The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick
Kevin: David, as we have been talking, I’ve been reading some books, and you have them now, as well, on memory. For thousands of years, man has utilized his memory and before books, memory was the only way of being able to recall something. In the past those generations would internalize, they would learn by heart, they would hear histories. Their parents would tell them stories, and they would memorize them, and learn by heart things that they felt were true.
What we have now is a society that has pure externalized memories. Why memorize anything because you have sound bites, you have the Internet, you have everything stored outside. You have the news. We can watch the financial news. Why would we commit anything to heart? I think it has changed civilization. It has changed society’s view on thinking.
David: And it’s not as if you can go back and say this is all negative. The Gutenberg Press was a revolution for education. It allowed for people who had never had access to books to now have access to, not only books, but learning, and it was a dramatic game-changer. But what also changed was how we interact with knowledge. As you are saying, it’s not just a question of knowing where to find it, using the Dewey decimal system in the library, or today, where to find it typing in a certain number of characters into a Google search. You had to, in past generations, know what you knew by heart. You learned it, you memorized it, you committed it, and that’s really how knowledge was transmitted, intergenerationally.
Kevin: David, I know you have studied philosophy, and the philosophers like Aristotle saw memory as a critical element to actually being able to think. It was what made us human. I will just apply this to what we have talked about so many times in the economy. Gold, for 4,000 years, you can go back and read recorded history and see that gold was just something that a person desired so that they could buy things, or so that they could save. Yet, we’ve seen an aversion to gold. This last generation, since we’ve gotten off the gold standard, it’s almost like gold is this anathema investment you hear from Roubini, George Soros, Warren Buffett. But what changed? How is it that gold no longer is deemed money, like we talked about a couple of weeks ago?
David: I think this does relate to how we have changed in terms of how we relate to knowledge. Immediate experience now determines what is relevant. Past and future, these sorts of things that are not here and now, are less relevant, and it really is a symptom of an information-driven society. More and more so, we are driven by what is called by some, the tyranny of the urgent.
This has led us, today, to be, frankly, the most easily manipulated generation, perhaps ever. We live in the moment, with sensory inputs, and the brain has been retrained to retain nothing, and lean heavily on the freshest data. Literally, we can refresh, refresh, refresh, refresh, and that’s how we get our information today. Just hit the refresh button on the computer and you have new data to look at, literally – refresh, refresh, refresh – new data every 10-15 seconds.
Kevin: Let’s look at our lifetime so far. In our adult lifetime, we’ve used a paper dollar for money. For all of our adult lives, we have not seen gold behind the dollar. What’s interesting is, that is just one generation in hundreds of generations that would not have had a paper currency with no backing. Now we have a world with no backing. So, if we had lived a lifetime of 100 years, or 200, or 1,000, or 2,000, we would look at this period of time as just a strange anomaly that is going to fail, but we see it as the norm. Does that make sense?
David: Yes, but again, the consequence of the shift is that we tend to focus on very short time frames, so whether it is the dollar, and I did an interview with Fox Business earlier this week, and the issue was the dollar, gold, where are we going next? What does this mean? The newest FOMC meetings – “What is the trade? What is the trade?” Literally, the day trade. And what I told Jerry Willis was, “What does this mean in the longer context? What do we see in the longer context?” This is, again, where remembrance and learning are a thing of the past. We have to have the freshest gloss, we have to have the newest tidbit, and that’s the most important thing. Context fades to irrelevance.
I think what is happening is an idea that is defined by the newsprint, when one reads this, whether it is online or via the blogs, it is defining how people deem information to be relevant. It is in 30-second to one-minute intervals. It is almost as if we are being hard-wired to be ADD. Does that make sense?
Kevin: Oh my gosh, it really does. When you look at texting, it really is a very convenient way to get a message across.
David: It’s fantastic.
Kevin: But really, that’s how we are thinking about things when we should be looking at the longer term. Last week you talked about being able to look further down the trail. I’ve been on three great mountain bike rides in the last week since we had that program, and I have been practicing looking way down the trail. It takes an effort, because it scares you a little bit. You do feel like you are going to hit that rock that is right underneath you and fall over. But you don’t, you look at the end of trail. That’s a hard thing, and with a civilization or a society that has no memory that is longer than, for instance, the day trade, as you said, how in the world can they make long-term correct decisions?
