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At TSI over the past year and at the TSI Blog two months ago I’ve made the point that the Fed gave itself the ability to pay interest on bank reserves so that the Fed Funds Rate (FFR) could be raised without the need to shrink bank reserves and the economy-wide money supply. I explained that the driver of this change in the Fed’s toolbox was the fact that the massive quantity of reserves injected into the banking system by QE (Quantitative Easing) meant that it would no longer be possible for the Fed to hike the FFR in the traditional way, that is, via the sort of small-scale shrinkage of bank reserves that was used in the past. Instead, the quantity of reserves has become so much larger than would be required to maintain a Funds Rate of only 0.25% that even a tiny increase to 0.50% would necessitate a $1 trillion+ reduction in reserves and money supply, which would crash the stock and bond markets. The purpose of this post is to point out that while the payment of interest on bank reserves is now the Fed’s primary tool for implementing rate hikes, there are two other tools that the Fed will use over the years ahead in its efforts to manipulate short-term US interest rates and distort the economy.

Before going any further I’ll note that it isn’t just logical deduction that led to my conclusion regarding the purpose of interest-rate payments on bank reserves. It happens to be the only conclusion that makes sense, but it’s also the case that the Fed, itself, has never made a secret of why it started paying interest on reserves. The Fed’s reasoning was reiterated in a 27th February speech by Vice Chairman Stanley Fischer. A hat-tip to John Mauldin and Woody Brock for bringing this speech to my attention.

The two other tools that will be used by the Fed to raise the official overnight interest rate are Reverse Repurchase agreements (RRPs) and the Term Deposit Facility (TDF). The RRP isn’t a new tool, but its importance has increased and will continue to do so. The TDF is a relatively new tool, having been introduced on a small scale in 2010 and having been expanded in 2014.

The RRP is used by the Fed to borrow reserves and money for short periods, with securities (bonds, notes or bills) from the Fed’s stash being used as collateral for these borrowings. Now, an institution that has the unlimited ability to create new money can never run short of money and will therefore never need to borrow money to fund its operations, but the Fed sometimes borrows money via RRPs as part of its efforts to manipulate interest rates. Specifically, by offering to pay financial institutions a certain interest rate to borrow reserves and money, the Fed pressures the effective interest rate towards its target.

The TDF is similar to a normal money-market account, except that it is provided by the Fed and can only be used by depository institutions. The term of the deposit is currently up to 21 days and the interest rate paid is slightly above the rate paid on bank reserves.

Further to the above, when the Fed eventually decides to hike the Fed Funds Rate it will not do so by reducing the quantity of bank reserves. The quantity of bank reserves will probably decline as part of the rate-hiking process, but the quantity of reserves in the banking system is now so far above what it needs to be that it is no longer practical for reserve reduction to be the driver of a higher Fed Funds Rate. Instead, when the Fed makes its first rate hike — something that probably won’t happen until at least September-2015 — it will do so by 1) raising the interest rate paid on bank reserves, 2) increasing the amount that it pays to borrow money via Reverse Repurchase agreements, and 3) boosting the rate that it offers to financial institutions for term deposits.

A recent Mineweb article warrants a brief discussion. The article contains several illogical statements, which is not surprising considering the author. For example, this is from the second paragraph: “…the fact remains that any entity with sufficient capital behind it can usually move any market in the direction that suits it…” Large financial institutions and hedge funds undoubtedly wish that this were true, but in the real world these entities ‘come a cropper’ when they take big positions that aren’t fundamentally justified. However, I’ll ignore the other flaws and zoom in on the Ted Butler assertion that constitutes the core of the article. I’m referring to the assertion that banking behemoth JP Morgan (JPM) has managed to accumulate a 350M-oz hoard of physical silver while simultaneously causing the silver price to trend downward via the selling of futures contracts. It’s analysis like this that gives gold and silver bulls a bad name, because anyone with knowledge of how markets work will immediately see that it is complete nonsense.

Selling commodity futures and simultaneously buying the physical commodity cannot cause a downward trend in the commodity price, assuming that the amount sold via the futures market is equivalent to the amount bought in the spot market. Price-wise, the only effect would be to boost the spot price of the commodity relative to the price for delivery at some future time. Selling more via the futures market than is bought in the spot market could temporarily push the price downward, but the operative word here is “temporarily” since every short-sale must subsequently be closed out with a purchase. In any case, I get the impression from the above-linked article that JPM has supposedly managed to bring about a downward trend in the silver price while remaining net ‘flat’. This is not possible.

