[This blog post is an excerpt from a TSI commentary published on 24th February]

Based on the par value of maturing securities on its balance sheet there was scope for the Fed to withdraw as much as $43B from the financial markets on 15th February. A week ago we noted that this ‘liquidity drain’ had no effect on the stock market, possibly because the effect would occur on the next trading day (Tuesday 19th February) or because the Fed chose to withdraw a lot less money than it could have. Now that the Fed has issued its latest weekly balance sheet update we can see why there was no effect from this potential bout of “quantitative tightening” (QT). We can also see that the general perception of what the Fed is doing has deviated in a big way from what the Fed actually is doing.

During the 7-day period from 13th to 20th February the Fed’s securities portfolio fell by $31B. In other words, the Fed implemented $31B of a potential maximum $43B of QT. Over the same period, however, the amount of money in the US federal government’s account at the Fed fell by $44B. This means that there was a $31B withdrawal of liquidity by the Fed in parallel with a $44B injection of liquidity by the government, resulting in a net liquidity ADDITION of $13B. No wonder there wasn’t a noticeable negative effect on the stock market from the Fed’s actions.

The difference between a Fed liquidity injection and a government liquidity injection is that whereas the Fed can inject new money, the government can only recycle existing money (the government returns to the economy the money it previously removed via borrowing or taxation). Government liquidity injections therefore are not inflationary, but their short-term effects can be similar to Fed liquidity injections.

Note that at 20th February the government had about $330B in its account at the Fed. This means that the government currently has the ability to inject up to $330B into the economy, but depending on the size of its desired cash float it may or may not make additional injections in the short-term.

Also note that notwithstanding all of the ‘dovish’ talk that has emanated from the Fed over the past two months, the QT program has continued. From 2nd January to 20th February the Fed removed $63B from the economy as part of its “balance sheet normalisation”. The pace of the liquidity removal is slower than the Fed’s self-imposed $50B/month limit, but it is not correct to say — as some pundits have said — that the Fed has stopped tightening. The Fed is still pulling on the monetary reins.

That the Fed is still tightening means that there is a substantial mismatch at the moment between perception and reality. The general perception is that the Fed is now either on hold or preparing to loosen, but, as mentioned above, this most definitely is not the case. Consequently, bullish speculators in the stock, commodity and gold markets are getting ahead of themselves.

It’s possible that the Fed will end its monetary tightening within the next few months, but that’s only going to happen if there’s another pronounced shift away from risk. To put it another way, the more the markets discount an easing of monetary policy the less chance the easing will occur. In fact, if the stock market extends its upward trend into May-June then the Fed probably will resume its rate-hiking in June.

Like every other financial market in world history, the gold market is manipulated. However, anyone who believes that manipulation of the gold market is an important influence on major gold-price trends does not understand the true fundamental drivers of the gold price.

To paraphrase Jim Grant, gold’s market value is the reciprocal of confidence — in the banking system (including the central bank), the economy and the government. In other words, gold should do relatively well when confidence is on the decline and relatively poorly when confidence is on the rise.

By comparing the gold/commodity ratio with measures of monetary and/or economic confidence it can be shown that gold generally does exactly what it should do. There are periods of divergence, but these tend to be short (no more than a few months) and barely noticeable on long-term charts.

The point outlined above can be illustrated by comparing the gold/commodity (gold/GNX) ratio with the IEF/HYG ratio, which I’ve done in the following chart.

The IEF/HYG ratio is fit for our purpose because it is a measure of what’s happening to credit spreads, and because the economy-wide credit-spread trend is one of the best indicators of economic confidence. Specifically, the IEF/HYG ratio increases when credit spreads are widening (indicating declining economic confidence) and decreases when credit spreads are narrowing (indicating rising economic confidence).

Therefore, it is fair to say that the following chart compares the gold/commodity ratio with the reciprocal of confidence in the US economy.

Lo and behold, the two lines on the chart track each other quite closely.

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

TARGET2 is the system set up in the euro-zone to clear inter-bank payments. The Bundesbank (Germany’s central bank) describes it as a payment system that enables the speedy and final settlement of national and cross-border payments. The problem is that often there is no “final settlement” under TARGET2. Instead, credits and debits can build up indefinitely.