David: We paraphrased from Charles Vollum, the conversation we had a few weeks ago with him. He said something to this point. “I do best when I look least.” That is, spending less time obsessing about his finances and enjoying life.
Kevin: Dave, he spends six months per year on a sailboat.
David: Pointing out that fixating comes at a high cost, not only to not spending time on other things that are, frankly, of more importance, but also that it begins to distort your view of things, and that the short-term judgment is not as accurate, is not as important, or even relevant, as the long-term judgment and the long-term trend. Viewing a metals position as a large cash position, instead of a commodity trade, that changes the dynamics of ownership. But it does take that kind of reflection from the past, not just the current trend which would define the precious metals as a commodity only, but as a cash position, volatility is certainly less relevant in that context. Step back from irrelevant chatter and see what is taking place in a broader context, and all of a sudden there is a lot less strain in that instance.
Kevin: David, today I would really like to see you talk a little bit about what we are seeing growth in, and inflation in, and I’m naming the emerging markets right now because most Americans don’t pay much attention to emerging markets unless they have a mutual fund that invests in them, or something on that scale. But actually, in the emerging markets right now because of the trade deficits, there is a brewing crisis that a lot of people have no idea they are vulnerable to.
David: On an evaluation basis you could make the case that the emerging markets are far more attractive than the U.S. markets. Maybe the European markets are right in there in terms of the emerging markets having some value opportunity in price.
Kevin: Could you define emerging markets for the listener who maybe doesn’t know what that is?
David: Let’s just go back to Goldman-Sachs’ acronym, the BRICs – Brazil, Russia, India, and China, and say that these are countries that are developing. Clearly, they are not third-world by any stretch. But they are also not as developed as the U.S. market, or many of the European markets, or the Japanese market, for instance. The BRICs represent the up-and-comers. The question is, how did they get there? This is one of the things we want to focus on today – hot money vulnerability.
Kevin: Hot money. Explain hot money. Let’s get our definitions down as we start.
David: Sure, I will. It is basically, what I would view as the trigger for the next global recession, and it may have already been tripped.
Kevin: So we need to know what it is.
David: Yes, and hot money is basically money that is coming into a market, and it doesn’t have a long-term intention to stay. It’s there because of a short-term opportunity. Again, this is not just the curse of an information age, we have had hot money flows into and out of countries going back the last 200-300 years. The problem has never gone away, it has just increased because of the amount of leverage in the financial system today, so the ramifications can be even greater today than they were in the past.
Kevin: So, hot money is money that goes into a country that probably won’t stay, but that country starts to change and starts to grow around the assumption that it is going to be there.
David: I think the best way of illustrating this is that when you have two banks to choose from in your home town and one is offering a 4% rate of return and one is offering a 2% rate of return, the only reason you are going to work with that bank that has the 4% rate of return is because the return is better. So, it’s not tied to the bank management, it’s not even tied to bank stability. In fact, you will find, if you check any of the safety ratings on that bank, that the one offering 4% is in a much more precarious place from a financial position than the one offering 2% rates of return, and yet, your judgment as an investor is to pursue the higher rate of return on a temporary basis. You are willing to leave if there is a better opportunity, and that’s the basis that you came in on, it’s also the basis that you go out on – another opportunity that is coming up on the horizon.
Kevin: And that happens to countries, as well.
David: Yes, and certainly that is the theme in the emerging markets today, the vulnerability, with hot money having flowed in, how much of it flows out, and how destabilizing is it? We’ll spend some time talking about that. There are some other issues here, though, that are also relevant to the emerging markets.
Before we get there, the irony here is that this period of 2009 to 2012, is a period when emerging markets were viewed as a real bright spot on the map. Number one, they weren’t as leveraged as the Western developed world financial centers. And number two, as we mentioned earlier, they were priced more attractively. In other words, if you are looking at the companies in these emerging markets, looking at the price earnings multiples, far more compelling, dividend yields more compelling. Everything from a fundamental valuation perspective, frankly, more compelling. The question is, what is their growth dynamic moving forward?
Kevin: And they had a lot of cash, as well, right? This is one of the things that causes the velocity, I guess you would say, in an emerging market?
David: What they didn’t have, and what they don’t have, arguably, yet – yet is the key word – is a sustainable path toward growth. You have developed world capital flows. Again, we are talking about the West, we are talking about the U.S. and we are talking about Europe, primarily. Developed world capital flows – it either flows, or it doesn’t. That’s the first thing. Is capital in the market flowing on a healthy basis? Then, everyone downstream either benefits from those capital flows or they don’t.
