The following article was written by Mary Anne and Pamela Aden for the March 2011 edition of Peter Schiff’s Gold Letter.
The commodity market is on fire! Be it copper, cotton, cattle, corn, sugar, energy, or resources… most tangibles are at record highs or new highs. This is why the CRB index also recently hit a record high.
Growing global demand has been the main driving force, with a boost from other factors like natural disruptions and political scares.
Gold and silver tend to move in the same general wave as the rest of the commodity world, but the reasons why are different in many ways.
Michael Pento’s Market Commentary
It now appears that the United States has finally succeeded in its efforts to destroy confidence in the U.S. dollar. Given the currency’s reserve status, its ubiquity in financial markets, and the economic power and political position of the United States, this was no easy task. However, to get the job done Washington chose the right man: Fed Chairman Ben Bernanke. Thanks to Bernanke’s herculean efforts, investors across the globe have now been fully weaned from their infantile belief that the U.S. dollar will remain the ultimate safe haven currency.
The proof of Ben’s success can be seen in comparing how the foreign exchange markets reacted to the recent crisis in the Middle East with how they reacted to the financial crisis of 2008. Back then, investors looking for safety abandoned their foreign currency positions and piled into the U.S. dollar (the market for U.S. Treasury Bonds in particular). As a result of these fund flows, the U.S. dollar surged 20% from August to November 2008.
However, during this latest round of global destabilization the dollar experienced no such rally. In fact, the greenback shed about 5% of its value since the Tunisia revolution began in December of 2010. The reason should be clear; the Fed has placed international investors on notice that it will unleash even greater doses of dollar debasement at the first whiff of additional economic weakness, deflation threat, or dollar appreciation. Just this week, Bernanke once again made clear that despite what he considers to be a better growth outlook at home and abroad, and spreading global inflation, the United States will not pull back from monetary accommodation, even as other nations conspicuously do so. The architect of U.S. monetary policy has stated explicitly that dollar debasement will continue for the indefinite future.
Knowing this, why would any international investor seeking a “safe haven” choose to park assets in U.S. sovereign debt? If Bernanke is to be believed, continued economic weakness in the U.S. will cause low-yielding Treasuries to lose value due to inflation while the weakening dollar erodes the underlying value of the bond in real terms. This is a one-two punch that sane investors will seek to avoid. It is no coincidence that a record percentage of U.S. Treasury auctions are now being bought by central banks, for whom sanity is a lowly consideration.
But in reality, the Fed has much less influence over the dollar’s value than do central bankers in Beijing. There is little disagreement among economists that without Chinese support, the dollar would be a dead duck. But for the last twenty years or so the monetary arrangement that pegged the yuan against the dollar served the interests of both countries. The U.S. enjoyed a flood of cheap imports, the benefits of ultra-low interest rates, and a strong currency. The Chinese received a booming export economy, which accounted for about a third of the country’s GDP, and the ownership of a significant portion of the future of the United States. To maintain this peg, the People’s Bank of China had to print trillions of yuan and perpetually hold more than $1 trillion U.S. dollars in reserve.
But recently, having led to rampant money supply growth and inflation in China, the peg has become more trouble than it’s worth, particularly from the Chinese perspective. The latest reading on YOY money supply growth has China’s M2 increasing by 17.2%; which has helped send their reported CPI up 4.9% YOY.
Inflation in China is pushing up the prices of its exports. According to the latest survey released February 14th from Global Sources (a primary facilitator of trade with Greater China), export prices of various China products are likely to increase in the months ahead, especially if the cost of major materials and components continues to soar. The survey of 232 Chinese exporters revealed that 74% of respondents said they boosted export prices in 2010. The U.S. Bureau of Labor Statistics reported in early January that its China import price index rose 0.9% in the fourth quarter after holding steady for the previous 18 months. And Guangdong, the biggest exporting province, said recently that it would increase minimum wages by around 19% this March.
But here is the rub; China maintains its peg in order to keep export prices from rising in dollar terms. But the peg is now causing export prices to rise anyway. As a result, the policy is a dead letter. The simple fact is that the threat to China’s exports will exist whether they let their currency appreciate or not. But a strong currency offers the benefit of greater domestic consumption, while a weaker currency offers them nothing.
The Chinese government will take the path that preserves and balances their economy while enriching their entire population, rather than go down the road to never ending inflation. For China the realistic hope is that the greater purchasing power of a strong currency will enable their growing middle class to supplant U.S. consumers as the end market for China’s own manufacturing efforts. However, for the U.S. the challenge will be to develop a diversified manufacturing base in an expeditious manner before surging interest rates, a plummeting dollar and soaring inflation overwhelm the economy.
