Real Interest Rates

"The recovery continues but it has weakened" is how the IMF sums up their 250-page compendium of rather sullen reading for most hope-and-dreamers. The esteemed establishment led by the tall, dark, and handsome know-nothing Lagarde (as evidenced by her stroppiness after being asked a question she didn't like in the Eurogroup PR) has cut global growth expectations for advanced economics from 2.0% to only 1.5%. Quite sadly, they see two forces pulling growth down in advanced economies: fiscal consolidation and a still-weak financial system; and only one main force pulling growth up is accommodative monetary policy. Central banks continue not only to maintain very low policy rates, but also to experiment with programs aimed at decreasing rates in particular markets, at helping particular categories of borrowers, or at helping financial intermediation in general. A general feeling of uncertainty weighs on global sentiment. Of note: the IMF finds that "Risks for a Serious Global Slowdown Are Alarmingly High...The probability of global growth falling below 2 percent in 2013––which would be consistent with recession in advanced economies and a serious slowdown in emerging market and developing economies––has risen to about 17 percent, up from about 4 percent in April 2012 and 10 percent (for the one-year-ahead forecast) during the very uncertain setting of the September 2011 WEO. For 2013, the GPM estimates suggest that recession probabilities are about 15 percent in the United States, above 25 percent in Japan, and above 80 percent in the euro area." And yet probably the most defining line of the entire report (that we have found so far) is the following: "Central bank capital is, in many ways, an arbitrary number." And there you have it, straight from the IMF.

When it comes to investing in gold, investors often see the world in black and white. Some people have a deep, almost religious conviction that gold is a useless, barbarous relic with no yield; it’s an asset no rational investor would ever want. Others love it, seeing it as the only asset that can offer protection from the coming financial catastrophe, which is always just around the corner. PIMCO's views are more nuanced and, we believe, provide a balanced framework for assessing value. Their bottom line: given current valuations and central bank policies, we see gold as a compelling inflation hedge and store of value that is potentially superior to fiat currencies.

There's a belief among certain economists – and the wider population – that if the government takes a more active role in the economy, the social outcome can be improved. Dr. Lacy Hunt, executive VP of Hoisington Investment Management Company (HIMCO), says it's a false belief… and he has proof to back it up. An unprecedented buildup of debt, he shows, can only lead to one outcome: a drop in Americans' standard of living. Must watch!

It is always amazing to observe how people become less risk averse after risk has markedly increased and more risk averse after it has markedly decreased. The stock market is held to be 'safe' after it has risen for many weeks or months, while it is considered 'risky' after it has declined. The bigger the rally, the safer the waters are deemed to be, and the opposite holds for declines. One term that is associated in peoples' minds with rising prices is 'certainty'. For some reason, rising prices are held to indicate a more 'certain' future, which one can look forward to with more 'confidence'. 'Uncertainty' by contrast is associated with downside volatility in stocks. In reality, the future is always uncertain. Most people seem to regard accidental participation in a bull market cycle with as a kind of guarantee of a bright future, when all that really happened is that they got temporarily lucky. Perma-bullish analysts like Laszlo Birinyi or Abby Joseph Cohen can be sure that they will be right 66% of the time by simply staying bullish no matter what happens. This utter disregard of the risk-reward equation can occasionally lead to costly experiences for their followers when the markets decline.

We have seen consecutive weeks of bullish strength in the gold and silver markets. Gold has completed what is known as a ‘Golden Cross’ and silver is poised to complete one in the coming days. A ‘Golden Cross’ occurs when not only the current price, but also shorter-term moving averages such as the 50 day moving average “cross” or rise above the longer term 200 day moving average. Gold’s 50 day moving average (simple) has risen to $1,651/oz and is now comfortable above the 200 day moving average (simple) at $1,645/oz and accelerating higher. Silver’s 50 day moving average (simple) has risen to $29.86/oz and will soon challenge the 200 day moving average (simple) at $30.47/oz.

XAU/EUR Exchange Rate Daily - (Bloomberg)

Gold at €1,355/oz, just 2.5% from the record high of €1,390/oz, is a sign of a continuing lack of trust in the euro and in Draghi’s stewardship at the ECB.

Gold prices languished from 1980 to 2000 and had declining correlations with debt levels because GDP growth was sufficient to mute fears about budget and deficit issues. The current economic recovery has been too weak to support a sustained rise in real rates above the 2% level that has acted an inflection point for gold prices. With energy and food inflation deepening and soon to affect consumer price indices, interest rates may have to rise significantly in order to restore real interest rates above 2%.  This is with ex Federal Reserve Chairman Volcker did in the late 1970’s - when he increased interest rates to above 15% in order to protect the dollar and aggressively tackle inflation. It is unlikely that similar ‘hawkish’ monetary policy would be implemented by the Bernanke Fed today. It is unlikely that they would and even doubtful if they could – given the appalling fiscal situation and levels of debt in the US and global economy.  A continuing succession of higher real gold prices above the inflation adjusted high, or real record high, of $2,500/oz is likely until we see interest return to more normal levels and zero percent interest policies are supplanted by positive real interest rates.