And that remains the case today. You have emerging markets that have a great long-term growth story and if you are looking at the developed world, which is very mature, and arguably doesn’t have that much room at the margins to grow, versus looking at the demographics of the emerging markets and saying, “Look, the demographics argue for this many millions of people, millions and millions of people coming into the middle class, what you have to have is a path toward growth that is independent from developed world capital flows,” and it’s not clear to me that that has yet taken place. So, this is why we look at a false hope in the emerging markets today. Again, emerging markets, great long-term story, but they remain tied, if you will, to the ballast of Western developed countries. This is a slowly sinking ship and you don’t want to be tied to that ballast.
Kevin: There are unintended consequences when you have those flows going in. Inflation is just one. Look at Brazil.
David: Yes, you have Brazil, the real, their currency, is at a four-year low, and inflation is humming along at about a 6½ percent rate. The Standard and Poors rating was moved to a negative outlook. It is at Triple B. That is exactly two places above junk.
Kevin: So that’s their debt. That’s not good. That’s a junk bond rating, almost.
David: And then you add to that, again, the 6½ percent rate of inflation. Is that the real rate? Is it higher, is it lower? Well, I can tell you what the people in the street think about a change in the price of anything. This week we have, 200,000 people was the best estimate, responding to an increase in bus fares with protests on the street. You go from the equivalent of three reals to 3.2 reals – a minor increase, but guess what? It was enough to represent a tipping point as a response to this nascent inflation. Will it continue? This is the point. Inflation has been, and always will be, destabilizing, not only to someone’s portfolio values, but, even more importantly, where the real danger lies, in social and political stability.
Kevin: Dave, there seems to be a correlation right now with these countries where the flows are coming in, these trade imbalances where they have surpluses, these are also the countries right now that are buying a lot of gold.
David: Let’s explore the confluence of both hot money dynamics, trade surpluses, and the countries that are most aggressively buying gold today. You have Asia, which continues to buy gold. By Asia, I’m talking about all of Asia, but specifically the two heavyweights, China and India. At one level, you have a cultural fascination with wealth and real wealth, tangibly held, has always had its allure in that part of the world, but more significant than that is the issue of trade surpluses and deficits, and this is going to be a little complicated, but very well worth walking through. You have U.S. trade deficits which have set up a tremendous amount of financial instability throughout the world.
Kevin: So our deficits, basically, create surpluses in those countries.
David: Exactly. So that is to say, our deficits have a balance, and that is the trade surplus dollars on the other side of the equation, which have collected with our various trade partners. When we think about deficits versus surpluses, we think that deficit is bad, surplus is good. Here is the problem. Balanced trade is the ideal. Surpluses or deficits, both, create distortions, and the primary form of distortion which takes place in a surplus country is that the massive money printing by the central bank required to neutralize the inflows of foreign currency, and prevent a spike higher in that domestic currency.
Kevin: So for the countries that have the surplus, it is inflationary, because they are having to print money to keep up with the excess that they are coming up with.
David: Exactly. Otherwise those trade surplus dollars would end up inflating the domestic currency and make them trade noncompetitive. Does that make sense? In order to maintain their trade advantage, or just maintain their status…
Kevin: They have to devalue their currency.
David: They devalue their currency as an offset to a natural push toward currency appreciation, given the volume of trade and the surpluses they are creating.
Kevin: David, the amazing thing about this, when we were on the world gold standard, back in the 1800s, these trade imbalances naturally figured themselves out, because you would have gold in one country going into another country, and it would flow back and forth, and ultimately, it would have to balance or one country would just end up with all the gold.
David: Yes, so the prime takeaway from the last ten years is that the monetary distortion which occurs as a consequence of an ongoing trade imbalance…
Kevin: In a paper currency system.
David: Yes. So then you find the natural consequences of money printing in those trade surplus countries, namely, the rates of inflation which are being pressed higher. That creates all kinds of dislocation, for consumers, for the middle class, for lower classes. The Brazilian bus fare illustrates this to a small degree. We also had, a few years ago, the Arab Spring dynamics. Here you see the justification for individuals protecting the purchasing power of their savings in gold ornamentation, in bars, in coins, so as to avoid the consequences of a reactive monetary policy.
Kevin: The amazing thing, too, is that most of these people are buying gold because they see that their currency is buying a little less. I don’t know that they understand this dynamic of trade surpluses, trade deficits.
