Real Interest Rates

The reliable data which policymakers and the public need if effective solutions are to be found is not available. As Tullett Prebon's Tim Morgan notes, economic data has been subjected to incremental distortion; Data distortion can be divided into two categories. Economic data has been undermined by decades of methodological change which have distorted the statistics to the point where no really accurate data is available for the critical metrics of inflation, growth, output, unemployment or debt. Fiscal data, meanwhile, obscures the true scale of government obligations. While he does not believe that the debauching of US official data is the result of any grand conspiracy to mislead the American people; he does see it as an incremental process which has taken place over more than four decades. From 'owner equivalent rent" to 'hedonics', few series have been distorted more than published numbers for inflation, and few if any economic measures are of comparable importance; and the ramifications of understated inflation are huge.

From a valuation perspective, Chinese equities do not, at first glance, look to be a likely candidate for trouble. The PE ratios are either 12 or 15 times on MSCI China, depending on whether you include financials or not, and do not scream 'bubble'. And yet, China has been a source of worry for GMO over the past three years and continues to be one. China scares them because it looks like a bubble economy. Understanding these kinds of bubbles is important because they represent a situation in which standard valuation methodologies may fail. Just as financial stocks gave a false signal of cheapness before the GFC because the credit bubble pushed their earnings well above sustainable levels and masked the risks they were taking, so some valuation models may fail in the face of the credit, real estate, and general fixed asset investment boom in China, since it has gone on long enough to warp the models' estimation of what "normal" is. Of course, every credit bubble involves a widening divergence between perception and reality. China's case is not fundamentally different. In GMO's extensive discussion below, they have documented rapid credit growth against the background of a nationwide property bubble, the worst of Asian crony lending practices, and the appearance of a voracious and unstable shadow banking system. "Bad" credit booms generally end in banking crises and are followed by periods of lackluster economic growth. China appears to be heading in this direction.

China now buys more gold than the Western world. Does that mean, as some commentators are suggesting, that future price growth for the gold price depends on China? That if the Chinese economy weakens and has a hard landing or a recession that gold will fall steeply? Of course, this is only one factor. With the global monetary system in a state of flux - with many nations creating bilateral and multilateral trade agreements to trade in non-dollar currencies, including gold - emerging market central banks see gold — the oldest existing form of money — as an insurance policy against unpredictable changes, and as a way to win global monetary influence.  As Zhang Jianhua of the People’s Bank of China said: "No asset is safe now. The only choice to hedge risks is to hold hard currency - gold."

The Fiscal Cliff theater was great 'off Broadway' drama, but the real show for traders took center stage Sunday December 16th in Japan. The curtain went up for the newly elected Prime Minister of Japan as the star actor in the unfolding global fiat currency drama. In the last 90 days the US, EU and now Japan have announced "unlimited", "Uncapped" monetary policy with UK's soon to be bank of England Governor, Carney indicating he wants inflation & growth targeting also when he assumes the reins. The goal has been to get interest REAL interest rates as low as possible, and the expected duration to be as long as possible. Market have reacted to this strategic and obvious debasement by stampeding, relentlessly into the Bond Market and creating a disturbing potentially destabilizing bond bubble. However, remember, Financial Repression is at work here and US Bond Yields and Interest Rates must be further reduced. We presently expect the 10 Year US Treasury Bill to eventually break below 1% and Equities will fall on the re-pricing of credit and risk, earnings revenue and margin issues and slowing real global growth.

Whether the repatriation of only some 20% of Germany's gold reserves from the Federal Reserve Bank of New York and the Banque of Paris back to Frankfurt manages to allay German concerns remains in question.  Especially given that the transfer from the Federal Reserve is set to take place slowly over a seven year period and will only be completed in 2020. The German Precious Metals Association and Germany's ‘Repatriate Our Gold’ campaign said that the move by the Bundesbank did not negate the need for a full audit of Germany's gold. They want this to take place in order to protect against impairment of the gold reserves through leases and swaps. Indeed, they have called for independent, full, neutral and physical audits of the gold reserves of the world's central banks and the repatriation of all central bank gold - the physical transport of gold reserves back into the respective sovereign ownership countries. It seems likely that we may only have seen another important milestone in the debate about German and global gold reserves.

By now most are aware of the various metrics exposing the unsustainability of US debt (which at 103% of GDP, it is well above the Reinhart-Rogoff "viability" threshold of 80%; and where a return to just 5% in blended interest means total debt/GDP would double in under a decade all else equal simply thanks to the "magic" of compounding), although there is one that captures perhaps best of all the sad predicament the US self-funding state (where debt is used to fund nearly half of total US spending) finds itself in. It comes from Zhang Monan, researcher at the China Macroeconomic Research Platform: "The US government is now trying to repay old debt by borrowing more; in 2010, average annual debt creation (including debt refinance) moved above $4 trillion, or almost one-quarter of GDP, compared to the pre-crisis average of 8.7% of GDP."