I don’t know how much physical silver is owned by JPM or what JPM’s net exposure to silver is*, and I couldn’t care less. I certainly see no good reason to comb through documents trying to find the answer because the answer is totally irrelevant to the investment case for silver. The investment case for silver is determined partly by silver’s market value relative to the market values of gold and the industrial metals, and partly by the same macro-economic fundamentals that are important for gold. Right now, silver has reasonable relative value and neutral fundamentals, with the fundamentals looking set to improve during the second half of this year.

I’m ‘long’ physical silver, despite, not because of, the ‘analyses’ of some of the most outspoken silver bulls.

*Neither does Ted Butler nor anyone else who isn’t a senior manager at JPM

At the beginning of last week I wrote that gold and the HUI were coiling, the implication being that a sharp 1-3 week move in one direction or the other would soon begin. There was no way of knowing the direction of the move, although the performance of the HUI/gold ratio relative to its 40-day moving average (MA) suggested that the direction would be up.

There were multiple head fakes last week, with a) gold bullion almost breaking out to the downside last Friday, b) the HUI chopping around near its 50-day MA, and c) the HUI/gold ratio being the only consistent indicator by sustaining its upside breakout. At this stage it looks like the HUI/gold ratio was sending the correct message, because both gold bullion and the HUI closed above the tops of their recent trading ranges on Tuesday 28th April.

The minor upside breakouts in gold-related stuff happened on the day before the Fed is scheduled to issue its next policy statement, which is out of character considering how gold has traded over the past 9 months. As noted in a commentary posted at TSI a few days ago, gold had closed lower over the course of the 5 trading days leading up to each of the past 6 FOMC meetings and would have stretched the negative pre-FOMC sequence to 7 if it had closed below $1201.80 on 28th April. Instead, it rebounded strongly and closed at $1211.50.

My thinking was that if the gold price had fallen over the first 2 trading days of this week it would have set the stage for a significant post-FOMC rebound, because the most likely outcome of this week’s FOMC meeting is a statement with almost no wording changes. No meaningful change to the wording of the Fed’s statement would mean that a June rate hike had effectively been taken off the table, which short-term speculators would undoubtedly view as gold-bullish (it’s actually irrelevant, but short-term moves are being driven by sentiment).

However, it seems that speculators have jumped the gun. As a result, buying in advance of Wednesday’s FOMC statement is now riskier. My guess is that gold and the gold-mining stocks will extend their gains if the Fed signals “no rate hike in June”, but there is now more downside risk associated with an unexpectedly ‘hawkish’ Fed statement.

One of the criticisms of the current monetary system is that the money isn’t backed by anything. However, while there are some big problems with the current system, this criticism isn’t valid. The reason is that money is never backed by anything.

Taking the specific case of the US dollar, the view that the US$ should be backed by something and the related view that the absence of backing implies a major flaw is a hangover from the Gold Standard. Under the Gold Standard that existed in the US prior to the early-1930s, a US dollar represented and was exchangeable into a fixed amount of gold.

The critical point is that under the Gold Standard the US$ wasn’t money; gold was money. The US dollars in circulation were receipts or IOUs that entitled the bearer to a certain amount of gold (money). The dollar itself wasn’t money. At most, it was a “money substitute”.

Today’s paper dollars are not IOUs or receipts. They are not “money substitutes”, they are money proper. Consequently, they do not need to be backed by anything. In fact, if they were backed by something then whatever was doing the backing would be money and the dollar itself would be a money substitute rather than actual money.

The situation isn’t as clear with regard to dollars in bank deposits as it is with regard to paper dollars, as the dollars in bank deposits are backed by the promise of the banking system to convert from electronic to paper on demand. It could therefore be argued that electronic dollars in bank deposits are money substitutes rather than money, although it is reasonable to count them in the money supply because the central bank has the ability to meet any demand for the conversion of electronic dollars into paper dollars.

The fact that today’s money isn’t backed by anything is therefore not the problem. If gold were money then the money also wouldn’t be backed by anything. That’s the nature of money. The problem, instead, is that for something to be GOOD money its supply should be fairly stable and it should be widely perceived to have value outside its role as a medium of exchange. The US dollar and all of today’s official monies fail to meet either of these requirements, whereas cryptocurrencies such as Bitcoin fail to meet the second requirement.

A hedging program can make sense for a gold producer, but hedging is something that — with a small number of exceptions — gold producers should never do. This is not because there will always be a direct cost or an opportunity cost associated with any hedging program, it’s because gold producers are so damn bad at it.