The dollar’s recent reaction to the turmoil in the Middle East and China’s inflation problem illustrate that we have come to a watershed moment in American history. The decade beginning in 2010 should prove to be the decade in which the U.S. dollar loses its status as the world’s reserve currency. As bad as that blow may be, the loss may provide the shock needed to get our economy back on a sustainable path. The real danger lies in refusing to adapt to the changing environment. Our current economic stewards are acting as if the dollar’s status is written in stone, when in fact it’s hanging by a thread.
Michael Pento’s Market Commentary
Civil revolt is currently spreading across the Arab world. What began in Tunisia has now metastasized into Bahrain, Egypt and Libya. Though two dictators have been ousted, the chances that these regimes will fundamentally transform from autocracy to a system of free markets and property rights are also up in the air. An important question is whether or not Saudi Arabia will eventually get into the mix; and, if so, whether the current struggle in Libya would morph into a proxy war between Saudi Arabia (Sunni Muslims) and Iran (Shiite Muslims). It remains to be seen whether the new regime in Egypt—whatever form it ends up taking – will allow Iran to use the Suez Canal to parade warships across the Mediterranean Sea and into Syria. If so, what would Israel’s reaction to such a perceived provocation be?
There are many unknowns, but what is known is that the turmoil has had an immediate and significant impact on the price of oil. WTI is now trading just below $100 a barrel and Brent Crude is already well above the century mark. If the unrest does indeed spread to Saudi Arabia – which produces 12 million barrels of oil per day and is the second largest producer in the world – mainstream analysts have made some wild predictions about how high the oil price could reach. Rising energy prices will further cripple the third world, which has already been placed under extreme pressure from skyrocketing food costs.
The United Nations announced in early February that global food prices were at an all-time high. The USDA indicated this week that 2011 corn inventories will be the lowest since 1974. Despite the fact that farmers have boosted the output of wheat, rice, and feed grain by 16% since 2000, demand has outstripped supply by 4 percentage points. Corn is up 95% and wheat has increased 70% since their year-ago levels. Overall, global food costs have jumped by 25% YoY since January 2009.
It is evident that global consumers continue to get pummeled by rising food and energy prices. Meanwhile, in addition to coping with rising inflation rates, the US consumer is also being hurt by the continued contraction in the price of houses – which are typically their primary assets. S&P/Case-Shiller indicated on Tuesday that their National Index dropped 4.1% from Q4 2009 thru Q4 2010. Home values have now dropped for 6 consecutive quarters and clearly indicate the real estate sector is suffering a double dip. The ramifications of all the above data are foreboding for US GDP growth. Most importantly, anemic economic growth will worsen our debt-to-GDP ratio and thereby place further pressure on our already damaged balance sheet.
The Fed’s reaction will be as predictable as ever.
We already know that Chairman Bernanke exculpates the Fed for any blame in creating inflation either domestically or abroad. In fact, he refuses to even consider rising food and energy prices in his definition of inflation. Americans could be paying $50/pound for ground beef, but as long as their houses are still losing value, Bernanke doesn’t see an inflation problem. Meanwhile, they’re eating squirrel for protein while making payments on a mortgage twice as expensive as the house.
The truth is that Bernanke doesn’t know what causes inflation, so he can’t be expected to spot it, much less do something about it. Using the Fed’s own history as a guide, Bernanke will view rising commodity prices as a threat to GDP growth and a sign of pending deflation. That’s because the Fed is caught up in a ‘Phillips curve’ philosophy that only equates economic growth and prosperity with inflation. In short, Bernanke believes that slow growth and rising unemployment rates equate to deflation, despite plentiful contrary examples in history.
Since he believes rising commodity prices are deflationary and have nothing to do with his own loose monetary policy, the Fed is likely to expand its balance sheet to a greater degree. The fact that the Fed’s massive money printing effort is the progenitor of global food riots completely escapes him. As more damage is done, the Fed will use the resulting contraction in GDP to justify a third round of quantitative easing – further harming the GDP.
Unfortunately, the vicious cycle of stagflation will grow more acute with each iteration of the Fed’s love affair with counterfeiting. Countries that make the mistake of continuing to peg their currencies to the US dollar will suffer more inflation and more destabilization. Since it will be hardest for the US to ditch the dollar, our hopes are dimmer.
Michael Pento’s Market Commentary
To counter the increasing demands that government reduce its micromanagement of the economy, last week the Obama Administration offered a fig leaf in the form of a white paper entitled “Reforming America’s Housing Finance Market.” In addition to marking the official end of the Bush era “ownership society,” where increasing the level of home ownership was a national priority, the document contains a recommended regulatory overhaul of the Federal Housing Authority (FHA) as well as Fannie Mae and Freddie Mac (together known as Government Sponsored Enterprises “GSE’s”), that intends to bring the share of government owned home loans from the current 95% to 40% over the next 5-7 years.