David: No, they don’t, that’s unimportant.
Kevin: They’re just reacting.
David: But if you are looking at first causes, it is these trade imbalances which begin to distort monetary policies the world over, and that ends up driving consumer behavior. So not only are there the ill effects from inflation, but the loose monetary policies which we have been describing, employed to neutralize foreign capital inflows and prevent the local currency from appreciating, also creates bubble dynamics in the local financial system.
Kevin: Let’s explain bubble dynamics, because that really has been our understanding of economics the last 20 years or so. We had the tech stock bubble, and then it moved to the real estate bubble here in this country, and then we moved to the government debt bailout bubble that we are currently in. It’s bubble after bubble after bubble. The problem is, bubbles pop.
David: Well, cheap credit and easy money always lead to mal-investment, lead to things that you shouldn’t have put money into in the first place, but because you had cheap credit and easy money, you took greater risks. There wasn’t a high cost to the capital, and therefore you went about investing it carelessly. That’s what happens.
Kevin: You can get addicted to that, too, Dave.
David: Right, so this is how you end up with bubble dynamics. You have asset classes that are the recipients of this mal-investment. And then guess what happens? You end up having too much money come in, and ultimately, those bubbles burst. This is the strange irony. We are really talking about the consumption habits of foreigners, specifically U.S. persons, our consumption habits driving the monetary policy of emerging market central bankers toward an inflationary outcome.
This is where it is ironic that the Fed is trying to hold up this sense of reality which is actually on the other side of the world driving gold demand. It is quite ironic. But this cheap money, easy credit, in an emerging market country, leads to an attractive growth proposition. This is your mini-bubble in the making, growth rates are attractive, and then guess what happens? As you begin to see a trend in growth in a particular country, now you have the hot money flowing in.
Kevin: Those are the investors who say, “Hey this is hot. I’m going to come on in here and capitalize on this, as well.”
David: These are your foreign investment dollars. They probably don’t speak the language. They probably don’t understand the culture. All they are looking at is the rate of return and they are saying, “What happened last year is what I hope happens this year. I’ll put my money on it.” We’ve seen that in the last couple of years. If you look at the Philippines stock market, if you look at the Thai stock market, they’ve been going bananas, best performing stock markets around. Well, until, I would say, the last 30, 60, 90 days, and that’s quite another story.
Again, this hot money, the foreign investment dollars which we call hot money, accelerates the growth rates in the asset bubble in question, and ultimately, this is where it hits the skids. Ultimately, the foreign capital hits the exits and the bubble turns to a bust. Then, in the context of a bust, you have major banking and financial market ramifications.
Kevin: But this time it would be a worldwide banking crisis. The emerging markets right now is where the money is going and where the money is.
David: But you know, Kevin, nothing has really changed. The emerging markets were dubbed the roach motels in the 1990s because of these same dynamics.
Kevin: Hot money.
David: Yes. It comes in, and it goes right back out. It’s not a permanent destination for long-term investment. When hot money begins to flow in, in spite of improved economic growth rates, financial experts in the emerging markets understand the consequences of the vacuum created by those same investment dollars when they leave, and that is the great fear of hot money. It’s not the money coming in, it’s the money going out, and understanding that it is a very fragile situation to be in.
This is why so many countries have limited access of foreign capital to their markets. We talked about Brazil earlier. If you look at their soft version of capital controls, Brazil put on a 6% duty for all incoming investment dollars. They have just reversed that recently, but basically, if you wanted to invest in Brazil, you paid 6% up front, like a tax.
Kevin: So they are trying to penalize the short-term speculator.
David: Yes, exactly. So you have to have a higher hurdle and a longer-term commitment to the investment in mind, because they are very fearful of, again, this roach motel recycling, dollars in, dollars out, and the destabilization in the financial market and the banking market, as a result of the money leaving.
Kevin: David, this reminds me of something. I am a fixed-wing glider pilot. I say fixed-wing glider pilot, because there are para-gliders out here, guys who jump off the top of a mountain with a parachute, but I’ll tell you, the thing that worries me about that is that when those chutes, sometimes at certain angles, lose the air inside of them, they may never open again. That’s what happens when hot money flows out, it’s a little bit like just sucking the wind right away from the chute, and it could be a long fall.
David: And you don’t have the aerodynamics supporting a glide to safety.