In order to optimise cash flow and make short-term financial performance more predictable, it will generally make sense for a gold producer to forward-sell some of its future production, either via a bullion bank or the futures market, after a run-up in the gold price to near a 6-month high. Provided that the total amount forward sold never exceeds more than half of the next 12 months of production, this type of hedging program would always smooth cash flows and would often increase cash flows. It would create an opportunity cost in a very strong gold market, but the cost would not be substantial because all production beyond the coming 12 months would remain unhedged.

However, gold-mining executives have proved over and over again that when it comes to the timing of their hedging moves, they are the proverbial dumb money. They get scared and put hedges in place following a large price decline and then get pressured into removing the hedges at great cost following a large price rise.

In other words, rather than locking-in relatively high prices for a portion of future production by hedging when the market is ‘overbought’, if they hedge at all it is usually when the market is ‘oversold’. Consequently, their hedges tend to lock-in relatively low prices for a portion of future production.

And it’s not just the hedging of future sales that gold-mining executives routinely make a mess of. They are usually just as bad when it comes to hedging their costs. For one example, Barrick Gold chose to mitigate the risk of future gains in the oil price by purchasing some oil production, the idea being that what its gold-mining business lost due to a higher oil price would be partially offset by increased profits from the oil business. The problem is that it made the purchase in mid-2008 — right at the secular peak for the oil price. For another example, the senior management of Gold Fields (GFI) implemented a hedging program covering the bulk of the company’s oil exposure through to the end of 2015. The problem is that the program was put into place just prior to last year’s oil price crash and therefore prevents GFI shareholders from obtaining any benefit from the lower oil price this year.

When trading or investing it is of vital importance to acknowledge your own weaknesses. For example, there is no shame in being a poor short-term trader provided that in recognition of this reality you risk very little money on short-term trades. Gold mining executives should acknowledge that they are hopeless at hedging and should stop trying to do it.

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 has been 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 is still my view. In other words, I think that the US has a roughly 0% probability of experiencing hyperinflation within the next 2 years. Furthermore, at no time over the past 15 years have I suggested being ‘long’ gold due to the prospect of a rapid rise in the CPI. This is partly because at no time during this period, including the present, has a rapid rise in the CPI seemed like a high-probability intermediate-term outcome, but it is mainly because gold has never been and is never likely to be a play on “CPI inflation”.

Gold is a play on the economic weakness caused by bad policy and on declining confidence in the banking establishment (led by the Fed in the US). That’s why cyclical gold bull markets are invariably born of banking/financial crisis and/or recession, and why a cyclical gold bull market is more likely to begin amidst rising deflation fear than rising inflation fear.

There are times when the declining economic/monetary confidence that boosts the investment demand for gold is linked to expectations of a rapid increase in “price inflation”, but it certainly doesn’t have to be. For example, the entire run-up in the gold price from its 2001 bottom to its 2011 peak had nothing to do with the CPI. Also, an increase in the rate of “CPI inflation” would only ever be bullish for gold to the extent that it brought about declining confidence in the economy or the banking establishment, as indicated by credit spreads, real interest rates, the BKX/SPX ratio and the yield curve. Since it’s possible for the CPI to accelerate upward without a significant decline in confidence, it’s possible that an upward acceleration in the CPI would not be bullish for gold.

The bottom line is that as far as the gold market is concerned, the CPI is more of a distraction than a driver. 

The US$ gold price has essentially gone nowhere in a boring way over the past 2 weeks, which probably means that a sharp 1-3 week move is about to start. The question is: In which direction?

Obviously, no one knows the answer to this question. The most we can do is look for clues in the price action.

On the minus side, gold closed below its 20-day moving average (MA) on Monday 20th April. This was the first daily close below this MA since mid-March and in isolation would be a sign that the price was rolling over to the downside. On the plus side, however, the price managed to hold at the 50-day MA on Monday. More importantly, the gold-stock indices made small gains despite an $8 decline in the gold price. This small bullish divergence between the bullion and the mining stocks tilts the odds in favour of the next $30+ move being to the upside.

Here are the relevant charts:

1. The first chart shows that gold has near-term resistance at $1210. A daily close above $1210 would suggest that the price was headed to at least $1230 and possibly as high as the $1280s.

2. The next chart shows that the HUI has managed to hold last week’s minor upside breakout, but has more resistance at 180. There is near-term (1-3 week) upside potential to 195.

