don’t have to waste time opening these. For example, last week someone sent me an email with “You are a moron” as the subject line. I don’t know what the email contained, because I never opened it. I just added the sender’s address to my “blocked” list and then deleted it. My guess, however, is that it was a reaction to a post I had published a day earlier (https://tsi-blog.com/2016/08/does-the-fed-support-the-stock-market/). The post in question debunked the claim that the Fed routinely props up the stock market by purchasing stocks, ETFs and/or futures, and I’ve discovered over the years that the surest way to provoke a vitriolic response is to write something that casts aspersions on a popular market-manipulation story or that expresses anything other than unequivocal optimism about gold and silver.

It has become easy for me to ignore emails from crappy people I don’t know, but it’s a lot more difficult, and not always possible, to ignore such people in our personal or business lives. However, if there are certain crappy people you can’t completely blot out, for example, if your boss is one or your sister is married to one, then you should at least minimise your interaction with them. Life is too short to do otherwise.

Here is an excerpt from a commentary posted at TSI on 6th August.

The monthly US employment reports have no relevance except for their influence on the Fed and market expectations regarding future Fed actions. The moderately strong employment data reported last Friday, for example, provides no information about the current or likely future performance of the US economy, but was noteworthy because it led to a slight increase in the expected level of the Fed Funds Rate (FFR).

The change in the expected level of the FFR in response to Friday’s employment news is illustrated by the following daily chart. The last bar on the chart shows a fall of 0.09 in the price of the January-2018 Fed Funds Futures (FFF) contract, which means that the expected level of the FFR in January-2018 rose by 0.09 (9 basis points) last Friday.

Now, under more normal circumstances a 0.09% change in the expected level of the FFR in 17 months’ time would not have a significant effect on the gold market, but these aren’t normal circumstances. These are circumstances in which the actions and expected future actions of central banks are dominating all other considerations. Consequently, just as a minor decrease in the expected FFR during the final week of July and the first two trading days of August propelled the gold price from around $1310 to the $1370s, a minor increase in the expected FFR on Friday predictably had the opposite effect.

Does this mean that if the expected FFR builds on Friday’s gain over the days/weeks ahead then the gold price will probably trend downward over the same period? Yes, that’s exactly what it means. It also means that if something happens in the world to cause the expected FFR to move below the lows of the past few weeks then the gold price will probably move to a new high for the year.

The answer to the above question is yes and no. If the question is does the Fed use the combination of monetary policy and ‘jawboning’ in an effort to push equity prices upward then the answer is definitely yes. However, if the question is does the Fed buy index futures or ETFs in an effort to elevate the stock market then the answer is almost certainly no.

It is no secret that today’s Fed considers the performance of the stock market when deciding on what monetary measures to implement. In fact, over the past 8 years the Fed has overtly targeted higher stock prices based on the erroneous belief that higher stock prices lead to greater consumer spending and a stronger economy. It is also clear that the public utterings of senior Fed representatives are often influenced by the stock market’s recent performance. For example, soon after the stock market takes a tumble you can safely bet your life on at least one Fed governor coming out with a public comment suggesting easier monetary policy. However, the idea that the Fed brings about higher stock prices by directly purchasing futures contracts or ETFs is just an appealing fantasy.

An obvious retort is that some other central banks, most notably the BOJ, are known to have bought ETFs as part of their efforts to boost economic activity, so why shouldn’t we believe that the Fed has gone down the same path?

My response is: How do we know that the BOJ et al have made these stock-market-related purchases? We know because the purchases have not happened in secret. They have been openly declared.

Doing it openly is the only way that a central bank such as the BOJ or the Fed could ever directly intervene in the stock market, especially if the intervention is designed to be large enough to have a significant effect on the overall market. A central bank trying to surreptitiously support the stock market via direct purchases would be akin to an elephant trying to surreptitiously make its way through your living room. That is, the evidence of the central bank’s actions would be blatant. There would be an obvious paper trail and a lot of people (a lot of potential whistleblowers) would have to be involved.

Another retort is that the Fed does its purchasing of equity-related instruments via an intermediary such as a major private bank.

Yes, if the Fed made stock-market purchases then it would, of course, act through an intermediary, but this doesn’t enable the purchases to be kept secret. For example, all of the Fed’s bond purchases have been made through intermediaries, but the evidence of the purchases is as plain as day on the Fed’s balance sheet and most people involved in the markets know exactly what the Fed has done.