Kevin: We were talking about the BRICs. China is one of those, and it’s almost too large to be considered an emerging market, isn’t it?
David: Yes, more accurately you could say they have emerged. What are the dynamics when we are talking about trade surpluses? This is a country that held a surplus of dollars in the year 2000 of 150 billion, 150 billion U.S. dollars in the year 2000. That grew to right to right around 2 trillion dollars by 2009.
Kevin: That was their trade surplus in 2009.
David: Trade surplus dollars. Huge growth. Huge growth in those dollars. Now you understand why they have pegged the currency to the dollar, in large part, because they don’t want to create a massive amount of inflation, and yet, they still are creating a massive amount of inflation, and we’ll talk about that in just a minute in terms of their credit growth.
Kevin: That was 2009. Where are we today?
David: In the interim we’ve tacked on an additional 1.4 trillion, another 71%, since then. That brings their total trade surplus dollars to 3.443 trillion dollars.
Kevin: Okay, that’s China. 3.4 trillion dollars is a lot. The other countries don’t have that kind of surplus.
David: No, the numbers in question are much smaller in the other export-oriented countries, but there is a similar pattern you can see with these surplus caches. You have Brazil, Mexico, India, South Korea, Russia, Turkey, Thailand, Indonesia. These are countries which have carried above-average rates of inflation, and have witnessed a healthy interest in gold.
Kevin: I’ve seen the lines. I saw that picture the other day on Mineset.
David: 10,000 people lined up to buy gold in Shanghai. There is a healthy interest in gold by the populace, but if you look at the trade surplus dynamics and the monetary policy that is usually attached to addressing having a trade surplus in the first place, it is inherently inflationary. So what you can see is that the interest in gold is a natural corollary to trade imbalances. It’s not because of trade surplus dollars seeking a new home, central banks saying, “Hey, we’ve got all this extra money, let’s put it into gold.” It’s because people react to an inflationary environment with self-preservation and wealth preservation-oriented choices.
Kevin: It’s like what we said. They may not understand exactly the dynamic of what caused it, but they certainly know that their dollars don’t go as far, or their particular currency doesn’t go as far.
David: They have good instincts when it comes to recognizing the rising costs of goods and services and what it takes in terms of their meager incomes to preserve purchasing power, and thus this inclination toward self and wealth preservation. So you have the expansion of credit. Finally, you have the expansion of credit in these countries, in these markets, and it can, and in many instances has, become problematic. China is the classic example today. Chinese credit expansion is now running at a rate that is equal to 198% of GDP.
Kevin: Oh my, so almost 200% of their GDP…
David: That is the rate at which their credit markets are expanding.
David: Again, when you think of credit, you are thinking about loans, you are thinking about the things that are being used to create new business. Okay, all well and good, but here’s the deal. Each dollar in credit expansion is only contributing about 17 cents to GDP growth. In a past iteration, like in the U.S., credit expansion had a positive relationship to GDP growth.
Kevin: The goal is to borrow a dollar and make two.
David: Well, if you can. And if you borrow a dollar, you make a dollar. But if you are borrowing a dollar and only getting 20 cents worth of growth, 17 cents worth of growth, 5 cents worth of growth in terms of GDP, you are setting yourself up for a disaster, and that’s really what we see – less and less to show for, or to justify, the debt that is being built into, the leverage that is being built into the financial system.
Kevin: David, we have talked about this before. Interest rate markets can’t be fooled for long, and when you have this increased problem, this 17 percent for how much debt is being taken out, there has to be a reaction in the interest rate markets. How do the banks react with other, as far as trusting each other to pay the loans back?
David: This is where the issue of too many loans leads to a problem with loan quality. So what we saw last week was a spike in the inter-bank lending rates in China. We all know of LIBOR, for no other reason than banks manipulating the number to their collective advantage. This was in Europe, the London inter-bank borrowing rate. We have SHIBOR, which is the Shanghai equivalent, and it represents the overnight rates between banks, one institution or another, lending to each other on an overnight basis. When one institution needs liquidity, it can be provided for a nominal fee, and it is usually, on an annualized basis, 2% or 4%. That’s a normal range, 4% representing those periods of duress in the banking system, a temporary spike where a bank is interested in protecting the capital, and wants to prevent losses. That’s what is in play.
Kevin: But at this point, David, you were saying, there may be higher risk of loss.
