What's behind the Global Flight into Gold?
The value of Gold has been subject to intense debate for centuries. Nathan Mayer Rothschild was once the richest man in Britain and probably in the world. His company, NM Rothschild, was appointed as the bullion broker to the Bank of England in 1840 and went on to operate the Royal Mint Refinery in 1852. When asked what the value of the barbaric metal was worth, Nathan used to reply, "I only know of two men who really understand the true value of gold—an obscure clerk in the basement vault of the Banque de Paris and one of the directors of the Bank of England. Unfortunately, they disagree.”
N M Rothschild & Sons rose to prominence in areas that included lending, underwriting government bonds, discounting commercial bills, direct trading in commodities, foreign exchange trading and arbitrage, as dealing in gold bullion. It was the brilliance and cunning of Nathan who paved the way for the firm to become the first international banking cartel.
In 1870 the Rothschilds formed the world's second largest oil producer, the Caspian and Black Sea Petroleum Company. The Rothschilds financed DeBeers Diamonds, becoming the biggest shareholder, and financed the railroad system of Europe and the Suez Canal for Britain. By 1905, the Rothschild interest in copper miner Rio Tinto amounted to 30-percent.
NM Rothschild was heavily involved in the gold market for nearly two decades. In 1919, Rothschild was appointed to chair the London meetings of the five principal market makers that performed the daily gold fixing and executed trades on behalf of customers, and as a principal, trading gold directly with customers.
So it was of great interest to bullion traders when on April 15th 2004, with the price of gold trading at $402 /ounce, NM Rothschild & Sons, which had fixed the price of gold twice a day for 85-years, suddenly announced its withdrawal from the London Gold Pool. By withdrawing from the Gold Pool, NM Rothschild was no longer obligated to sell its gold to anyone, including central banks. Were the Rothschilds anticipating some new dynamics that would send the yellow metal soaring to new heights?
Since then, the yellow metal has tripled in value to around $1,250 /oz. Central bankers overseeing emerging economies have become net buyers of gold, and mergers and acquisitions in the gold mining industry have put more of the yellow metal’s supply into fewer hands. Also tilting the balance into gold’s favor is the biggest explosion of the global fiat money supply in history.
Central bankers have monetized trillions of dollars worth of government bonds and mortgage debt in Euros, British pounds, Japanese yen, and US-dollars. In response, investors from all corners of the globe, including central banks in China, India, Russia, and Saudi Arabia, have been accumulating vast quantities of gold as a hedge to protect their purchasing power of their national reserves or savings.
Tokyo Gold Acts as a Hedge Against Government Debt
Historically, Gold has been renowned as a hedge against inflation by tracking the direction of key commodities such as grains, crude oil, and industrial metals, for early clues about the future direction of inflation. Gold is also touted as a "safe haven," from tensions between warring nations, or dangers lurking from a global banking crisis. In recent years the very same factors that have caused global stock markets to plunge have helped the price of gold to climb sharply higher. Today the widespread integration of the global economy has made it possible for banking and economic failures in Europe or the US to destabilize the entire world economy.
Seeking to counter the worst downturn in the global economy since the Great Depression years of the 1930’s, the "Group-of-20" finance ministers and central bankers initiated emergency support measures for their economies, which included issuing trillions in sovereign debt and printing trillions in paper currency. The IMF calculates debt in the Group of 20 economies will reach 118% of GDP in 2014, up from about 80% before the crisis, yet so far the massive issuance of G-20 debt has avoided the ire of bond investors and credit rating companies.
However, one of the key drivers that’s been propelling the gold market to record heights is the massive build-up of debt, issued by the world’s biggest debtor nations. The dynamic is based upon a simple equation. At the end of the day, more debt will equal more money printing by central banks. Japan for instance, is issuing a record 44-trillion yen ($473-billion) of bonds this fiscal year, as falling tax revenues and the rising costs of supporting an aging population widened Japan’s deficit.
Japan’s public borrowings, including bonds and short-term bills, totaled a record 883-trillion yen as of March 31st, up 4.3% from a year earlier. Japan’s $8.73-trillion of outstanding debt equals 178% of its $4.9-trillion annual economic output, by far the highest debt-to-GDP ratio in the world. Tokyo now spends 35% of its tax revenue on servicing its debt. As such, Tokyo has turned to the Bank of Japan (BoJ) to monetize or buy-up to roughly half of its debt issuance this year, equaling 21.6-trillion yen of purchases of Japanese government bonds (JGB’s).