The belief that the Fed secretly buys and sells in the stock market as part of a largely-successful effort to keep the stock market in an upward trend is therefore ridiculous. However, the idea that the Fed will eventually intervene directly in the stock market is not farfetched. Actually, there’s a high probability that it will happen in the future. But if/when it does happen there will be no need to make wild guesses regarding the central bank’s actions, because the actions will be publicly announced ahead of time in the same way that the bond-buying programs were publicly announced ahead of time.

Some commentators have been anticipating a “commercial signal failure” in the gold market for more than 15 years. Moreover, whenever the gold price experiences a large rally the same commentators routinely cite the potential for a commercial signal failure (CSF) as a reason to maintain a full position, the argument being that the coming CSF is bound to result in massive additional price gains. The reality, however, is that whereas a CSF is an extremely unlikely event in any commodity market, in the gold market it is an impossibility.

A CSF theoretically becomes possible in a commodity market after the price has been trending upward for some time, and speculators, as a group, have built-up an unusually-large net-long position in the commodity futures. Naturally, if speculators have a large net-long position then “commercials” have an equivalently-large net-short position, since one is a mathematical offset of the other.

Commercials are generally hedging or spread-trading, so once they have established a position they will usually be indifferent with regard to future price direction. Whatever they lose on the futures they will make in the physical, and vice versa. However, in some commodity markets it is possible for the supply or demand in the physical market to undergo such a sudden and dramatic change that exploding margin requirements on the futures side of a commercial-trader’s hedge or spread-trade could force the commercial to exit (buy back) the short futures position, even though the short position in the futures is ‘covered’ by a long position in the physical. For example, take the case of a wheat farmer who has locked in the price of his yet-to-be-harvested crop by selling wheat futures. If extreme and unexpected weather suddenly causes a moon-shot in the wheat price then the farmer might — depending on how his price hedging has been structured — be faced with a huge margin call on his futures position and forced to exit his hedge, even if his own crop is unaffected by the extreme weather. Exiting the hedge would involve buying wheat futures into a sharply rising market, which would only exacerbate the price rise.

If it happens on a market-wide scale, the hypothetical case of the wheat farmer described above could be part of what’s called a “commercial signal failure”. The so-called signal failure involves commercial traders being forced, en masse, to cover their short futures positions at large losses despite the short futures positions being offset by long positions in the physical commodity. By definition, it can only happen when speculators have built up a large net-long position in the futures market (meaning, when commercial traders have built up a large net-short position in the futures, thus generating the bearish warning signal), a situation that will usually only arise after the price has been in a strong upward trend for several months. Due to the CSF, speculators on the long side make more money more quickly than they were expecting.

However, even in a market where a CSF is technically possible, a prudent speculator would never bet on it. The reasons are that 1) a CSF requires a sudden and totally UNPREDICTABLE change in either supply or demand, and 2) CSF’s almost never happen. In the rare cases when a CSF happens it tends to be the result of an unexpected supply disruption. In agricultural commodities, the most likely cause is an unforeseeable bout of extreme weather.

Major supply disruptions are possible in the markets for all agricultural and industrial commodities, but they are not possible in the gold market. This is primarily because almost all the gold ever mined still forms part of the supply side of the equation, which means that shifts in the current year’s mine production will always be trivial relative to total supply. In other words, in the gold market there is no chance that a CSF could be caused by a major supply disruption.

Although a major supply disruption is not possible in the gold market, there could at some point be a large and unanticipated demand disruption (note that the bulk of the world’s gold is demanded (held) for investment, store-of-value, speculative or monetary purposes). However, such a disruption would not cause a “commercial signal failure”; it would be the EFFECT of a total monetary-system failure.

A “commercial signal failure” is, by definition, an event that results in bullish futures speculators making large and rapid gains, but bullish speculators in gold futures could not profit from a total monetary-system failure. In fact, they would be big losers because the futures market would shut down in such an outcome.

The bottom line is that it is not a good idea to bet of a “commercial signal failure” in any market, because the probability of it happening is extremely low. It is, however, a particularly bad idea to make such a bet in the gold market because in the gold market the event has a probability of zero.

Here is an excerpt from a recent TSI commentary about another absurd course of action now being seriously considered by the monetary maestros.

Once upon a time, the concept of “helicopter money” was something of a joke. It was part of a parable written by Milton Friedman to make a point about how a community would react to a sudden, one-off increase in the money supply. Now, however, “helicopter money” has become a serious policy consideration. So, what exactly is it, how would it affect the economy and what are its chances of actually being implemented?