David: And that’s what happened last week. The number went, instead of to 4%, the SHIBOR spiked to 8.29%. And it did this because you had China Everbright Bank, which defaulted on about a billion dollars worth of debt – 979 million dollars’ worth of debt. This triggered defaults at Industrial Bank, to whom the money was owed, and then there was a daisy chain of faults which ensued from there. And of course, banks start saying, “We don’t know who is next, and therefore, if you want money from us overnight, it is going to be at a very high rate.”
Kevin: Dave, when you are talking 8.29%, we don’t even have junk bonds paying that over here.
David: No, that’s right. Anne Stevenson-Yang works for J Capital Research, this is from Grants. She notes that that means that banks believe that lending to each other overnight was riskier “than lending to some dodgy property developer in Gansu for six months.” That’s really scary.
Kevin: That’s because the inter-bank rate should be one of the safest rates.
David: Well, you assume that you know what their business is since you are in the same industry. The problem is, when there is an increase in credit, there is an increase in the number of problematic loans, because scarce money equals a scarce lending policy. Ubiquity, when it comes to money, if it is everywhere, if it is virtually free, guess what happens to it? It goes everywhere. And those loans, a lot of them were not justifiable in the first place. That’s why the quality of loans in question becomes a problem for the future stability of that banking and financial system.
Kevin: So what you are saying is that this is a credit bubble that is blowing up at this point. This is just an emerging market credit bubble, including China.
David: I think last week is a pretty interesting thing, because perceptions of soundness and stability can change in a nanosecond, and that is, I think, what it illustrates. You go from 2% to 8% in literally a day or two, and that is how fast the credit markets can change when they are concerned about credit quality. And it is only now that Fitch is reporting that China has a credit bubble, that they are saying it is actually unprecedented in modern world history, the scale and the scope of the Chinese credit bubble. For us, you have to consider the bursting of that bubble and the consequences, again, not only from the emerging markets, or to the other trade partners that China deals with, but also to the developed world.
Kevin: I think we saw an example of a country trying to take over on this whole gold trade imbalance with India. Look at the rupee, look at gold, look at what Indians are doing. We talked about Chinese buying, but India has been buying almost as much.
David: Exactly. You have a swelling current account deficit. It takes more rupees to buy everything, and in response to devaluation, you have people running into gold. Why? Inflation rates of 9.4%, people are desperate to protect their savings. They are facing massive demand for gold over the past several years, and frankly, they are now having to consider draconian measures to slow, or even stop, the importation of gold. That is where the back story is really important. Similar to what we have been discussing, the Indian rupee is about 58.4 to the U.S. dollar, near the cheapest on record relative to the U.S. dollar, and another way of saying that is that there has been a consistent inflation which has been eroding the purchasing power of the Indian rupee. That inflation rate is officially running at a 9.4% rate, maybe higher.
Kevin: Well, we have learned that it usually is higher. The official number is not the one that is true.
David: And that is a compelling story for why the Indian masses continue to buy gold. You have the cultural element, we have the Indian wedding season just around the corner. But on the other hand, if you work all day long in the field, and you save whatever you can from your harvest, what do you intend to do with it? Put in into the banking system? Put it into rupees where you are guaranteed a 9% or greater loss? Or put it into something that you believe will hold value regardless of central bank activity.
Kevin: And the Indian government is trying to make that decision much more difficult because of raising the tax from 6% to 8%. That was quite a hit to try to slow down gold imports.
David: Right. The notion is that if you shoot the messenger, the message really won’t get out. Gold in rupees is saying that you must own the metal to preserve wealth. If you are an Indian citizen, gold in rupees is saying, you must own it, you must own it. You have massive imports of gold, and it has created a problem. There is so much being imported in terms of gold, it has turned a trade surplus in India into a trade deficit.
Kevin: Because they have to buy from outside.
David: That’s exactly right. We saw a very similar dynamic to Vietnam a few years ago when inflation was running about 25% on an annualized basis. The Vietnamese government set up a limit on gold imports, and that quota was filled very quickly, and in the face of government control of official imports, guess what happened?
Kevin: I’ll bet you the black market just went crazy.
David: Of course. The trade in the black market picked up considerably. Why? This is really basic, and I think it is something that we in the developed world don’t appreciate, because choosing between an arbitrary regulation and self-preservation is a no-brainer anywhere else in the world. Gold’s unpopularity with financial authorities, this is going back to that notion that if you can just get rid of the barometer, if you can shoot the messenger, if you can break the barometer, take out the hammer and smash it, you will never have a storm. There won’t be a storm if you don’t see it coming. And that’s the problem. Gold tells you there is an issue with policies that are in play, whether they are of a trade nature, whether they are of a fiscal nature, whether they are of a monetary nature, they tell you that there are problems.