The BoJ’s monetization of the government’s debt has flooded the local banking system with ocean of liquidity and added to downward pressure on bond yields. Despite an avalanche of new debt sales this year, and projections for a 57-trillion yen deficit next year, Japan’s 5-year bond yield tumbled to 0.35% this week, the lowest level in seven years. The ability to print unlimited quantities of yen by the central bank, and its coveted status as a member of the G-7 clique has so far allowed Tokyo to escape the debtor’s prison that the Greek government finds itself.
Despite the wide availability of ultra-low 0.1% borrowing rates, Japanese banks are finding few takers. Japanese bank lending is -2% lower than a year ago. There are signs that Japan’s fragile economy is starting to stagnate again, and is at risk of a "double-dip" recession. Japan lost 240,000 jobs in May, the fourth straight monthly drop in employment for a total of 820,000 jobs lost since February. The jobless rate rose to 5.2% with the number of employed workers tumbling to a 20-year low.
Spending by working households in Japan slid -1% in May to a 24-year low in real terms, and annual export growth slowed for a third consecutive month. Japan could feel the pain from Europe’s debt crisis later, and European-bound shipments could take a hit from further rises in the yen against the Euro. Thus, Japanese bankers are excess yen into JGB’s, and 5-year yields could approach zero-percent if the central bank ramps up its money printing operations.
For yield starved fixed income investors in Japan, holding $16.5-trillion in domestic savings, the nightmare scenario is getting worse. Investing in higher yielding bonds overseas entails substantial risks from adverse currency fluctuations. However, for many investors the safer bet is buying Tokyo Gold, which has increased in value by 150% against the yen over the past five years for an annualized return of 30%.
Shanghai Gold Tracking FX Reserves, Global Instability
When Far Eastern central bank buying of gold begins to outstrip Western central bank selling, the price of gold could soar to levels that most observers can scarcely imagine today. China has vaulted ahead of India to become the world’s biggest gold consumer, buying 461-tons last year spurred by ultra-low Chinese bank deposit rates of 2.25% that are yielding less than the rate of inflation. Turnover of spot gold traded on the Shanghai Gold Exchange increasing +22.6% last year, and totaled 1.1-trillion yuan (US$162-billion).
China is also the world’s largest gold miner with output reaching a total of 310 tons in 2009. In Shanghai traders keep an eye on the size of China’s foreign currency reserves which has mushroomed to $2.45 trillion. Traders suspect the government is diversifying its currency holdings into gold—clandestinely buying the yellow metal directly from state owned miners—and at lower prices than elsewhere.
If Beijing is buying gold from its own miners, then it’s exporting less and keeps supplies off the world markets. The Chinese Politburo doesn’t need to disclose the size of its official gold reserves to the world until it deems the timing to be strategically advantageous. China is in a tenuous position since any announcement of even a small increase in its gold reserves could jettison the yellow metals' price sharply higher. Beijing can play this card if or when it wishes to.
However, the Chinese Politburo no longer has the luxury of stimulating its exports by keeping its currency pegged at an artificially low level compared to the US-dollar. Instead, under the mounting threat of protectionist legislation that’s targeting Chinese exports, and is veto-proof in the US Congress, Beijing has grudgingly agreed to engineer a gradual devaluation of the US dollar versus the yuan.
Beijing hasn’t disclosed the size of the upcoming devaluation of the US dollar in order to dissuade currency speculators from jumping on the bandwagon. However, on June 23rd, angry US senators said they are not impressed by China's baby steps to partly free the yuan and vowed to push forward legislation to punish a Chinese currency misalignment of as much as 40% against the US dollar exchange rate, which the US senators say distorts trade and steals jobs.
The US Congress has taken notice of the big rebound in Chinese exports in June to a near record of $132-billion as evidence of the yuan’s misalignment with the dollar. "They take a step forward, and then a step back. It’s the same pattern we have seen for years," said Democratic Senator Charles Schumer. "The Chinese will keep treating us like they have us on a yo-yo unless we make a serious push for our legislation. On the currency issue, not enough is being done. So we are going to move our bill," Schumer warned. The bill has about 80% of support in Congress.
The specter of a Chinese, US trade war is just one of several worries that is driving the Shanghai red-chip index sharply lower this year. The Shanghai Composite index has tumbled to 2,427, its lowest close in 14 months, and is on course for a 22% slide over the second quarter as the Euro zone debt crisis and a tighter Chinese monetary policy fueled a broad selloff. Property stocks have been very hard hit amid fears that China’s real estate market could soon begin to deflate, which in turn would badly hurt the earnings of China’s top banks.