To understand the issue it first must be understood that although the 19 countries that comprise the euro-zone use a common currency, the euro-zone isn’t really a unified monetary system. It is more like 19 separate monetary systems, each of which is overseen by a National Central Bank (NCB). These NCBs are, in turn, overseen and coordinated by the ECB. TARGET2 is the means by which money is transferred quickly and efficiently between these 19 separate monetary systems. The transfer may well be quick and efficient, but, as noted above, it often doesn’t result in final settlement.

Further explanation is provided by the Bundesbank, as follows:

“…both the Bundesbank and the Banque de France will be involved in a cross-border payment transaction made in settlement of a German export to France, for instance. That transaction begins when the French importer’s commercial bank in France debits the purchase amount from the importer’s account and submits a credit transfer in TARGET2 to the German exporter’s commercial bank in Germany. The Banque de France then debits the amount from the TARGET2 account it operates for the French commercial bank and posts a liability owed to the Bundesbank. For its part, the Bundesbank posts a claim on the Banque de France and credits the amount to the German commercial bank’s TARGET2 account. The transaction is concluded when the commercial bank credits the amount in question to the account it operates for the German exporter.

At the end of the business day, all the intraday bilateral liabilities and claims are automatically cleared as part of a multilateral netting procedure and transferred to the ECB via novation, leaving a single NCB liability to, or claim on, the ECB.

Viewed in isolation, the transaction used as an example above leaves the Banque de France with a liability to the ECB and the Bundesbank with a claim on the ECB at the end of the business day. These claims on, or liabilities to, the ECB are generally referred to as TARGET2 balances.”

The example given above by the Bundesbank refers to a German export to France, but the same process would apply when someone transfers money from a bank deposit in one EZ country to a bank deposit in another EZ country. For example, the electronic wiring of funds from a commercial bank account in Italy to a commercial bank account in Luxembourg would leave the Banca d’Italia with a liability to the ECB and the Banque Centrale du Luxembourg with a claim on the ECB.

The process described above means that there is never any net clearing of cross border payments at the NCB level. Unless the money flowing in one direction (into Country X) equals the money flowing in the opposite direction (out of Country X), credit/debit balances will build up and there is no limit to how large these balances can become.

As illustrated by the following chart from Yardeni.com, this is not just a hypothetical issue. The NCBs of some EZ countries, most notably Germany and Luxembourg, now have huge positive TARGET2 balances, and the NCBs of some other EZ countries, most notably Italy and Spain, now have huge negative TARGET2 balances.

As at October-2018, the central bank of Germany was owed 928 billion euros by the TARGET2 system, while together the central banks of Italy and Spain owed 887 billion euros to the TARGET2 system. Is this a problem?

The system is so strange that there doesn’t appear to be a clear-cut answer to the above question, at least not one that we can fathom. It could be a huge problem or it could be no problem at all.

The Bundesbank is sitting there with an asset valued at almost 1 trillion euros that will never pay any interest and cannot be collected. At first blush this appears to be a huge problem. It implies that at some point the asset will have to be written off, perhaps leading to a very expensive bailout funded by German taxpayers. But then again, due to the way the current monetary system works it may well be possible for TARGET2 balances to grow indefinitely with no adverse consequences. That’s why we haven’t devoted any commentary space to this issue in the past.

If we were forced to give an answer to the above question it would be that rising interest rates, burgeoning government debt levels and private bank failures will become system-threatening issues in the EZ long before the TARGET2 balances pose a major threat.

Bank reserves are a throwback to a time when the amount of receipts for money (gold) that could be issued by a bank was limited by the amount of money (gold) the bank held in reserve. Under the current monetary system bank reserves have no real meaning, since it isn’t possible for a dollar in a bank deposit to be genuinely backed by a dollar held somewhere else. The dollar can’t back itself! However, it is still important to understand what today’s bank reserves are/aren’t and how changes in the reserves quantity are linked to changes in the economy-wide money supply. Remarkably, these bank-reserve basics are misunderstood by almost everyone who comments on the topic.

The simplest way for me to deal with the common misunderstandings about bank reserves is in point form, so that’s how I’ll do it. Here goes:

1) Bank reserves aren’t money, that is, they are not considered to be general media of exchange and are not counted in the True Money Supply (TMS). Instead, they provide ‘backing’ for part of the money supply.