In the report, the Obama Administration makes the important admission that government interference in housing had dangerously distorted the market. And, while the goal of reducing the government’s footprint in the housing market is certainly laudable, the reform plan is not only too little too late, but fails miserably to address the nucleus of the problem. Even if all the recommendations are adopted, the government would actually extend its explicit guarantees to bail out failing lenders. Most importantly, the proposal completely overlooks the most significant government distortion of the housing market: the Federal Reserve’s manipulation of interest rates. Thus, this plan will insure that government’s role in the mortgage market will likely expand in the years ahead.
Banks are in the business of borrowing on the short end of the yield curve and lending on the long end. Since interest rates are generally lower for shorter time durations, banks make profits by capturing the spread. But if the gap between long term and short term rates narrow, or sometimes vanish completely, banks have a much harder time operating. Rapid and dramatic changes in interest rates also expose banks to money losing risks.
In a free market, whenever the supply of savings contracts the cost of money tends to increase. Those rising interest rates curb the demand for borrowing and increase the propensity to save. Conversely, increased savings rates lower the price of money, thereby encouraging more borrowing. Consequently, in a free economy market forces tend to stabilize interest rate volatility. However in the United States interest rates are anything but free.
When interest rates are set by a few people behind closed doors, as they are by the Federal Reserve, massive distortions can occur in the supply demand metric. For example, the S&L crisis of the late 80’s and early 90’s was brought about by the loose monetary policy of the 70’s. Rising interest rates, which were a direct response to rising inflation, soon found S&L’s paying out more on their short-term borrowed funds than they were collecting on their long term assets. The consequences for those imbalances caused by our central bank rendered nearly one thousand banks insolvent.
To mitigate this problem, early in the last decade banks began turning more and more to securitization as a way to unload the mortgages on their books by packaging and selling loans to outside investors. Not only does securitization bring in fees and reduce banks’ risk exposure but it also sucks in more capital to the real estate market, while increasing financial sector profits. It’s no wonder that the securitization market grew to over $10 trillion in the U.S. before the credit crisis of 2008. On paper this was a good solution to the problem, but additional government involvement in the securitization market threw in a monkey wrench.
Given the size and diversity of the investment market in the U.S. and around the world, there was adequate private demand for securitized mortgages. With relatively low risk and more generous yields than government debt, pension funds and other institutional investors bought heavily. However, as the Federal Reserve continued to lower rates and as the government engineered housing boom finally went bust, this private label demand dried up almost completely. The GSEs now provide financing for 9 out of 10 mortgages. Therefore, the real estate market today is virtually 100% distorted and manipulated by government forces.
Treasury Secretary Geithner—the President’s main pitch man for the program—touted the proposed solution of a hybrid federal reinsurance plan that would include a standing federal catastrophic reinsurer for private guarantors of mortgage-backed securities. The government has already clearly shown that its erstwhile implicit guarantee is now in fact explicit for GSE debt. That condition would remain intact. However, now government involvement would also morph into an explicit guarantee to reinsure private label mortgages. Therefore, in typical government fashion, the proposed reforms are merely a repackaging of the previous sham. Even if the plan were to be successfully carried out, the GSEs would still account for nearly half of all mortgage financing. Only now the government would also back private insurance for private label MBS with yet another explicit guarantee in case of emergency. Who can doubt that such conditions will inevitably arise? As to how this can ever satisfy the need to remove moral hazard or getting the government out of the housing market is beyond me.
In other words, there is no meaningful governmental withdrawal from the market. Most importantly, the plan does nothing to address the Fed’s role in making interest rates much lower and more volatile than they would otherwise be. Unfortunately the housing market will remain in government control for years to come and another real estate crisis will inevitably occur.
By Peter Schiff
Based on his recent public comments, Fed Chairman Bernanke seems determined to give the U.S. dollar the reputation of Egypt’s Hosni Mubarak: an unwanted relic of the past that everyone agrees must go, but stubbornly clings to a privileged position. The dollar is currently the world’s ruling currency, but, as with Mubarak, I believe that growing public discontent will spur regime change quicker than most pundits expect.
By Peter Schiff
A lot of people ride motorcycles, but there’s a reason most don’t try to be Evel Knievel. Sure, there’s a big reward if you can land a jump over 14 school buses – but what if you don’t?