On June 18th Xia Bin, one of three top advisers on the People’s Bank of China's (PBoC) monetary committee, said China must pursue policies to tighten liquidity this year to deflate asset bubbles. He urged the PBoC and bank regulators to stick to plans to reduce new bank lending and curb property speculation. PBoC deputy Su Ning signaled that the central bank is aiming to slow the growth of China’s M2 money supply to +17%, from a +21% clip in May, and is also targeting 7.5 trillion yuan in new loans for this year, or roughly half of last year’s supply of credit.
This means that China's economy, the world’s biggest buyer of base metals, would likely slow from a +11.9% annualized growth rate in the first quarter to around 8% growth by year’s end. The dollar's upcoming devaluation, and/or threat of tariffs in the United States, is also likely to take a bite out of Chinese exports. Thus, global stock market operators cannot expect China to continue as the world’s economic locomotive that would protect it from the specter of a "double dip" recession.
Whereas base metals such as aluminum, copper, nickel, and iron ore are tumbling in sympathy with the sharp slide in Shanghai red-chips, the local gold market has moved in the opposite direction, climbing steadily higher to a record 8,614-yuan /oz. Shanghai Gold is a safe haven from a "perfect storm," a Euro-zone debt crisis, a probable 5% devaluation of the US dollar versus the yuan, and possible instability in the Chinese banking system itself due to souring loans on reckless real estate lending. In 2009 China spent 343 billion yuan ($50-billion) on imports of iron ore and 206 billion yuan ($30 billion) on imports of copper, but it can expect to get better bargains on base metals this year.
Bank of India Lingers Far Behind the Inflation Curve
In neighboring India the central bank is lingering far behind the "Inflation Curve," and is under considerable pressure to further tighten its monetary policy despite the deepening troubles in the European and US economies. "For us, inflation is a bigger concern than Europe," warned KC Chakrabarty, a deputy at the Reserve Bank of India (RBI), after a government report showed the benchmark wholesale price inflation unexpectedly accelerated to 10.16% rate in May.
India’s manufacturing growth surged +19.4% higher in April from a year earlier, its fastest pace in 15 years, leading to capacity constraints and cementing India's inflation rate in double-digit territory for the remainder of this year. The RBI says the prevailing inflationary situation is very "worrisome" and has hiked its repo rate 50-basis points since mid-March to 5.50 percent. But the RBI’s rate hikes have done little to contain inflationary pressures or the surging Bombay Gold market where the yellow metal hit a record 58,600-rupees /oz. The RBI is expected to deliver another hike of 25-basis points to 5.50% on July 27th, but "too-little and too-late."
According to the Bombay Bullion Association the surge in gold prices wasn’t fueled by demand for physical bullion. Rather, gold imports into India are projected to have fallen by 75% in June from 30-tons a year ago. India has traditionally been the world’s biggest consumer of the yellow metal, so after many years of steadily investing when gold was cheap, Indian investors own roughly 20,000 tons of gold worth about $800 billion in private hands according to trade estimates.
While almost the entire holdings are parked in physical gold there is a new class of Indian investors who are looking to take exposure to the yellow metal through gold exchange traded funds (ETFs). There’s been a 57% surge in gold ETF accounts this year, the biggest in any category of funds in percentage terms. Two mutual funds investing into shares of gold mining firms have attracted 17-billion rupees.
For Bombay gold traders the yellow metal has served as a reliable hedge against the explosive growth of the Indian M3 money supply which hit a record 56.7 billion rupees in June, or 140% higher from five years ago. Even today India’s M3 money supply is growing at a 14% annualized clip, far outpacing the 8% growth rate of its economy and feeding the flames of inflation. Combined with historically low RBI interest rates Bombay gold is going parabolic!
The RBI itself entered into an off-market transaction during October 19-20th, 2009 by purchasing 200 tons of gold from the IMF at market-based prices of an average of $1,045 /oz, trying to atone for a disastrous investment policy over the past two decades. India’s foreign exchange reserves have grown to $276 billion as of June 25th, of which gold comprised only $9.6 billion, or equaling just 3.4% of its FX stash, and down sharply from over 20% in 1994.
Fractures in Euro Currency, Lifting Gold and Swiss Franc
For almost a decade yields on bonds issued by different Euro-zone governments moved in close synchronization. By joining the Euro-bloc currency regime, every member state could suddenly reap the benefits of "free-riding" or borrowing at almost the same interest rates as Germany—the world’s fourth largest economy—irrespective of whether the country’s finances justified the lower rate.
But as the Greek debt crisis exploded into mayhem in late April, yields in the Euro-zone bond market started to radically diverge. Global investors became more selective and started demanding higher interest rates from member states with large budget and external trade deficits. Euro-zone yield spreads diverged more widely than at any time since the introduction of the Euro, with Germany and France enjoying the lowest interest rates and Greece and Portugal offering the highest.
