The following chart shows that on a monthly closing basis, bank reserves held at the Fed peaked in August of 2014 at $2.79T and by August-2016 had shrunk to $2.35T. This amounts to a $440B decline in bank reserves over the space of two years. Furthermore, $320B of this $440B decline happened since last October. Does this mean that while the financial world vigorously debates whether the Fed will/should take a ‘baby step’ along the rate-hiking path next week, behind the scenes the Fed has been tightening the monetary screws for 2 years and especially over the past 10 months?

In a word, no. Up until now the Fed has done nothing to tighten monetary conditions.

I am, of course, aware that there was a tiny increase in the Fed’s targeted interest rate last December, but this rate hike was not implemented via a money-supply or reserve reduction and therefore did not constitute genuinely-tighter monetary policy. What, then, is the explanation for the significant reduction in bank reserves held at the Fed?

Before getting to the explanation I’ll reiterate that there are only three ways for US commercial bank reserves to decline. They can be converted to physical currency in circulation in response to increasing demand on the part of the public for notes and coins, they can be shifted to other accounts at the Fed, or they can be removed by the Fed. Only the last of these constitutes monetary tightening by the Fed.

Part of the explanation for the decline in bank reserves is the increasing demand on the part of the public for notes and coins. Due to “inflation”, this demand increases almost every year and is satisfied by the conversion of reserves into physical currency. This naturally has the effect of reducing bank reserves, but the process does not change the money supply because the physical currency replaces electronic currency. For example, when you withdraw $100 at an ATM, $100 is converted from electronic form to paper form while the total money supply is obviously unaffected. This $100 of ‘paper’ comes from the bank’s reserves.

The following chart shows the steady increase in “Currency in Circulation” over the past 5 years. As noted above, this increase involves the siphoning of reserves (in physical form) out of the banking system to replace electronic money. An implication is that if the Fed does nothing and the public’s demand for physical notes/coins is rising, bank reserves will dissipate over time.

Since last October, when the rate of decline in bank reserves accelerated, “Currency in Circulation” has risen from $1392B to $1464B, or by $72B. In other words, increasing demand for physical notes/coins only explains $72B of the $320B reduction in reserves since last October. If the remaining $248B reduction wasn’t due to the actions of the Fed, what caused it?

Before I answer the above question I’ll provide evidence that the reserve reduction wasn’t engineered by the Fed. The evidence is the following chart showing total Federal Reserve Credit. Notice that Total Fed Credit has flat-lined since the end of QE in October-2014. This indicates that since October-2014 the Fed has not made any sustained additions to or deletions from the quantity of money or the quantity of bank reserves.

Getting back to the question asked above, the answer is the US Treasury. More specifically, about 90% of the remaining $248B reduction in bank reserves has been caused by the US Treasury hoarding a lot more cash than usual at the Fed.

As I mentioned earlier in this piece, bank reserves can’t leave the Fed unless they are removed by the Fed or get converted to physical currency in response to increasing public demand for notes/coins, but they can get shifted to other (non-reserve) accounts at the Fed. One of these accounts is called the US Treasury General Account, which, as the name suggests, is the US government’s account at the Fed.

As illustrated by the following chart, the Treasury General Account was about $50B at the end of October last year and was about $275B at the end of August this year. This means that over the 10-month period beginning in November of last year the US Treasury removed about $225B from the economy-wide money supply and removed the equivalent amount from bank reserves.

Just to be clear, the government removes trillions of dollars per year from the economy, but it normally recycles the money very quickly. Usually, money comes in one door via taxation or borrowing and immediately goes out another door. The difference this year is that the Federal Government has been maintaining a much higher ‘cash float’ than usual.

I don’t know why the US Federal government has suddenly started keeping a lot more cash in reserve. Perhaps the leadership wants to make sure that, come what may, there will always be plenty of ready cash to pay the salaries/benefits of politicians and senior bureaucrats.

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.