Keeping an Eye on Inflation Expectations?

Leo Kolivakis's picture

Submitted by Leo Kolivakis, publisher of Pension Pulse.

William Rees-Mogg of the London Times asks which will come out on top: paper or gold?:

week the price of gold rose to $1,100, the highest ever recorded. Gold
is still an important measure of the world economy. The theory of the
19th-century gold standard was that gold was “real money” in the same
way as landed property was “real estate”. All types of paper money are
capable of being created by banks or governments, so the supply is
potentially unlimited. It was observed that gold holds its purchasing
power over centuries, whereas paper money tends to depreciate towards
the value of zero.

Of course, the rise in the gold price
reflects the weakness of the dollar as well the strength of gold. I
have been writing about the significance of the gold price since the
early 1970s. The latest rise in price reflects the significance of gold
as part of the world’s monetary reserves.


The immediate cause of
the rise was a purchase of 200 tonnes of gold bullion by the Reserve
Bank of India from the International Monetary Fund. The Indian purchase
is quite large in terms of the gold market, but not particularly large
in terms of the Indian reserves. India’s reserves now amount to $277
billion, of which this new purchase of gold amounts to only $6.7


The significance of the
purchase is that it may be the start of a new phase in the struggle
between gold and paper. Since 1971, when President Nixon ended the
convertibility of the dollar into gold under the Bretton Woods
Agreement, the world’s central banks have tended to be net sellers of
gold and net buyers of dollars. Now the Indians have decided that they
have more dollars than they want.


Sri Lanka has followed the Indian lead, with a purchase of five tonnes
of gold. If the new fashion spreads, and particularly if it is joined
by China, then Asia would have decided that it is better to have gold
which is rising in value than an unlimited supply of dollars which are
falling in value.


In the 19th
century, bankers trusted gold precisely because they did not trust
other bankers, or the paper that other bankers issued. They could hold
gold in their own vaults; it would not be dependent on other people’s
debts or on the printing of paper money. Most central bankers still
believe that the purchasing power of money is ultimately determined by
the quantity that is created.


Asian bankers know that the West,
and particularly the US, has been creating new money in huge and
unprecedented quantities. They must assume that this increase in the
creation of dollars will result in a fall in the purchasing power of
the dollar itself. China may or may not join in the movement to buy
gold, but the logic of the market would justify it doing so. Why should
China go on losing in dollars when the gold price is rising?


new logic extends outside gold and outside currencies. The real
struggle between gold and paper is a struggle for power. If paper money
is the dominant form of currency, as it is at present, then the
ultimate governors of the world economic system are the bankers who
have the power to create money.


If, however, gold is regarded as
the ultimate standard, as “real money”, then the market decides the
valuation. The floating rate system which emerged after 1971 depends on
relatively stable relationships between different currencies. If
countries develop a preference for gold over paper, then paper
currencies will have to demonstrate that they have a stable value in
gold, as they did in the years before 1971.

This may help to
explain the strange events that occurred in the G20 finance meeting at
St Andrews. In the 1970s, an American economist, James Tobin saw very
clearly the speculation that would arise after Nixon ended the
convertibility of the dollar into gold. Tobin, who later won a Nobel
Prize, knew that gold had been the standard by which other currencies
were valued. Once that was removed, he feared a growth of excessive
speculation, such as the inflation of the 1970s, or the successive
bubbles of recent years. He thought that this speculation could be
controlled if it were taxed. He advocated a new transaction tax.


St Andrews, Gordon Brown unexpectedly advocated the adoption of a
global Tobin tax. He was immediately repudiated by Timothy Geithner,
the US Treasury Secretary, and by Dominique Strauss-Kahn, the head of
the IMF. The proposed global Tobin tax has the support of Oxfam and of
some left-wing economists, but without American support, it does not
have the least chance of being adopted.


The Swedes experimented
with a national transaction tax in the 1980s. It did not work because
bankers avoided paying tax by transferring transactions to markets in
which it was not imposed. The tax had to be abandoned in the early
1990s. This negative history must have been known to Mr Brown; perhaps
the clumsiness of his diplomacy reflects the pressure he is feeling.