“Helicopter money” is really just Quantitative Easing (QE) by another name. QE hasn’t done what central bankers expected it to do, so the idea that is now taking root is to do more of it but call it something else. Apparently, calling it something else might help it to work (yes, the people at the upper echelons of central banks really are that stupid). The alternative would be to question the models and theories upon which QE is based, but such questioning of underlying principles must never be done under any circumstances. A Keynesian economist calling into question the principle that an economy can be made stronger via methods that artificially stimulate “aggregate demand” would be akin to the Pope questioning the existence of god.

The only difference between QE as practiced by the Fed and “helicopter money” is the path via which the new money gets injected. Under the Fed’s previous QE programs, new money was created via the monetisation of debt and ended up in the accounts of securities dealers*. Under a “helicopter money” program, new money would still be created via the monetisation of debt. However, in this case the new money would be placed by the government into the accounts of the general public, via, for example, tax cuts and welfare payments (handouts), and/or placed by the government into the accounts of contractors working for the government.

If promoted in the right way, “helicopter money” could have widespread appeal among the general public. Unlike the Fed’s traditional QE, which had the superficial effect of making the infamous top-1% richer and the majority of the population poorer, the average member of the voting public could perceive an advantage for himself/herself in “helicopter money”. Unfortunately, regardless of who gets the new money first there is no way that an economy can be anything other than weakened by the creation of money out of nothing. The reason is that the new money falsifies the price signals upon which economic decisions are made, leading to ill-conceived investments and other spending errors.

Due to the distortions of price signals that they bring about, both traditional QE and “helicopter money” are bad for the economy. However, an argument could be made that “helicopter money” is the lesser of the two evils. The reason is that with “helicopter money” the effects of the monetary inflation will more quickly become apparent in everyday expenses and the popular price indices. That is, “helicopter money” will quickly lead to inflationary effects that are obvious to everyone. This limits the extent to which the policy can be implemented.

Putting it another way, traditional QE had by far its biggest effects on the prices of things that, according to the average economist, central banker and politician, don’t count when assessing “inflation”, whereas the effects of “helicopter money” would soon become obvious in the prices of things that do count. A consequence is that a “helicopter money” program would be reined-in relatively quickly and the long-term damage to the economy would be mitigated.

With regard to the chances of “helicopter money” actually being implemented, we think the chances are very good in Japan, very poor in the euro-zone (due to there being a single central bank ‘serving’ a politically-disparate group of countries) and somewhere in between in the US.

Although it presently seems like the more extreme policy, the US has a better chance of experiencing “helicopter money” than negative interest rates within the next two years. This is because a) the next US president will be an economically-illiterate populist (regardless of who wins in November), b) the average voter will likely perceive a financial advantage from “helicopter money”, and c) hardly anyone outside the halls of Keynesian academia will perceive anything other than a disadvantage from the imposition of negative interest rates.

In summary, then, “helicopter money” is QE by a different name and path. It would inevitably reduce the rate of economic progress, but it has a reasonable chance of being implemented in the US the next time that policy-makers are desperate to do something.

*Every dollar of Fed QE adds one dollar to the commercial bank account of a Primary Dealer (PD) and one dollar to the reserve account at the Fed of the PD’s bank, meaning that every dollar of QE adds one reserve-covered dollar to the economy-wide money supply.

Here is an excerpt from a commentary posted at TSI last week. Not much has changed in the interim, so it remains applicable.

The US Treasury Bond (T-Bond) entered a secular bullish trend in the early-1980s. As evidenced by the following chart, over the past 30 years this trend has been remarkably consistent.

There is no evidence, yet, that the long-term bull market is over. Furthermore, such evidence could take more than a year to materialise even if the bull market reaches its zenith this month. The reason is that for a decline to be clearly marked as a downward leg in a new bear market as opposed to a correction in an on-going bull market it would have to do something to differentiate itself from the many corrections that have happened during the course of the bull market. In particular, it would have to result in a solid break below the bottom of the long-term channel. This is something that probably wouldn’t happen until at least the second half of next year even if the bull market just reached its final peak.

However, we don’t need to have an opinion on whether or not the bull market is about to end to see that the risk/reward is currently favourable for a bearish T-Bond speculation. What we need to do is look at a) future “inflation” indicators, which point to rising price inflation over the coming months, b) sentiment indicators, which suggest the potential for a large majority of speculators to be caught wrong-footed by a T-Bond decline, and c) the position of the T-Bond within its long-term channel.

With regard to the channel position, to become as stretched to the upside as it was at the 1986, 1993 and 1998 peaks the T-Bond would have to move about 5 points above this month’s high, but it is already at least as stretched to the upside as it was at the 1996, 2003, 2008, 2012 and 2015 peaks.