3. The final chart paints the most bullish picture.

Gold’s true fundamentals (the fundamentals that many gold bulls studiously ignore as they instead choose to fixate on irrelevancies such as the amount of gold being imported by China) are neutral and gold/euro does not yet appear to be close to completing the intermediate-term correction from its January-2015 ‘overbought’ extreme, so the start of a major gold rally is probably not imminent. In other words, if the recent choppy price action leads to a quick advance over the next couple of weeks it probably won’t mean that we’ve seen the last opportunity to buy gold below $1200.

There’s an old saying that goes something like: If you owe the bank $100K and you can’t pay then you have a problem, but if you owe the bank $100M and you can’t pay then the bank has a problem. This saying applies to the current negotiations between the Greek government and the other euro-zone (EZ) governments regarding the Greek government’s ability to obtain additional support from its official-sector creditors. In particular, it explains why the governments of Germany, France, Italy, Spain, etc. are very keen for Greece to remain part of the EZ.

The following table shows the official-sector EZ exposure to Greek government debt. More specifically, the table shows the direct and indirect (via supranational organisations) financial exposure of each EZ member state to the bonds issued by Greece’s government. Total exposure amounts to about 330B euros, with individual exposure typically being in the 3%-4% of GDP range. In nominal euro terms, the states with by far the biggest exposure are Germany (92B), France (70.3B), Italy (61.5B) and Spain (42.3B).

If Greece leaves the EZ and the Greek government defaults on its debt, how will the political leaders of the remaining EZ members explain the resultant hit to their taxpayers? If they were honest (which, of course, they aren’t), the explanation would be along the lines of:

“On my watch we transferred an amount of money equivalent to more than 3% of our country’s GDP from you, the taxpayer, to various programs designed to bail out your counterparts in Greece. Actually, that’s not true. Far from being bailed out by the money transferred from your good-selves, the Greek government was saddled with a vastly greater debt burden and Greece’s economy was pummeled further into the ground. It was actually the private holders of Greek government bonds who were bailed out. Why? Well, in my defense, Greece’s economy was in the toilet anyway and I was advised that there would be a euro-zone-wide financial crisis if the bond-holders weren’t bailed out. I’m aware that the current crisis is much worse than the crisis we avoided by implementing the bailout, but there’s no point crying over spilt milk. So, please let bygones be bygones and vote for me anyway.”

The desire to avoid having to make a sanitised version of the above speech will be a powerful motivator as Greece-related deadlines approach over the weeks immediately ahead.

The following charts relate to an email that will soon be sent to TSI subscribers.

CHART 1 – THE US$ GOLD PRICE

CHART 2 – THE HUI

CHART 3 – THE HUI/GOLD RATIO

CHART 4 – THE NYSE COMPOSITE INDEX

CHART 5 – THE CANADIAN DOLLAR

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

If you are speculating in gold-mining stocks it is important to have your eyes wide open and to not be hoodwinked by the pundits who argue that the current low prices for these stocks imply extremely good value. The fact is that at the current gold price not a single senior gold-mining company is under-valued based on traditional valuation standards such as price/earnings and price/free-cash-flow. Also, while some junior gold-mining companies are very under-valued, most are not. In other words, the low price of the average gold-mining stock is not a stock-market anomaly; it’s an accurate reflection of the performance of the underlying business.

The relatively poor operational performance of the gold-mining industry is not something new. It is not something that has just emerged over the past few years or even over the past two decades, meaning that it can’t be explained by, for example, the advent of ETFs (the gold and gold-mining ETFs actually boosted the prices of both gold and the stocks owned by the ETFs during 2004-2011). The cold, hard reality is that with the exception of the banking industry, which usually gets bailed out once per decade at the expense of the rest of the economy, since 1970 the gold-mining industry has wasted capital at a faster pace than any other industry. That’s why the gold-mining-stock/gold-bullion ratio is in a multi-generational decline that shows no sign of reversing.

It’s certainly true that a lot of money can be made via the judicious speculative buying of stocks in the gold-mining sector, because these stocks periodically generate massive gains. It’s just that in real terms (relative to gold) they end up giving back all of these gains and then some.

Even the most well-meaning and rigorous attempt to come up with a single number (a price index) that reflects the change in the purchasing power (PP) of money is bound to fail. The main reason is that disparate items cannot be added together and/or averaged to arrive at a sensible result. For example, in one transaction a dollar might buy one potato, in another transaction it might buy 1/30,000 of a new car and in a third transaction it might buy 1/200 of a medical checkup. What’s the average of one potato, one-thirty-thousandth of a new car and one-two-hundredth of a medical checkup? The creators of price indices claim to know the answer, but obviously there is no sensible answer. However, in this post I’m going to ignore the conceptual problem with price indices and briefly explore the question: Which is probably closer to reality — the official CPI or the CPI calculated by Shadowstats.com?