Britain, there is an urgent need for a new tax base. One can take
almost any very large figure as the sum needed to balance the budget.
At some point, Britain will have to raise taxes and cut expenditure. It
is hard to see where this additional revenue can be found.


doubt it would be helpful to Mr Brown if the other governments of the
world would join him in policing a worldwide transaction tax on the
banks. Britain would be a major beneficiary. Like the US, Britain has a
combination of very large bank debts with a very large budget deficit.
As a response to the recession, large sums of money have been injected
into these economies. That has eroded global confidence in the pound
and dollar.


If there is no Tobin tax, it will be difficult to
rebuild confidence in these currencies, and the Tobin tax is not going
to happen, if only because it would not work. Two factors emerge. Gold
will be a stronger reserve currency than paper, and the market will
increasingly decide national policies. “You can’t buck the market”,
whether in taxes, in dollars or in gold.

thought all you gold bugs would enjoy reading the article above. But
there is another thing worth tracking in these markets. Matt Phillips
of the WSJ writes as the rally rolls, keep an eye on inflation expectations:

clues on inflation expectations in this carry-trade-crazed market,
Tuesday’s auction of some $25 billion in 10-year treasury notes is
something to pay attention to.


week’s Fed statement signaled all clear for the carry trade. And last
weekend’s G-20 confab confirmed that the stimulus spigots at central
banks will be open for the foreseeable future. But the Fed noted in its
statement that it’s still going to be paying close attention to
inflation expectations in the marketplace


An auction of some $40
billion in three year notes on Monday went well, and the equities
market rally ratcheted up in response afterward, suggesting that some
participants are keeping a close eye on the bond market. But the
shorter end of the curve is anchored by the Fed’s near zero policy.
Inflation worries are more likely to crop up in some of the
longer-dated debt from Uncle Sam.


there’s already some signs that worries about inflation are floating
around out there. For one thing 10-year breakevens — that gap between
the yield on 10-year Treasury Inflation Protected Securities (TIPS) and
the yield on plain-vanilla 10-years — have been inching higher, a
somewhat inflationary sign, although we’d need more evidence to confirm
that inflation expectations are starting to break out.


tougher part for the Treasury will be selling (Tuesday’s) 10-year and
Thursday’s 30-year auctions in light of the growing inflation
expectations as measured by the TIPS, among other signs,” writes Peter
Boockvar, of Miller Tabak.


If those auctions don’t go so well,
and the yield on the longer end of the curve jumps, that might prompt
more serious soul searching at the Fed. And uncertainty about how long
the Fed will keep the spigots gushing liquidity could push some who’ve
been betting on the weak dollar/rising risk trade to take a bit of
money off the table.

Those auctions will go very well. In fact, on Monday, Treasuries prices moved steadily higher after solid 3-year note auction:

government debt prices rose on Monday after a record-sized Treasury
note auction drew strong demand and investors bet other debt sales this
week would get a similar reception.


The three-year note sale won a rousing bid as investors stood to gain
an extra 0.50 percentage point yield over two-year notes for taking on
slightly more interest rate risk.


would call the auction stunning," said William O'Donnell, head of U.S.
Treasury Strategy at RBS Securities in Stamford, Connecticut.


"I like to focus on the bid-to-cover ratio and just looking at that it
was the best bid-to-cover ratio for the 3-year Treasuries since
November 1990."


Three-year Treasury note US3YT=RR was trading 1/32 higher with the
yield at 1.36 percent, down from 1.37 percent late on Friday.


Benchmark 10-year notes US10YT=RR were trading 10/32 higher in price to
yield 3.46 percent, down from 3.51 percent late on Friday, while
30-year bonds US30YT=RR were 15/32 higher to yield 4.37 percent from
4.40 percent.


the three-year auction, the Treasury will sell $25 billion in benchmark
10-year notes on Tuesday and $16 billion in 30-year bonds on Thursday
as part of this week's $81 billion quarterly refunding.


"Two-year notes are already through their resistance level, so I think
the very steep slope of the curve is going to help the bond auctions
tomorrow and Thursday," added O'Donnell.


Before Monday's note auction, Treasuries appetite was curbed by a pickup in stocks and other riskier assets in the wake of a Group of 20 pledge to stick with measures to bolster the global economy.

see how the auctions go this week but my feeling is that Treasuries
will be snapped up fast. Moreover, it will take a lot more of this
liquidity rally to sustain a higher shift in inflation expectations.
Given the slack in the global economy, inflation expectations will be
capped for at least another year and possiby for a lot longer.