Kevin: David, we are talking about emerging markets, and we know there is an incredible hunger for gold, like these draconian measures are trying to fight, but here in America there is a lot of confusion, and the question keeps coming up, “Gosh, how much further is it going to go down, is anybody interested in it, is it ever going to do what it is supposed to do?”
David: Kevin, you look at the daily, you look at the weekly, you look at the monthly charts for gold in U.S. dollar terms, and they are all in a basing pattern, arguably, with a significant bottom already put in.
Kevin: Dave, talking about these support levels on gold and some of the outlooks that you have, we’ve put two charts on the website that our listeners can look at to see what you are talking about.
David: What we see is not always obvious to our listeners and so putting the pictures, if you will, up there, you will be able to see exactly what we are talking about, as we are talking about it.
Kevin: So they are building a base. That’s what a basing pattern is.
David: With Fed comments becoming more and more powerful to a base of traders, and to leveraged speculators, we have a good week to ten days where this three-month basing pattern is on edge. We have included some charts on the website and you can see these progressive lows. They are continuing to be higher lows, progressively, and that’s very constructive. It can be undone on the basis of a short-term market perception, created by a Fed comment, which may or may not actually reflect reality, or the actions that they are going to take. But nevertheless, this is the nature of jawboning. If they can manipulate the strength of the dollar, if they can manipulate perceptions that improve the long-term prospects of the Dow and the S&P, bring about stability in the bond market, are they willing to do whatever it takes?
This is what we suggested a few weeks ago. If things are difficult, this is when you lie. And that is what I think we need to assume, that the Fed is between a rock and a hard place. This is your classic liquidity trap. They have no place to go. The only solution that they can employ, and it’s not a real workable solution in the end, is more and more money printing. So what they will do is try to talk their way out of what is an inevitability, which is more money printing.
Kevin: Ben Bernanke studied economics at Princeton, and taught economics, but actually he really has had to become more of a propagandist. He doesn’t really know the economics of getting out of this rock and a hard place. Do you stop quantitative easing and let the country just completely fall apart? Do you continue to print? Well, you continue to print, but you tell people that you probably are not going to continue to print.
David: This is the difference between models and market practitioners. You have a Fed that is full of model-makers. They are academics, very bright, but they don’t have a lot of practice in the marketplace. There is a way out. It is a painful way out, but it can be done. We can get this done. We don’t have to continue to run deficits. We can right our ship, from a fiscal standpoint. We don’t have to print. But you realize there will be a price to pay for that, and that is where, politically, the price to pay is unpalatable, to the point where it is not on the table for discussion.
So we revert back to the models that the Fed is running, and the models don’t deal with the kind of real-time stress that we see in the emerging markets, in the developed markets, in the markets today.
Kevin: Let’s face it, Dave. We have talked about gold, historically, being worth about the same amount of buying power, historically, it is worth about a loaf of bread a day for a year, 350-400 loaves of bread. It has been that way for hundreds, thousands of years. What we are really talking about here is the dollar. What is the value of the dollar relative to gold?
David: Sure, because when we are talking about demand for gold in India, we are really talking about the weakness of the rupee, and people dealing with that the only way they know how, which is self-preservation via the gold market. Very importantly, the dollar has broken down. And this is the second chart that you can look at. We are due for several days’ worth of a rally, but you look at the weekly, you look at the monthly charts, and they look terrible.
The dollar is broken down below its 50-day moving average, below its 100-day moving average, below its 200-day moving average, and it should recover some ground this week, and likely head lower after that, but you are underneath the 200-day moving average, for it to bounce back and retest that, try to get above it, maybe even get above it for a couple of days, or even a week. That is likely. As you can see on the chart, the last point of support before dropping to 0.725 is right there at 0.80.
Kevin: So your opinion is, the dollar is now in a down-trend. That is what you mean by breaking down. It will trend down, even if for a few days it may show some strength.