2) A corollary of the above is that banks can’t use their reserves to buy things outside the Federal Reserve system.

3) Banks can lend their reserves to other banks, but the banking industry as a whole cannot expand or shrink its reserves. In other words, the banking industry has no control over its collective reserves. The central bank has total control.

4) Bank reserves can be shifted around within accounts at the Fed, but the only way that reserves can leave the Fed and enter the economy is via the withdrawal, by the public, of physical currency from banks. For example, when $100 is withdrawn from an ATM, $100 is converted from deposit currency to physical currency. This doesn’t alter the money supply, but it causes the bank to lose a $100 liability (the bank customer’s deposit) and a $100 asset (the physical currency held in the bank’s vault). When the quantity of physical currency held in a bank’s vault gets too small, the bank will replenish its supply by withdrawing reserves from the Fed in the form of new paper dollars. Although it may appear that this imposes some sort of limit on the supply of physical dollars, the Fed stands ready, willing and able to meet any increase in demand. This is further discussed in point 5).

5) Under the current monetary system, reserves effectively are created out of nothing. To be more precise, the Fed creates reserves when it purchases bonds and other assets. Since there is no limit to the dollar value of assets that can be purchased by the Fed, the banking system will never run short of the reserves it needs to meet the public’s demand for physical currency. Also, the Fed can remove reserves whenever it wants by selling bonds and other assets.

6) Except for the siphoning of reserves in response to the public’s increasing demand for physical currency, it is accurate to say that reserves at the Fed stay at the Fed until they are removed by the Fed. A corollary — as already mentioned in point 3) — is that the commercial banking industry cannot draw-down its reserves.

7) The Fed pays interest on ALL reserves, not just so-called “excess reserves”. In any case and as outlined below, for all intents and purposes all US bank reserves, with the exception of the relatively small portion required to meet any increase in the demand for physical currency, are now excess and have been for the past few decades.

8) The way the US monetary system now works it is fair to say that all reserves are excess. The reason is that the quantity of bank reserves has no bearing on the amount by which banks expand/contract credit. In effect, the US now has a zero-reserve fractional reserve banking system. That’s why it was possible for the greatest expansion of bank credit in modern US history, which took place during 1990-2007, to happen while the commercial banking industry had almost no reserves. During this period total bank credit rose by $6 trillion, from $2.5T to $8.5T, while bank reserves at the Fed dwindled from $64B to $40B.

9) Further to point 8), bank lending doesn’t ‘piggy-back’ on bank reserves. It possibly did 40 years ago, but it hasn’t for at least the past 25 years. Hopefully, economics textbooks eventually will be updated to reflect this reality.

10) An implication of points 7) and 8) is that interest payments on reserves are neither an incentive nor a disincentive to bank lending. When a bank makes a loan to a customer it doesn’t lose any reserves and therefore continues to collect the same interest-on-reserves payment from the Fed.

11) The sole purpose of paying interest on reserves is to enable the Fed to hike the Fed Funds Rate during a period when the banks are inundated with reserves, without having to massively reduce the quantity of reserves. This was discussed in previous blog posts, for example HERE.

12) When the Fed was ‘quantitatively easing’ many pundits wrote that it was adding to bank reserves but not the money supply. This is wrong. When the Fed buys X$ of securities as part of a QE program it adds X$ to bank reserves AND it adds X$ to the economy-wide money supply. I previously described the process HERE.

13) By the same token, now that the Fed is ‘quantitatively tightening’ it is not just removing bank reserves. When the Fed sells X$ of securities as part of what it refers to as its balance-sheet normalisation program it removes X$ from bank reserves AND it removes X$ from the economy-wide money supply. In essence, it’s the process I described in the above-linked post (point 12) in reverse. That’s why the balance-sheet normalisation program is vastly more important, as far as monetary conditions are concerned, than the rate-hiking program.

[This blog post is an excerpt from a TSI commentary published about three weeks ago and covers a few general thoughts about what will happen in the financial world this year. Specific thoughts about what I expect this year from the stock, gold, bond, currency and commodity markets have also been included in TSI commentaries over the past three weeks.]

1) Early last year we predicted that the US stock market would experience greater-than-average volatility over the year ahead. This obviously happened, as there were more 2%+ single-day moves in the SPX during 2018 than in an average year.