A new craze among our competitors is to push gold buyers into “leveraged accounts.” In one of these accounts, the dealer lends you money to buy gold, on the assumption that gold will go up faster than the rate of interest on the loan. In other words, if you call with $5K, they’ll give you another $20K in credit to make a $25K total purchase of gold bullion.
The sales pitch is that since we all know gold is going up, you might as well maximize your returns by leveraging up. What they don’t often mention is what happens if gold goes through a correction. You’ll likely be asked to send in more cash for a “margin call.” If you don’t, they’ll sell your gold for a substantial loss.
The following article was written by Mary Anne and Pamela Aden for the February 2011 edition of Peter Schiff’s Gold Letter.
The year ended with a bang – record or multi-year highs in gold, copper, silver, palladium, cotton, tin, cattle, and other commodities. 2010 was a particularly great year for the precious metals, as they beat stocks, bonds, and the dollar. It seems like a perfect moment to take stock of gold’s bull run and forecast where it might go next.
Gold has now closed in on 10 years of consistent yearly rises, gaining 30% in 2010. Silver was even more impressive, gaining 83.5% last year. Yet, with all this bullishness, Americans are just now becoming aware of the lasting power of precious metals. Disbelief is turning into acceptance.
Michael Pento’s Market Commentary
In a heated debate on the February 1st episode of CNBC’s “The Kudlow Report”, financial commentator Donald Luskin offered his “textbook” definition of inflation as “an overall rise in the general price level.” I countered with the “dictionary” definition. My 1988 edition of Webster’s Dictionary defines inflation as follows: “An increase in the volume of money and credit relative to available goods, resulting in a substantial and continuing rise in the general price level.” [Emphasis added.] These differences are not academic and go a long way toward explaining why economists argue so vociferously.
In an inflationary environment, general prices tend to rise, although particular market segments tend to do so at uneven rates. This is hardly controversial. The more disputed question is why prices rise in the first place. As Luskin is well aware, the US Dollar is backed by nothing but confidence and perception. Its value depends upon our collective belief in its current and future purchasing power, and the hope that its supply will be restricted. When its supply is increased, users of the currency lose faith in its buying power and prices rise.
As a corollary, if dollar-holders believe that the US will have no choice but to monetize trillions of dollars of Treasury debt in the near future, the currency will falter. In this manner, currencies that are backed by nothing but confidence tend to behave like stock prices. The share value of a corporation represents the strength of the company. Likewise, the value of a currency represents the strength of a sovereign state.
Looked at through this prism, the fate of the US dollar in the future may not be all that different from the fate of Enron shares in 2001. In the 1990s, Enron was one of the most respected corporations in America, and the share price soared. But once the accounting scandal broke, and Enron’s profits were proven to be illusory, the purchasing power of its shares plummeted. Eventually, the shares became worthless.
The shares did not collapse simply because Enron issued more shares and diluted value. The big change came when investors lost faith in Enron. Likewise, the US dollar may lose value because of garden-variety dilution, but the real leg down will occur if holders of US government debt lose faith that they will be paid in full. Even if there is the mere perception such an outcome is likely, it will cause the dollar to tank and aggregate prices to rise.
The Fed and Treasury have set out on a deliberate strategy of creating inflation in order to monetize most of the $14.1 trillion national debt— a debt that is growing by well over a trillion dollars per year!
The charts tell the tale. There can be little doubt that the dollar is being debased. The graph below traces the growth of the monetary base, which consists of physical currency and Fed bank credit:
No doubt here. The supply of high-powered money has exploded.
But it is not only the monetary base that has expanded; take a look at M2, an aggregate of money and money substitutes:
Since the recession began in December, 2007, the M2 money supply has increased by over 18%.
Next is the chart of the CRB Index, a group of 19 commodities used to track the overall price of raw materials:
The index clearly shows a strong trend upward, suggesting a general loss of value by the USD.
Yet, for my money, the trajectory of gold prices is the best yardstick to measure that value of the dollar. Below is a ten-year chart of the dollar price of gold. It is self explanatory.
Now, let’s look at some charts of the US dollar vs. other fiat currencies.
Here’s a two-year chart of the USD vs. the Australian dollar:
Here’s a two-year chart of the US dollar vs. the Canadian dollar:
Finally, a two-year chart of the US dollar vs. the Japanese Yen:
Most dollar defenders point to the relative stability of the hallowed Dollar Index, but this only points to a deep flaw in that index; namely, it contains such a high percentage (58%) of the equally challenged euro that it vastly understates the dollar’s weakness.
In our recent “Kudlow Report” debate, Luskin claimed that rising commodity prices no longer provided good inflation signals, saying that “for the last decade or so, the canaries [commodity prices] that we’re using in this mine shaft just aren’t functioning right.”