David: Listen, I’m curious at what point commentators are going to begin remarking on the dollar with the “after a 20% decline, the dollar is now at a bear market.” Keep in mind, we have been in a dollar bear market for the better part of a decade. If you define any bear market as exceeding a 20% decline from a peak number, that’s what they keep on throwing on, throwing on, the gold market. And yet, the dollar has been in a secular bear market for better than ten years. We don’t talk about it at all. On the one hand, this is the mantra that relates to gold. You don’t want to see gold do better if you are in the financial markets, because if you can break the barometer, so be it. You don’t want the storm that is coming to be on anyone’s radar, or frankly, to admit that it is even possible, that it can occur.
Kevin: Dave, it has been a few years since we have breached that 0.725 level on the dollar. What happens if we do it again?
Dave: I think you are opening up the possibility of the dollar devaluing from current levels about 30%, which would take us to about 0.57 on the dollar.
Kevin: That would be a substantial drop from where we are now.
David: It would, and again, you have these levels that represent temporary support – 0.80, 0.725, 0.57, but there are issues worthy of note here, because the dollar has been in decline since the beginning of June. The commodity currencies are also weakening at the same time.
Kevin: You are talking about Australia, Canada, they call those the commodity currencies.
David: Exactly. And the dollar has shown no inverse strength. If the dollar in Australia is declining, sometimes you will see the U.S. dollar improving. In this case, you have all of them declining simultaneously. It shows that the dollar is weak, both in absolute, and in relative terms. Again, this is in the context of suggesting the end of QE.
Kevin: Which would normally strengthen the currency.
David: It would normally strengthen the currency. The question here, really, is do we have any concerns for gold at this point, given the fact that the currency markets are saying, “We see further depreciation ahead. We see further money printing ahead. We don’t really trust what is going to be said from the Fed. We can already see, and are taking our position, that the actions already in play and likely to remain in play, are dollar-negative.
Kevin: David, if I’m figuring this right, you are looking at a 30% decline in the dollar from here. To put that into context, for the person who is listening who just has to pay his bills every month, think about taking a 30% cut in pay in what your month actually brings in in income. What would that do? You have to ask yourself in practical terms how that affects the average Joe.
David: And I think this is really what is in play. The strategy in play is ultimately to inflate the value of the currency and repress the financial markets to the point where the government is moving us toward a state of recovery. It just is a very painful and laborious and extended period, and if they can fudge the inflation numbers, as we have talked about before, where the official rate is somewhere between 5% and 10%, that they admit to 2 or less, then they are playing catch-up, to be able to pay their bills with a cheaper and cheaper currency every year via inflation. And then that repression, that issue of a very low rate set for a very long period of time, is a reallocation of capital. It is a redirection of cash flow. It should be going to savers, it should be going to depositors, bank depositors and retirees, and it’s not. It’s going to subsidize the national debt, which takes tremendous pressure off of the Treasury.
This is why it is almost absurd to consider stepping away from the purchase of Treasuries and mortgage-backed securities because of the ramifications into those markets. Higher rates mean that you are putting the goalposts that much farther out of reach in terms of solving our fiscal and economic issues. What they are doing will work over a long enough period of time. The price to pay is for the middle class and for the saver who will lose their shirts via inflation, and via interest rate repression, that frustration of not receiving your just deserts in terms of income from savings.
This is their way of fixing the system. Will it ultimately work? With enough time, it can. But this is where inflation is one of those things that is an X factor. It can go from 2% to 10% very quickly. It can go from 2% to 15% or 20% very quickly. This, to us, is where we are, on the cusp of an inflation awareness. You are already seeing it in the emerging markets, an inflation awareness that is driving street-level activity into the gold markets.
Again, we’ve talked about trade imbalances, and how that distorts monetary policy, and the monetary policies, once in place, create economic realities which investors have to respond to, have to react to, and they do, in large measure, by buying gold. We haven’t seen that in the West. Why? Because, to a large degree, the repressive nature of the policies that are in place today, keeping rates at zero, as the Fed has done, as other central banks have done for a long period of time now, have covered over the fact that we have inflation brewing.
And as, and when, the public in America, and the public in Europe, is concerned with inflation, not brewing, but present, a real and present danger, do you know what their response is? It’s the same as we see all over the world. They move with their feet into gold, and that is what we expect to see, over the next 6, 12, 18, 24 months. We see the fundamentals for gold continuing to improve, not devolve, and it is because we have continued trade imbalances, monetary policy imbalances, fiscal imbalances, and natural human survival instincts amongst investors, who preserve assets over time, in ways that have traditionally been employed, that is, the purchase of precious metals as an insurance against said outcome.