We expect the same for this year, that is, we expect price volatility to remain elevated. The reason is that the two most likely scenarios involve abnormally-high price volatility. One of these scenarios is that a cyclical bear market began last October, and bear markets are characterised by periods of substantial weakness followed by rapid rebounds. The other scenario is that a very long-in-the-tooth cyclical bull market is about to embark on its final fling to the upside.

2) When attempting to predict when a period of economic growth will end it is futile to look more than 6-12 months into the future, because there are no leading recession indicators that can predict that far ahead with acceptable reliability. There are, however, leading indicators that can be used to determine the probability of a recession beginning within the next few quarters.

Early last year these indicators told us that a US recession would not begin during the first half of the year. They currently tell us that the US economy stands a good chance of commencing a recession this year, most likely during the second half of the year. Note, though, that if a recession does get underway this year it won’t become official until 2020, because recessions usually aren’t confirmed by the National Bureau of Economic Research until about 12 months after they start.

3) Regarding ‘cryptoassets’, at around this time last year we wrote:

“…it’s a good bet that the Bitcoin bubble reached its maximum level of inflation late last year. Also, the broader bubble in cryptoassets is set to burst during the first quarter of this year.”

And:

“By the end of 2018 it will be apparent that the public’s enthusiasm for Bitcoin and the “alt-coins” was one of history’s great speculative manias.”

This assessment looks correct.

We don’t have a strong opinion about what will happen to ‘cryptoassets’ in 2019. This is partly because there is no reasonable way to determine the fair value of these assets. For Bitcoin, for example, a price of $3,000 is no more or less sensible than a price of $30,000 or a price of $300.

Distributed ledgers can be very useful, but there should be ways to implement them without consuming a lot of resources. If so, the price of Bitcoin eventually will drop to almost zero.

A year ago we also predicted:

“Despite spectacular collapses in the prices of the popular ‘cryptoassets’ during 2018, central banks including the Fed and the ECB will firm-up plans to introduce their own blockchain-based currencies. This will be driven by a desire to eliminate physical cash, the thinking being that if there is no physical money it will be more difficult for the average person to make/receive unreported payments and escape a negative interest rate.”

As far as we know the major central banks didn’t firm-up plans to introduce their own blockchain-based currencies last year, but we continue to expect that they will — for the reasons mentioned above.

4) Regarding the Fed’s expected actions in 2018, early last year we wrote:

“Due to rising commodity prices it’s a good bet that “price inflation” will become a higher-profile issue during the first half of 2018, prompting the Fed to move ahead with its quantitative tightening (QT) and make two more rate hikes. However, both the QT and the rate-hiking will be put on hold during the second half of the year in reaction to increasing downside volatility in the stock market.”

We got the anticipated rate hikes during the first half and the increasing downside stock-market volatility during the second half of last year, but the Fed stuck to its guns. However, over the past three weeks the Fed Chairman has made it clear that the Fed will be quick to change direction if the stock market continues to decline and/or the economic numbers point to significant weakness.

For 2019 we expect one Fed rate hike, most likely in June. Also, we expect that people ‘in the know’ will explain to senior Fed members that it’s the balance-sheet reduction program (QT) that really counts, prompting the Fed to slow the pace of QT during the first half and conclude the QT program before year-end.

5) The ECB has just ended its QE program and has a tentative plan to implement its first rate hike during the third quarter of 2019. Given that nothing has been learned from the failed monetary experiments of the past few years, it’s a good bet that evidence of declining economic activity in the future will be met by the ramping-up or reintroduction of policies that failed in the past. Therefore, we predict that the ECB will not increase its targeted interest rates this year and will restart QE during the second half of the year.

6) This is not a prediction for 2019, but rather an observation that could apply for decades to come. We suspect that the age of real estate has ended.

We don’t mean that from now on it will be impossible to achieve good returns by investing in real estate, but that gone are the days when anyone could buy a house almost anywhere and likely end up with a sizable profit as long as they held for 10 years or more. From now on only astute investors will consistently make good returns from real estate, where “astute” means able to time the cyclical swings in the broad market or able to correctly anticipate future supply-demand imbalances in specific areas.

For the average person, residential property will transition from an investment to what it was prior to the 1970s: a consumer good (something bought solely for its use value).