I’m not sure why Luskin has decided to stop relying on market prices to determine the rate of inflation. Apparently, he now prefers dubious inflation metrics provided by the very government that creates the inflation. This is equivalent to trusting Enron’s bookkeepers over an independent audit. For a smart guy, such faith is surprising.
By contrast, US dollar-holders around the world are increasingly losing faith in our currency and our government. They are tiring of the Fed’s 26-month marathon of zero percent interest rates, and the Treasury’s ballooning balance sheet. They are fearful that their bonds cannot withstand the twin threats of devaluation and default. That’s why the dollar is losing its reserve currency status and inflation rates are rising. But hey, at least Luskin can keep the faith – I just hope he doesn’t mind being the only one.
Michael Pento’s Market Commentary
In current economic analysis, inflation is largely in the eye of the beholder, and depending on how you choose to look, very different stories emerge. In the U.S., food and beverages count for just 16.4% of the CPI calculation. The Chinese apparently believe that the basic necessities of life should count for more, assigning a 33% weight to the nutritional components. These differences in measurement are partially responsible for the divergent inflation climate in both countries, and make most people believe that inflation is fickle and localized. From my perspective, inflation is a global wave that will ultimately swamp all shores.
As the world’s economic leaders gather in Davos Switzerland, much of the discussion has been focused on a report jointly issued by the Global Economic Forum and McKinsey & Co. which forecasts a $100 trillion increase in global debt in the coming decade. The authors of the report argue that such an increase will be needed to maintain global economic health. Strangely, while acknowledging how the massive increase in credit caused the global financial crisis of 2008, the report’s authors admit no fear of even greater leverage today. They conclude: “Credit is the lifeblood of the economy, and much more of it will be needed to sustain the recovery and enable the developing world to achieve its growth potential.”
But the global credit stock has already doubled from $57 trillion in 2000 to $109 trillion in 2009, with disastrous consequences. The WEF report wouldn’t be so alarming if it wasn’t emanating from a gathering of global central bankers, business leaders and politicians. These are, unfortunately, the folks with all the power to turn these ideas into reality.
In his State of the Union address, President Obama kept pace with the madness in Davos by vowing to “slash” government debt by just $400 billion in 10 years. However, almost simultaneously the Congressional Budget Office upped its 2011 deficit projection to $1.48 trillion, which is over $400 billion more than it previously forecasted — effectively wiping Obama’s cuts before they are even formally proposed.
The myopia extends into the legislative branch. In a recent appearance on NBC’s Meet the Press, Senator Harry Reid said, “When we start talking about the debt, the first thing people do is run to Social Security. But Social Security is fully funded for the next 40 years.” Apparently the Senator pays no attention to the non-partisan CBO either. Last week the office states that Social Security will run permanent deficits beginning this year, 5 years sooner than expected. If we aren’t going to be honest about the insolvency of Social Security and Medicare, how can they possibly be fixed, and how can the costs ever be contained? The unfortunate truth here, once again, leads to the conclusion that financing our nation’s entitlement programs will be done courtesy of the Federal Reserve.
The CBO also said that the government will run up an additional $12 trillion in debt over the next decade if current taxing and spending policies remain in effect. Their report contained this foreboding comment: “…a growing level of federal debt would also increase the probability of a sudden fiscal crisis, during which investors would lose confidence in the government’s ability to manage its budget, and the government would thereby lose its ability to borrow at affordable rates.” The fact that our elected leaders fail to understand basic economics, or simply bury their heads in the sand, underscores why inflation will be a major factor in the years ahead.
For me, there is no escaping the conclusion that inflation will continue to surge. Inflation is, after all, the increase in money supply. And there appears to be no escaping the likelihood of massive floods of new money rolling off presses around the world, especially in Washington. But to a degree that is virtually ignored by many economists, a currency’s purchasing power is not only affected by money supply growth but also from the mere perception of it. Just like Enron shares became worthless overnight, if the U.S. is deemed to be insolvent because it cannot pay back its debt, the currency could plummet in a very short period of time, even if that pending supply of dollars has yet to be printed.
When you understand these basic issues, the decision to include precious metals, and other stores of value, in investment portfolios becomes a foregone conclusion.
By Peter Schiff
Back in October of 2009, when Congress first announced the formation of a commission to investigate the cause of the 2008 financial crisis, I knew immediately that their ultimate conclusions would support the agendas of their respective political parties. (Watch the video blog I recorded that day) Particularly, I knew that the commission’s Democrat majority would use the crisis to justify more government involvement in the financial markets. These concerns have now been fully validated.