Needless to say, we continue to like the bearish T-Bond trade.

A chart similar to the one below was included in a blog post under the heading “Bank C&I Loan Charge-Offs Soaring Again”. This chart caught my attention because it seems to indicate that bank C&I (Commercial and Industrial) loan charge-offs are happening at one of the fastest rates of the past 30 years — the sort of rate that would be consistent with the US economy being in recession.

The problem is that the above chart shows the percentage change of a percentage, which opens up the possibility that what is in reality a small increase is being made to look like a large increase. For example, an increase from 1% to 2% over the course of a year in the proportion of loans charged-off would be a 100% increase if expressed as a year-over-year percentage change in the percentage of charge-offs, whereas all you’ve actually got is a 1% increase in the total proportion of loans that have been charged-off.

The next chart is based on exactly the same data, but instead of displaying the year-over-year percent change in the percentage of C&I loans that have been charged off it simply displays the percentage of C&I loans that have been charged off. This is not just a more correct way of looking at the data, it is a way that has not given any false recession signals over the past 30 years.

The first chart’s message is: an economic recession is either in progress or imminent. The second chart’s message is: the US economy is not in recession and is presently not close to entering recession.

The same data, opposite messages.

Rarely does a month go by when I don’t read at least one article in which interest rates are said to be the price of money. This is wrong. The price of money is what money can buy. The rate of interest is something completely different.

If an apple sells for 1 dollar then the price of a unit of money in this example is 1 apple. If a car sells for 30,000 dollars then the price of a unit of money in this example is 1/30,000th of a car. In more general terms, just as the price of any good, service or asset can be quoted in terms of money, the price of money can be quoted in terms of the goods, services and assets that it buys. In a large economy, at any given time a unit of money will have millions of different prices.

As an aside, this is why price indices that purport to represent the purchasing power of money will always be bogus. Regardless of how rigorous and well-intentioned the effort, it is not possible to come up with a single number that properly indicates the “general price level”. There is simply no such thing as the general price level.

What, then, is the interest rate?

The interest rate is the cost incurred or the payment received for exchanging a present good for a future good. If there is no risk of loss involved in the transaction then the interest rate will reflect nothing other than the time preferences of the person who parts with the present good (usually called the lender) and the person who receives the present good (usually called the borrower). In other words, if there is no risk of loss then the interest rate can correctly be thought of as the price of time.

In most cases there will, of course, be a risk of loss due to the possibility that the borrower will default or the possibility — if it was money that was exchanged — that the loan will be repaid in terms of money that doesn’t buy as much as it did when the initial exchange took place. In most cases the interest rate will therefore be the price of time plus a premium to account for default risk and “inflation” risk.

Time preference sets a lower limit on market interest rates and time preference will always be positive. The negative interest rates set in place by some central banks therefore have nothing to do with market forces and everything to do with heavy-handed manipulation by people who have far more power than sense.

In a recent letter John Mauldin worries that central banks are ‘out of bullets’, but this is not something that any rational person should be worried about. Instead, they should be worried about the opposite.

The conventional view is that with interest rates at all-time lows and with vast amounts of debt having already been monetised, if a recession were to occur in the not-too-distant future there would be nothing that the central banks could do to ameliorate it. However, this view is based on the false premise that central banks can smooth-out the business cycle by easing monetary policy at the appropriate time. The truth is that by distorting interest rates, central banks get in the way of economic progress and cause recessions to be more severe than would otherwise be the case.

Think of it this way: If it is really possible for a committee of bureacrats and bankers to create a better outcome for the economy by setting interest rates (the price of credit), then it logically follows that a healthier economy would result from having all prices set by committees comprised of relevant ‘experts’. There should be an egg committee to set the price of eggs, a car committee to set the price of cars, a massage committee to set the price of massages, etc. After all, if it really is possible for a committee to do a better job than a free market at determining the most complicated of prices then it is certainly possible for a committee to do a better job than a free market at setting any other price.

However, hardly anyone believes that all prices should be set by committee or some other governing body. This is undoubtedly because that type of price control proved to be an unmitigated disaster wherever/whenever it was tried throughout history. Most people therefore now realise that it would make no sense to have committees in place to control prices in general, but are strangely incapable of making the small logical step to the realisation that it makes no sense to give a committee the power to control the most important price in the economy — the price of something that influences the price of almost everything else.

Getting back to the worry that central banks are out of bullets, it would actually be good news if they were. This is because a central bank does damage to the economy every time it fires one of its so-called monetary bullets. The damage usually won’t be apparent to the practitioners of the superficial, ad-hoc economics known as Keynesianism, but it will inevitably occur due to the falsification of price signals.