The reason for the change is the interest-rate trend. The 3-4 decade downward trend in interest rates resulted in a 3-4 decade upward trend in housing affordability for buyers using debt-based leverage (that is, for the vast majority of buyers). There were corrections along the way, but provided that long-term interest rates continued to make lower lows there would eventually be a pool of new debt-financed buyers able to pay a much higher price.

There’s a good chance that the secular interest-rate trend reversed from down to up during 2016-2018. If so, future house buyers that don’t have good timing and/or substantial area-specific knowledge generally won’t make long-term capital gains on their residential property purchases.

The ‘true fundamentals’ began shifting in gold’s favour in October of last year and by early-December the fundamental backdrop was gold-bullish for the first time in almost a year. However, there is not yet confirmation of a new gold bull market from the most reliable indicator of gold’s major trend. I’m referring to the fact that the gold/SPX ratio is yet to achieve a weekly close above its 200-week MA. Here’s the relevant chart:

The significance of the gold/SPX ratio is based on the concept that the measuring stick is critical when determining whether something is in a bull market. If a measuring stick is losing value at a fast pace then almost everything will appear to be in a bull market relative to it. For example, pretty much everything in the world has been rising in value rapidly over the past few years when measured in terms of the Venezuelan bolivar. It should be obvious, though, that not everything can be simultaneously in a bull market. To determine which assets/investments are in a bull market we can’t only go by performance relative to any national currency; we must also look at the performances of assets/investments relative to each other.

That’s where the gold/SPX ratio comes in. Gold and the world’s most important equity index are effectively at opposite ends of the ‘investment seesaw’. Due to their respective natures, if one is in a long-term bull market then the other must be in a long-term bear market. In multi-year periods when they are both trending upward in dollar terms it means that the dollar is in a powerful bear market, not that gold and the SPX are simultaneously in bull markets.

An implication — as noted on the following chart — is that a gold bull market did not begin in December-2015. Gold cannot be in a bull market and at the same time be making new 10-year lows relative to the SPX, which is what it was doing until as recently as August-2018. At least, it can’t do that if a practical and sensible definition of “bull market” is used.

It’s possible that a gold bull market got underway in August-2018, but as mentioned above this has not yet been confirmed.

About five months ago I posted an article in response to stories that the Chinese government had pegged either the SDR-denominated gold price or the Yuan-denominated gold price. These stories were based on gold’s narrow trading range relative to the currency in question over the preceding two years, as if government manipulation were the only or the most plausible explanation for a narrow trading range in a global market. To illustrate the silliness of these stories I came up with my own story — that it was actually the Japanese government that was pegging the gold price. My story had, and still has, the advantage of being a better fit with the price data.

Just to recap, my story was that the Japanese government took control of the gold market in early-2014 and subsequently kept the Yen-denominated gold price at 137,000 +/- 5%. They lost control in early-2015 and again in early-2018, but in both cases they quickly brought the market back into line.

The following chart shows that they remain in control.

The narrow sideways range of the Yen gold price over the past 5 years is due to the Yen being the major currency to which gold has been most strongly correlated. The correlation is positive, meaning that the prices of gold and the Yen have a strong tendency to trend in the same direction. This is evidenced by the following daily chart, which compares the US$ price of gold with the US$ price of the Yen.

Moving from the fantasy world to the real world, the relationship depicted above doesn’t exist because the Japanese government is pegging gold to the Yen. It exists because both gold and the Yen trade like safe havens, meaning that they tend to do relatively well when economic growth expectations and the general desire to take-on risk are on the decline, and relatively poorly when economic growth expectations and the general desire to take-on risk are on the rise.

Gold trades like a safe haven because in part that’s what it is. The Yen is a piece of crap, but it trades like a safe haven due to the relentless popularity of Yen carry trades. These carry trades involve borrowing/shorting the Yen to finance long positions in higher-yielding currencies, and are a form of yield-chasing speculation. Periodically they have to be exited in a hurry to mitigate the losses caused by declining prices in the aforementioned high-yielding speculations. When this happens the Yen rallies, and sometimes the rallies are dramatic. Last week, for example.

Divergences or non-confirmations between gold and the Yen can create trading opportunities. However, the two markets are in line with each other at the moment, meaning that there is currently no divergence or non-confirmation worth trading.