Unlike many other members of the ‘sound money camp’, I’ve never been a fan of the Shadowstats CPI and I’ve only ever mentioned it in TSI commentaries to note that it is just as bogus as the official CPI. It always seemed to me that the Shadowstats number was derived by adding an approximately constant fudge-factor to the official (bogus) CPI to essentially arrive at another bogus number that, regardless of the message being sent by real-world experience, was always much larger than the official number. As illustrated by the following chart from the Shadowstats web site, since the late-1990s the growth-rate difference between the official and Shadowstats CPIs has consistently been about 7%/year.

From my perspective the Shadowstats CPI never appeared to be doing a better job than the official number of reflecting the dollar’s change in purchasing power. I therefore never paid any attention to it and never bothered to analyse why, given that the only differences between the Shadowstats calculation and the official calculation were the changes in calculation methodology that were implemented by the BLS (Bureau of Labor Statistics) since the early-1980s, there would be such a big difference between the official and the Shadowstats numbers. However, Ed Dolan has recently taken the time to analyse and explain the difference in a 31st March article at EconoMonitor.com.

The above-linked article starts by comparing the price changes of similar items that actually took place between 1980 and 2014 to show that the official CPI appears to under-estimate the change in the dollar’s PP and that the Shadowstats CPI appears to over-estimate the change in the dollar’s PP, with the magnitude of the Shadowstats over-estimation being vastly greater than the official under-estimation. It goes on to show that using the Shadowstats CPI to convert nominal GDP to real GDP leads to nonsensical results. For example, according to the real GDP calculation based on the Shadowstats CPI, the output of the US economy is no higher today than it was in 1990. This is a patently false result. Lastly, it attempts to answer the question: Has John Williams, the proprietor of Shadowstats.com, simply made a calculation error?

The answer, apparently, is yes. It seems that in the calculation of the Shadowstats CPI the effects of the same change to the official methodology are counted multiple times. Consequently, the rate of CPI growth estimated by Shadowstats has consistently been at least 4.5%/year too high over the past 15 years, even by Shadowstats’ own methodology.

I’ll be very interested to see whether John Williams can explain-away the apparent multiple-counting of the same BLS changes and, if not, whether the Shadowstats calculations are revised to remove this major error.

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

Last October I wrote a piece that explained why gold mining had been such a crappy business since around 1970 and why it was destined to remain so as long as the current monetary system was in place. The explanation revolved around a boom-bust cycle and the associated mal-investment linked to the monetary machinations of central banks.

The crux of the matter is that when the financial/banking system appears to be in trouble or it is widely feared that central banks are playing fast and loose with the official money, the stock and bond markets are perceived to be less attractive and gold-related investments are perceived to be more attractive. However, gold to the stock and bond markets is like an ant to an elephant, so the aforementioned shift in investment demand results in far more money making its way towards the gold-mining industry than can be used efficiently. Geology exacerbates the difficulty of putting the money to work efficiently, in that gold mines typically aren’t as scalable as, for example, base-metal mines or oil-sands operations.

In the same way that the mal-investment fostered by the Fed’s monetary inflation has caused the US economy to effectively stagnate over the past 15 years, the bad investment decisions fostered by the periodic floods of money towards gold mining have made the industry inefficient. That is, just as the busts that follow the central-bank-caused economic booms tend to wipe out all the gains made during the booms, the gold-mining industry experiences a boom-bust cycle of its own with even worse results. The difference is that the booms in gold mining roughly coincide with the busts in the broad economy.

In a nutshell, the relatively poor performance of the gold-mining industry over the past several decades is an illustration of what the Fed and other central banks have done, and are continuing to do, to entire economies.

Obviously, gold itself is not made less valuable by the monetary-inflation-caused inefficiencies and widespread wastage that periodically beset the gold-mining industry. That’s why gold bullion has been making higher highs and higher lows relative to the average gold-mining stock since the late-1960s, and why the following weekly chart shows that the BGMI/gold ratio (the Barrons Gold Mining Index relative to gold bullion) is now at its lowest level since the 1920s.

When the next bust gets underway in the broad economy, the surging demand for gold will temporarily generate huge real gains for gold-stock investors. At the same time it will lead to yet another round of massive mal-investment in the gold-mining industry that ensures the eventual elimination of these gains