May 9, 2004
By: Eric Hommelberg
Confused about the latest sell-off in Gold and its shares? Fear for more pain to come? Doubts about Gold's future potential? What should we do? Sell? Buy? Is the economy really heating up today? Is Greenspan's strategy (open the spigot of Money supply) paying off?
Are we underestimating the power of a ballooning M3? Are rising interest rates the death for Gold?
Lots of questions and lots of contrary statements passing by lately.
Please take a few steps back and enjoy the big picture which I'll try to explain below.
Again, are we underestimating the power of a ballooning M3?
I don't care about economic growth fuelled by Bernankes printing presses, growth won't compensate for ever increasing debt. Like Ian Gordon (Vice President Canacord Capital and editor of the Long Wave Analyst) says: " It's the Debt Stupid!!" For every $10 dollar which is created nowadays only $1 contributes to GDP. The consensus today that a rise of interest rates is dollar bullish and therefore gold bearish is simply NOT true ! I always tell people to look at the big picture and forget about daily noise. In other words, keep it simple! What do I mean by that?
Well, you'll certainly remember the latest bull market in Gold from 1970 to 1980 right?
So what did interest rates do during that period? Indeed they rose!
Yes, the 10 year yield rose from a mere 5% from early seventies to an astronomical high of 15% in the early eighties!
How's that possible? Simple, rising rates did reflect inflation (not combat it). As you know, inflation is very gold friendly.
From the early eighties till 2000 the 10 year yield came down again from 15% to 5%.
What did gold do during this period? Yes, it came down all the way from $850 to $255.
Just look at the chart of 10 Y TSY and judge yourself:
Conclusion: rising interest rates are gold's death is simply a lie!
Interest rates have bottomed right now so what do you think large bond holders will do? Well, just ask Bill Gross (managing director of Pimco, US largest bond dealer). This is what he recently said:
Bill Gross | April 2004
Once a central bank reaches its ultimate destination, however, (and who could argue that 1% is not far from absolute 0?), a bondholder is stuck with the worst of all worlds. Not only is she earning a low "real" interest rate (negative, as a matter of fact in today's market), but she has to look forward to the inevitable day in which rates go back up and prices back down. She is damned with a 1% money market fund and damned with a 4.8% 30-year Treasury that almost inevitably will generate capital losses, as the re-"flation" steers long yields higher. The 1% money market rate, as a matter of fact, along with a 1% or so risk premium for holding longer dated bonds is a pretty good approximation for what an investor in U.S. bonds should earn over the next 4-5 years. Staring 2% returns in the face, what is a bond investor to do?
The solution to this conundrum is to be rather choosy about the country where you hold your duration, to reduce it in reflating countries (U.S., Japan) and increase it in relatively vigilant ones (Euroland, U.K.).
Just repeat one single sentence here:
"What is a bond investor to do?
reduce it (bond holdings) in reflating countries (U.S., Japan)
and increase it in relatively vigilant ones (Euroland, U.K.)."
So there it is, Bill Gross is saying: "sell your US bonds"!
Selling bonds means higher rates to come, period!
On top of that, it seems that Japan just ended their dollar intervention scheme so bonds are on their own right now. This coma patient will die without this artificial life-support (imo).
To give you an impression how much needed this artificial life support really was, just take a look at the chart below. Jim Sinclair provided this chart to his readers at JSMineset.com (May 3) and logically explained that everything what goes up vertical is unsustainable. Everything what is not sustainable simply stops!
Again, it seems that Japan just ended their dollar intervention scheme, they didn't purchase one single dollar lately and thereby leaving the poor US bonds on their own.
So what we're seeing is the largest dollar/bonds supporter is withdrawing itself from the scene while at the same time the largest US bond holder is saying: "sell your bonds"
Rising long term rates are here to come!
What kind of risk do rising rates have on the US economy?
Richard Russel recently said:
"So the trillion dollar question ahead, as I see it, is interest rates. If rates head up from here, there's going to be hell to pay. There is now about $22 trillion in domestic debt. On top of that there is an estimate seven times that outstanding in derivatives. Roughly 85 percent of all derivatives are interest-rate oriented. So the truth - nobody knows what will happen if rates start up, and more importantly if rates spike up. Nobody, I repeat, NOBODY including the Fed, has the answer to what could or will happen if rates suddenly start to spike."
And what about financial power houses such as Fannie Mae and Freddie Mac? Do you think they will appreciate sharp rising interest rates? No, they are scared to death for sharp rising interest rates. And yes, a default of one of these giants can buckle the US$!
Should we take this risk serious? Well, in just a matter of weeks, Greenspan, Snow and Fed governor Pool issued strong warnings regarding these financial giants, you really think this is without a reason?
This is what Fed governor Pool said on May 5:
Poole said that while there is no crisis evident for the obligations of the housing government sponsored enterprises, "their capital positions were "undesirably thin" and leave the firms "unnecessarily vulnerable to surprise shocks."
He said clear procedures for closing either company in a crisis should be established.
"Should a crisis occur, it will take hold so quickly that GSE obligations will in a matter of hours, or days, become illiquid. While any one holder of GSE debt can exit, not all holders can exit at once," Poole said.
What kind of consequences a crisis at Fannie/Freddie could unfold according to Pool?
"There is no question but that a crisis affecting either Fannie Mae or Freddie Mac would have widespread effects because these firms are so large," Poole said in remarks prepared for delivery to a banking conference organized by the Chicago Federal Reserve.
So a crisis at Fannie/Freddie is certainly not an issue which will be celebrated by government.
Is a crisis imminent at Fannie/Freddie? Just repeat again the following:
"their capital positions were "undesirably thin" and leave the firms "unnecessarily vulnerable to surprise shocks.""
What surprise shocks you think he is referring to? Well, my guess is sharply higher interest rates!
But hey, aren't we witnessing sharply rising rates right now (10y 3.7% to 4.7% in just 3 month time!)? Didn't Bill Gross tell us to sell US Bonds (which will drive up rates even further ?). No more Japan to the rescue? Inflation worries all over the place? So what do you think long term rates are up to? My guess is up!
A sharp rising interest rate increases the risks at Fannie/Freddie. Dollar bullish or bearish? You may tell.
The bottom line is this:
rising long term rates, inflation and a declining dollar are simply the best ingredients for a powerful bull market in Gold.
Comments are welcome at:
May 9, 2004
-- Posted Monday, May 10 2004