The Fed probably will implement another 0.25% rate hike this week, but at the same time it probably will signal either an indefinite pause in its rate hiking or a slowing of its rate-hiking pace. The financial markets have already factored in such an outcome, in that the prices of Fed Funds Futures contracts reflect an expectation that there will be no more than one rate hike in 2019. However, this doesn’t imply that the Fed is about to stop or reduce the pace of its monetary tightening. In fact, there’s a good chance that the Fed unwittingly will maintain its current pace of tightening for many months to come.

The reason is that the extent of the official monetary tightening is not determined by the Fed’s rate hikes; it’s determined by what the Fed is doing to its balance sheet. If the Fed continues to reduce its balance sheet at the current pace of $50B/month then the rate at which monetary conditions are being tightened by the central bank will be unchanged, regardless of what happens to the official interest rate targets.

Another way of saying this is that a slowing or stopping of the Fed’s rate-hiking program will not imply an easier monetary stance on the part of the US central bank as long as the line on the following chart maintains a downward slope.

The chart shows the quantity of reserves held at the Fed by the commercial banking industry. A decline in reserves is not, in and of itself, indicative of monetary tightening, because bank reserves are not part of the economy’s money supply. However, when the Fed reduces bank reserves by selling securities to Primary Dealers (as is presently happening at the rate of $50B/month) it also removes money from the economy*.

I use the word “unwittingly” when referring to the likelihood of the Fed maintaining its current pace of tightening because, like most commentators on the financial markets and the economy, the decision-makers at the Fed are oblivious to what really counts when it comes to monetary conditions. They are labouring under the false impression that monetary tightening is effected mainly by hiking short-term interest rates and that the current balance-sheet reduction program is a procedural matter with relatively minor real-world consequences.

Therefore, over the next several weeks there could be a collective sigh of relief in the financial world as traders act as if the Fed has taken its foot off the monetary brake, followed by a collective shout of “oops!” when it becomes apparent that monetary conditions are still tightening.

*When the Fed sells X$ of securities to a Primary Dealer (PD) the effect is that X$ is removed from the PD’s account at a commercial bank and X$ is also removed from the reserves held at the Fed by the PD’s bank.

Apart from a 2-week period around the middle of the year, my Gold True Fundamentals Model (GTFM) has been bearish since mid-January 2018. There have been fluctuations along the way, but at no time since mid-January have the true fundamentals* been sustainably-supportive of the gold price. However, significant shifts occurred over the past fortnight and for the first time in quite a while the fundamental backdrop is now very close to turning gold-bullish. In fact, an argument could be made that it has already turned bullish.

Below is a chart comparing the GTFM (in blue) with the US$ gold price (in red).

The above chart understates the significance of the recent fundamental shift, because it appears that the GTFM has done no more than rise to the top of its recent range while remaining in bearish territory (which, of course, it has). However, a look beneath the surface at what’s happening to the GTFM’s seven individual components reveals some additional information.

The most important piece of additional information is the recent widening of credit spreads. The credit spreads input to the GTFM turned bullish four weeks ago, but since then it has moved a lot further into bullish territory. This has improved the fundamental situation (from gold’s perspective) without affecting the GTFM calculation.

Here is a chart showing the positive correlation between a measure of US credit spreads (the green line) and the gold/GNX ratio (gold relative to commodities in general). As economic confidence declines, credit spreads widen and gold strengthens relative to other commodities.

All things considered, for the first time in many months the true fundamentals appear to be slightly in gold’s favour. If the recent trend in the fundamental situation continues then we should see the gold price return to the $1300s early next year, but, of course, that’s a big if. Furthermore, even if the fundamental backdrop continues to shift in gold’s favour over the weeks ahead it will make sense for speculators who are long gold and the related mining equities to take money off the table when sentiment and/or momentum indicators issue warnings.

*Note that I use the term “true fundamentals” to distinguish the actual fundamental drivers of the gold price from the drivers that are regularly cited by gold-market analysts and commentators. According to many pontificators on the gold market, gold’s fundamentals include the volume of metal flowing into the inventories of gold ETFs, China’s gold imports, the volume of gold being transferred out of the Shanghai Futures Exchange inventory, the amount of “registered” gold at the COMEX, India’s monsoon and wedding seasons, jewellery demand, the amount of gold being bought/sold by various central banks, changes in mine production and scrap supply, and wild guesses regarding JP Morgan’s exposure to gold. These aren’t true fundamental price drivers. At best, they are distractions.