As the world anticipates Bernanke's speech on Friday - which most do not expect to explicitly say "NEW-QE-is-on-bitches" - we started thinking just what it is that he can suggest that would provide more jawboning potential. His speech is likely to lay out 'lessons learned' and outline the various conventional, unconventional, and unconventional unconventional policy options available (as we noted here). While open-ended QE, cutting the IOER, and 'credit-easing' are often discussed, none would be a surprise; this reminded us of an article from Morgan Stanley two years ago - after QE2 - that raised the possibility of Price-Level Targeting (PT), which is quite different from Inflation-Targeting. While its cumulative effect could be anti-debtflationary, it is however tough to communicate, reduces the Fed's inflation-credibility, and could be seen as inconsistent with the Fed's dual mandate. Our hope is that by understanding this possibility, the mistaken shock-and-awe is dampened.

It is hard to find fiscal situations that are worse than Japan's. The gross government debt/GDP ratio, at more than 200%, is the worst among the major developed economies. Yet yields on Japanese government bonds (JGBs) have not only been among the lowest, they have also been stable, even during the recent deterioration during the European debt crisis. This apparent contravention of the laws of economics is both an enigma for foreign investors and the reason for them to expect fiscal collapse as a result of a sharp rise in selling pressure in the JGB market. As Goldman notes, the European debt crisis has led to an increase in market sensitivity to sovereign risk in general and questions remain on when to expect the tensions in the JGB market and the fiscal deficit to reach a breaking point in Japan. In the following 14 charts, we explore the sustainability of fiscal deficit financing in Japan and Goldman addresses the JGB puzzles.

When we wrote Part I of this paper in June 2009, the total U.S. public debt was just north of $10 trillion. Since then, that figure has increased by more than 50% to almost $16 trillion, thanks largely to unprecedented levels of government intervention. Once the exclusive domain of central bankers and policy makers, acronyms such as QE, LTRO, SMP, TWIST, TARP, TALF have found their way into the mainstream. With the aim of providing stimulus to the economy, central planners of all stripes have both increased spending and reduced taxes in most rich countries. But do these fiscal and monetary measures really increase economic activity or do they have other perverse effects?...  The politically favoured option of financial repression and negative real interest rates has important implications. Negative real interest rates are basically a thinly disguised tax on savers and a subsidy to profligate borrowers. By definition, taxes distort incentives and, as discussed earlier, discourage savings.... The current misconception that our economic salvation lies with more stimulus is both treacherous and self-defeating. As long as we continue down this path, the “solution” will continue to be the problem. There is no miracle cure to our current woes and recent proposals by central planners risk worsening the economic outlook for decades to come.

While some have talked of the 'credit-easing' possibility a la Bank of England (which Goldman notes is unlikely due to low costs of funding for banks already, significant current backing for mortgage lending, and bank aversion to holding hands with the government again), there remains a plethora of options available for the Fed. From ZIRP extensions, lower IOER, direct monetization of fiscal policy needs, all the way to explicit USD devaluation (relative to Gold); BofAML lays out the choices, impacts, and probabilities in this handy pocket-size cheat-sheet that every FOMC member will be carrying with them next week.

There have been quite a few stories comparing the post-WWII American economic "renaissance" with expectations that the same confluence of beneficial circumstances may repeat now, resulting in the same benign outcome. Many of these stories touch upon the key points debated in today's everyday politics: taxes, massive debt overhang, and the treatment of private business. Sadly, most of these stories are also just that: mythical representations of an idealized reality, which however have no analogy to what actually happened in the 1950s. In other words, none of the conditions that were in place in 1950 which allowed net US debt to decline from 80% of GDP to just 46% in one decade, are here now.

Just two weeks after the 'Back To The Future'-Day hoax, Citi's Global Head of International Economics Nathan Sheets, notes that, the experience with fiscal deleveraging after World War II offers some striking lessons, as well as some important caveats, for the United States in the present episode. With the debt again on a high and rising trajectory, even if the headwinds that are now afflicting U.S. aggregate demand quickly abate, economic growth is unlikely to be as strong as that recorded in the late-1940s and 1950s. At the very least, demographics are less supportive. Similarly, while we cannot dismiss the risk that the Federal Reserve may stumble as it eventually exits from its unconventional policies. The key, Sheets concludes, is to find a path for expenditures and revenues that avoids the so-called “fiscal cliff” in the near term but that firmly reduces the trajectory of the debt over the medium to long run. Without such a solution, we leave ourselves vulnerable to the vagaries of sentiment in the bond market, thus opening the door to an unwelcome set of severe financial risks.

On occasion of the publication of his new gold report (read here), Ronald Stoeferle talked with financial journalist Lars Schall about fundamental gold topics such as: "financial repression"; market interventions; the oil-gold ratio;  the renaissance of gold in finance;  "Exeter’s Pyramid"; and what the true "value" of gold could actually look like. Via Matterhorn Asset Management.

Erste Group's Ronald Stoeferle, author of the critical "In gold we trust" report (2011 edition here) has just released the 6th annual edition of this all encompassing report which covers every aspect of the gold space. What follows are 120 pages of fundamental information which are a must read for anyone interested in the yellow metal. From the report:  "The foundation for new all-time-highs is in place. As far as sentiment is concerned, we definitely see no euphoria with respect to gold. Skepticism, fear, and panic are never the final stop of a bull market. In the short run, seasonality seems to argue in favor of a continued sideways movement, but from August onwards gold should enter its seasonally best phase. USD 2,000 is our next 12M price target. We believe that the parabolic trend phase is still ahead of us, and that our long-term price target of USD 2,300/ounce could be on the conservative side."