Unfortunately, central banks have an unlimited supply of bullets. This has been demonstrated over recent years by zero not proving to be a lower boundary for the official interest rate and by asset monetisation proving to be not restricted to government bonds. We should therefore expect central banks to keep firing until they are reined-in by market or political forces.

The real worry, then, isn’t that central banks are out (or almost out) of bullets. The real worry is that they are not remotely close to being out of bullets.

When the Baltic Dry Index (BDI), an index of international ocean-going freight rates, plunged to a multi-decade low early this year it provoked excited commentary from the “economic armageddon is nigh!” crowd. An example can be found HERE. However, bearish commentary is unhelpful after the prices of useful things have fallen to the point where the suppliers of these things are financially in dire straits.

There’s always a risk that the stock price of an individual company will go to zero, but there’s never a risk that freight rates or the prices of useful commodities will go to zero. Therefore, the further they move into an area where they are low by historical standards, the lower the downside risk will generally be.

I’m lumping ocean-going shipping rates and commodity prices together in this post because they are linked. They usually trend in the same direction and reach important peaks/troughs at around the same time. A consequence is that it doesn’t make sense to be bullish on commodities and at the same time anticipating a large decline in shipping rates, or bearish on commodities and at the same time anticipating strength in shipping rates. For example, after commodity prices reversed upward during January-February of this year it made no sense to expect a continuing downward trend in shipping rates.

The link between shipping rates (as represented by the BDI) and commodity prices (as represented by the Goldman Sachs Spot Commodity Index – GNX) is illustrated below. The two indexes have been positively correlated for a long time. Divergences are not uncommon, but the divergences are always short-term.

So, here’s an idea: Rather than piling onto the bearish bandwagon, when the real price of an indispensable service or commodity drops to a multi-decade low it might make more sense to be bullish.

A popular line of thinking is that the US banking system is not making as much use of its “excess” reserves as it should be because of the interest rate that the Fed now pays on these reserves. This line of thinking reflects a basic misunderstanding of how the banking system works.

There are two reasons why it is wrong to believe that the 0.50% interest rate now being earned by US banks on their reserves is encouraging the banks to stockpile money at the Fed rather than take a risk by making more loans. The first reason is that there is no relationship between bank lending (and the associated creation of new bank deposits) and bank reserves. I’ve covered this concept in previous blog posts, including HERE, so today I’ll focus on the second reason.

The second reason is that the banking system has no control over its reserves. An individual bank can reduce its reserves by lending reserves to another bank, but banks as a group have no say in the total quantity of reserves. In other words, even if the US banking system desperately wanted to reduce its collective reserve quantity it would be powerless to do so.

By way of further explanation, there are only three ways that reserves can leave the US banking system. They can be removed by the Fed (the Fed has unlimited power to add or delete reserves), they can exit in the form of notes and coins in response to increasing public demand for physical cash, or they can be transferred to governmental accounts at the Fed. The third way will always be temporary because the government is always quick to spend any money it gets, so there are really just two ways that the banking system’s reserves can decline: a deliberate action by the Fed or increased demand for physical cash within the economy.

In other words, regardless of how many loans are made and how many new commercial bank deposits are created, every dollar of reserves currently in the US banking system will remain there until the Fed decides to change the system-wide level or until it leaks into the economy via the conversion of electronic deposits to physical cash.

An implication is that changing the rate of interest that the Fed pays on reserves will not affect the pace at which banks expand/contract credit within the economy. For example, if the Fed increased the interest rate on reserves from 0.50% to 1.00% the banks would generate more interest income from their reserves, but there would be no change in the incentive to make new loans because the banks will earn this additional income regardless of whether they lend more or less money into the economy (the creation of a bank loan doesn’t cause bank reserves to disappear). For another example, if instead of paying banks a positive rate on their reserves the Fed started charging banks, that is, if the Fed adopted Negative Interest Rate Policy (NIRP), the banking system as a whole would have no additional incentive to grow its loan book since there would be nothing it could do to avoid the cost. In fact, the cost imposed by the NIRP could indirectly REDUCE the incentive to make new loans.

As an aside, this doesn’t guarantee that NIRP won’t happen in the US, especially given the evidence that the Fed’s senior management is almost as clueless as Mario Draghi. However, the obvious failure of the policy in Europe lessens the risk of it happening in the US.

Summing up, the interest rate paid on reserves cannot be a reason for either more or less bank lending. As explained previously, the only 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 while it pumped huge volumes of dollars into the economy and into the reserve accounts of banks.