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

In an article titled “China’s monetary policy must change” Alasdair Macleod discusses a path that China’s government could take to make the Yuan gold-backed and thus bring about greater economic stability in China. Keith Weiner pointed out some flaws in the Macleod article, including the fact that the sort of Gold Standard that involves pegging a national currency to gold is just another government price-fixing scheme and therefore doomed to fail. We will single out an error in the article that Keith didn’t address and then briefly explain why a gold-backed Yuan is a pipe dream.

This excerpt from the article contains the error we want to focus on:

“China’s manufacturing economy will be particularly hard hit by the rise in interest rates that normally triggers a credit crisis. Higher interest rates turn previous capital investments in the production of goods into malinvestments, because the profit calculations based on lower interest rates and lower input prices become invalid.”

No, higher interest rates do not turn previous capital investments in the production of goods into malinvestments. A rise in interest rates can help reveal malinvestments for what they are, but it doesn’t create them.

Malinvestment occurs on a grand scale when the banking system creates a large amount of money out of nothing, generating false interest-rate signals and making it seem as if the amount of real savings in the economy is much greater than is actually the case. In response to the misleading (artificially low) interest rates and the increased future demand that these interest rates imply (more saving in the present implies more consumption in the future), investments are made in productive capacity. Many of these investments will prove to be ill-conceived, because future demand will turn out to be lower than expected. The investments only appeared to make sense due to the false impressions created by banks loaning copious quantities of new money into existence.

Another way to look at the situation is that a build-up of real savings requires a temporary reduction in consumption. Think of it as a savings-consumption trade-off. People abstain from consumption in the short term so that they will be able to consume more in the long term. When that happens on an economy-wide basis, interest rates move lower.

The falling interest rate indicates that savings are being increased and, by extension, that consumption will be higher in the future. In other words, the falling interest rate is a message that long-term investments in productive capacity are likely to pay off. The problem is that when money is created in large amounts out of nothing, interest rates tend to fall at the same time as consumption is increasing. So, entrepreneurs are being told (by the falling interest rate) that consumption will be greater in the future and to invest accordingly, but at the same time consumers are spending aggressively and ‘tapping themselves out’. Naturally, this doesn’t end well.

The crux of the matter is that malinvestment stems from artificially low interest rates. Also, once it has happened, it has happened. Rising interest rates can be part of the process via which the mistakes are revealed, but the mistakes won’t disappear if interest rates are prevented from rising. Putting it another way, it is not possible to avoid the painful consequences (economic recession or depression) that follow a period during which malinvestment was rife. This is relevant, because the Macleod article argues that interest rates could be kept low in China by linking the Yuan to gold and that by doing this the amount of existing investment that falls into the ‘mal’ category could be greatly reduced.

The reality is that regardless of what happens to interest rates in the future, the extent of the previous malinvestment is such that China’s economy will experience either a collapse or a very long period (probably at least a decade) of virtual stagnation. Given the control that the government has over the banking industry, we guess the latter.

The point is that linking the Yuan to gold wouldn’t be a way around the massive problems that are already baked into the cake. In any case this is a side issue, because there are two simpler reasons that the idea of a gold-backed Yuan is a non-starter.

The first reason is that in a world in which most international trades are US$-denominated, tying any currency apart from the US$ to gold would result in that currency’s exchange rate becoming as volatile as the US$ gold price. In fact, the exchange rate of the gold-backed currency would be totally determined by the performance of the US$ gold price. For example, if the US$ gold price were to rise by 20% in quick time then so would the exchange rate (against the US$) of the gold-backed currency.

The second and more important reason is that any government that implemented a Gold Standard would be relinquishing control of its currency. There would be no further scope for the manipulation of interest rates and currency exchange rates. Also, there no longer would be any scope for debt monetisation in particular and monetary stimulus in general. If we were to make an ordered list of the governments that are LEAST likely to give up these powers, China’s government would be at the top.

Summing up, linking the Yuan to gold would not prevent China’s economy from suffering the consequences of the widespread malinvestment of the past decade and probably would lead to much greater volatility in the prices of imports and exports. Most importantly, there is no way that the control freaks who lead the Communist Party of China are going to implement a monetary system that severely restricts their ability to intervene.