It is hard to find a policymaker who hasn’t actively tried to talk his currency down. The few who don’t talk, act as if they were intent on driving their currency lower.  Citi's Steven Englander argues below that the ‘currency wars’ impact is collective monetary/liquidity easing. Collective easing is not neutral for currencies, the USD and JPY tend to fall when risk appetite grows while other currencies appreciate. Moreover, despite the rhetoric on intervention, we think that direct or indirect intervention is credible only in countries where domestic asset prices are undervalued and CPI/asset price inflation are not issues. In other countries, intervention can boost domestic asset prices and borrowing and create more medium-term economic and asset price risk than conventional currency overvaluation would. So the MoF/BoJ may be credible in their intervention, but countries whose economies and asset markets are performing more favorably have much more to lose from losing control of asset markets. So JPY and, eventually CHF, are likely to fall, but if the RBA or BoC were to engage in active intervention they may find themselves quickly facing unfavorable domestic asset market dynamics.

Gold fell $20.20 or 1.2% in New York yesterday and closed at $1,664.50/oz. Silver slipped to as low as $29.972 and finished with a loss of 2.55%.

Gold in US Dollars (1 Month) – (Bloomberg)

• Introduction – Gold’s Gains In All Fiat Currencies in 2012

• Much of Gold’s Gains in 2012 On 11% Price Gain in January 2012

• Japanese Yen Shows How Gold Protects From FX Devaluations

• Food Inflation Risk As Wheat and Soybeans Surge in Price

• Currency Wars and Competitive Currency Devaluations

• Gold Remains Historically and Academically Proven Safe Haven

• Conclusion – Gold in 2013

By the Deceptive means of Misinformation and Manipulation of economic data the Federal Reserve has set the stage for broad based moral hazard. Through Distortions caused by Malpractice and Malfeasance, a raft of Unintended Consequences have now changed the economic and financial fabric of America likely forever. The Federal Reserve policies of Quantitative Easing and Negative real interest rates, across the entire yield curve, have been allowed to go on so long that Mispricing and Malinvestment has reached the level that markets are effectively Delusional. Markets have become Dysfunctional concerning the pricing of risk and risk adjusted valuations. Fund Managers can no longer use even the Fed's own Valuation Model which is openly acknowledged to be broken.

How does one of the best strategists view the world as we close the page on 2012, and look toward 2013? Find out with the help of these 35 charts.

There are five distinct stages in the life cycle of sovereign nations. These life cycle stages map to generational cycles and to Long Cycles such as the Kondratieff Cycle. Since these cycles are fundamentally behavioral shifts, they consequentially take the nations economic and political process with it. Democracies become exposed and borderline ungovernable in Stage V. This is a result of the electorate's expectations, entitlements and James Madison's "Complicity from the Tyranny of the Majority", as outlined in the "Federalist Papers". Success breeds complacency and complacency breeds leverage. Fiat currency enables a late stage country to delay the realization that it is no longer rich, but not avoid it. In a period of major Global Imbalances, which the world presently faces, this will make democratic policy setting extremely difficult and in fact will show democracies to be borderline ungovernable. In cases of grossly distorted expectations, such as the US, it will be found to be ungovernable.

It must be pointed out that gold is certainly no longer the bargain it was at the lows over a decade ago (at which time Warren Buffett undoubtedly hated it just as much as today). This is by no means akin to saying that there is no longer a bull market in force though. What seems however extremely unlikely to us is that the long term bull market is anywhere near to being over. After all, the people in charge of  fiscal and monetary policy all over the globe are applying their 'tried and true' recipe to the perceived economic ills of the world in ever bigger gobs of 'more of the same'. Until that changes – and we feel pretty sure that the only thing that can usher in profound change on that score is a crisis of such proportions that the ability of said authorities to keep things under control by employing this recipe is simply overwhelmed – there is no reason not to hold gold in order to insure oneself against their depredations.

Just yesterday, Goldman Sachs suggested its clients should sell their gold (to them?) as the precious metal cycle had turned. It seems Morgan Stanley disagrees; the firm's preferred fundamental metal exposure for 20913 is Gold. Expecting Silver to outperform also (given its 'cheaper' store of value), MS believes nothing has changed on the fundamental thesis for owning gold as the adoption of QE 3 (and 4...) and the ECB's commitments (and BoJ) remain the most important factors for a continuation of weakness in the TWI trend for the US Dollar. They also add that low nominal and negative real interest rates, ongoing geopolitical risk in the Middle East and continued mine supply issues are also supportive. From India and ETF demand to central bank buying and USD weakness - MS seems to be buying what GS is selling (or is less about muppet-mauling).

Gold fell $3.10 or 0.18% in New York yesterday and closed at $1,693.60/oz. Silver climbed to $33.24 then slid to $32.51, but finished after an afternoon rally with a loss of 0.33%.

Gold inched down on Thursday, near the monthly low reached in the prior session under pressure from a stronger greenback as players await the European Central Bank rate decision at 1245 GMT and US Initial Jobless Claims at 1330 GMT.

Physical buying of gold bullion has increased on the dip, particularly in Asia, and many are seeing these levels as a floor for prices.