The vision of Euro-zone economies and interest rates converging behind the shield of a shared currency, pulling Europe together economically in order to rival the might of the United States, has begun to unravel, raising skepticism about the long-term viability of the Euro itself and sparking a flight into Gold as a safe-haven. Already three Euro zone economies—Spain, Greece, and Portugal—are under heavy attack from the global banking crisis and credit rating downgrades.
Currency union may have narrowed the wide gap between the richer and poorer nations of Western Europe, but the good times also masked the underlying structural differences between the various economies, which are now becoming more visible. The interest rate gap between the Euro countries is widening. Serious economists are wondering when the first state will go bankrupt. After that it’s only a short step to catastrophe—the collapse of the currency union.
Membership in the Euro currency was originally tied to strict budgetary discipline. The annual deficit of a member country was to be limited to a maximum of 3% and its total debt to 60% of the country’s gross domestic product (GDP). But for many years Greece, Spain, and Italy took advantage of the easy money that came their way, borrowing beyond their treaty-set limits, while their trade deficits remained wide. But the music stopped when S&P downgraded Greece’s debt to BB+ on April 26th, or junk status, citing a budget deficit of approaching 14% of its GDP.
On May 10th the wealthier Euro zone nations and the IMF unveiled a €750-billion bailout fund, representing a gigantic transfer of public funds to the Oligarchic banks who are creditors of Greece, Portugal, Spain, and other heavily indebted borrowers in the private sector. The "shock and awe" rescue plan was the biggest since G-20 leaders injected money into the global banking system following the collapse of Lehman Brothers. Standby loans and guarantees are offered that could be tapped by Greece, and any government shut out of credit markets. Teetering on the edge of default the banks have averted catastrophe with repeated short-term fixes.
The ECB agreed for the first time to directly buy government and corporate bonds by printing Euros. Though it might delay the bankruptcy of certain European countries, such a bailout would not repay their debts or reduce their budget deficits. The existing €110-billion European-IMF bailout plan for Athens would only end up increasing Greece’s debt while provoking a catastrophic collapse of its economy by pushing through massive cuts in state wages, and a higher VAT tax.
Greek unemployment jumped to a 10-year high of 11.7% in the first quarter and is tipped to keep rising to 15% through 2010 as a savage austerity plan designed to repair the recession-hit country’s public finances takes effect. In the credit default swap market the odds of a Greek default or restructuring of its debts hit an all-time high of 1,325-basis points this week, signaling that the EU-IMF’s scheme to put out the wildfire in the Greek bond market has failed. Likewise, gold has soared to record heights against the Euro, tracking the Greek CDS market anticipating severe distress in the European banking system in the months ahead.
The recent run-up in gold prices versus the Euro, up nearly 20% so far this year, is tracking the widening yield spread between Greek and German bonds on ideas that the divergence in yields represents the first cracks in the Euro currency union. If a Euro-zone banking crisis turns into a credit crunch the temptation for weaker member states to opt-out of the Euro regime in favor of currency devaluation, or demanding a restructuring of government debt might become unavoidable.
There’s been widespread capital flight out of the Euro and into other pathetic paper currencies, such as the Japanese yen, Swiss franc, and US dollar. In foreign exchange the winners are the least ugly currencies at any given moment in time. Year-to-date the Euro has lost 14.3% against the US-dollar, is down 18.3% against the yen, and is 10.9% lower versus the Swiss franc, hitting a record low.
On June 30th, Austrian central banker Ewald Nowotny tried to put a positive spin on the Euro’s sharp devaluation. "The stability of the euro is guaranteed. We are approximately within the normal levels. And in reality it has had advantages for us that this overvalued euro has gone down. This helps our exports," he said. But in the marketplace, there are no guarantees, and every investment entails risk.
As for Greece, Portugal and Spain, they export little outside the Euro-zone and other European countries with currencies pegged to the single currency. Only 4% of Greek exports are shipped to countries outside of the Euro-zone, 7% of Spain’s and 9% of Portugal’s. Thus, their recession ridden economies are not expected to benefit from increased external demand for their goods driven by a decline in the Euro itself. In contrast Germany exports 22% of its goods outside of Europe. The weaker links within the Euro-zone could break at anytime if a "double-dip" recession unfolds.
How should individual investors respond to the crises that lie ahead? "You have to choose between trusting the natural stability of gold and the honesty and intelligence of members of the government. With due respect for these gentlemen, I advise you, as long as the capitalist system lasts, to vote for gold," George Bernard Shaw, 1928.
About Gary Dorsch
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