By Scott Silva
Editor, The Gold Speculator
11-14-11
Eurozone Driving the Markets
There is no doubt that the
European sovereign debt crisis is a major factor driving the global markets
lately. The imminent Greek default and the loss of confidence that Italy can
avoid contagion and its own severe debt crisis has toppled both governments and
set the stronger Eurozone nations on a path to socialized bailouts and eventual
monetization (printing trillions more Euros). These actions may forestall
immediate catastrophe but also create other serious economic problems, such as
inflation, recession or both (stagflation) across the Continent.
The Eurozone crisis pushed
global equity markets up and down in triple digit waves,
as drama played out first in
Greece with the resignation of Prime Minister George Papandreou, and then the
ouster of Italy’s Silvio Berlusconi, who resigned over the weekend.
The bond market had forecast the
Italian capitulation, as we identified in the last issue of The Gold Speculator. The bond vigilantes
attacked the Italian 10-year note, driving its yield to over 7%, the signal
used by many that the end had arrived. Portugal required bailout funds when its
bond yield hit 7%, a full 4 points above the German Bund.
The new governments in Greece
and Italy are expected to pass and implement severe austerity measures in
return for debt relief from the new European Financial Stability Facility, the
co-investment fund that is soliciting investors to establish a 1 Trillion Euro
firewall to stem contagion in the Eurozone, the ECB and the IMF.
And there’s the rub. Greeks have
already begun to riot to protest deep cuts to entitlement benefits. Italian
citizens may also turn to the streets and shut down essential services in a general
strike. Italy is now forced to cut programs that support much of the population
at the same time that economic growth is stalling. It’s a classic death spiral.
It is unclear that any amount of debt restructuring can fix the fundamental
problem for the dying social welfare state.
US markets seem fixated on the
travails of the Eurozone debt crisis. The fact is, US banks have
relatively little direct exposure to Italian debt, with $47 billion in
exposure, compared, for example, to France's $416.4 billion. But larger U.S. banks may be carrying vastly
more indirect risk from struggling European economies as a result of the credit
default swaps, or CDS. U.S. banks are holding almost three times as much as
their $181 billion in direct lending to the five countries at the end of June,
according to the most recent data available from BIS. Adding CDS raises the
total US bank risk to $767 billion, an amount reminiscent of the mortgage
backed securities meltdown.
One outcome resulting from
continued uncertainty in Eurozone is the flight to safety.
We can see this in the price of
gold, which has moved up to challenge the $1800/oz level.
US Debt Policy and the
Markets
Fear of Eurozone debt contagion
is not the only factor driving the markets. There is also a major event looming
for the US economy, namely the showdown of the Super Committee. With the
deadline to craft the $1.5 Trillion debt reduction deal now nine days away,
there seems to be little progress by the select lawmakers. In fact, the talks
broke down when Democrats walked out this last week after ignoring the latest
Republican proposal. The US budget battle is likely to reach center stage once
again over the next ten days. An impasse will roil the markets once more.
The credit agencies may act before
the Super Committee does. Many analysts believe a further downgrade of US
sovereign debt is probable. Rather than taking the lead at this critical
juncture, the president is taking a trip to Hawaii and Asia. It is becoming
more apparent that the Administration would rather there is no deal; another
example of the “do nothing opposition”.
There was a time in this country when our leaders put needs of the
country before politics. Those were the days…
So fasten your seat belt. We’re
in for a bumpy ride. The stock market will remain highly volatile with daily
triple digit swings. The bond market offers no escape. Treasury prices are bid
up as funds flow out of Europe and equities into “safe” US notes, despite
negative real interest rates for the instruments, and bid down when investors
flood back into higher yielding stocks. Each trade represents a loss of capital
(as well as a tax event).
It’s no wonder that prudent
investors are once again turning to gold as the true safe-haven trade.
Fed to the Rescue?
It is inevitable that the
Federal Reserve will implement more Quantitative Easing in a last ditch attempt
to jump start the ailing US economy. Chairman Ben as much as said so in remarks
this week before a military audience in Texas when he pointed out the economy
could “tolerate a little more inflation.”
He was referring to the ancient belief held by Keynesians that there is
a trade-off between inflation and employment, as embodied in the Phillips
Curve. The theory, which dates back to 1958, states higher employment comes at
the expense of higher inflation. No one would argue that 9% unemployment today
is trivial. The true measure (U-6) is
16.2% as of October. To the contrary, the Fed chief called the US unemployment
a “national crisis.” Likewise, the
Chairman characterized 2% inflation as “tame.” So, given the Fed’s mandate to
support full employment, it could easily justify creating a bit more inflation
by printing more money, as it did under QE1 and QE2. Using the calculus of the
Phillips Curve, implementing QE3 at about $1 Trillion would bring unemployment
down to 6% or so.
The problem with that logic is
that QE1 and QE2 failed to create net new jobs over that last three years. The
other problem is the Phillips Curve theory fails in general to account for the
coincidence of high inflation and high unemployment, as occurred in the 1970s’
stagflation under Carter.
But facts have never dissuaded
the Chairman from pursuing his preferred political policy. Besides, QE3 would
be good for Wall Street.
Inflation and the Money
Supply
We know from Nobel Laureate
Milton Freidman that inflation always and everywhere a monetary phenomenon. We
also know that commodity prices are a good proxy for inflation. That is higher
commodity prices reflect higher inflation. So we can examine the Commodity
Price Index in comparison to the money supply for correlation.
We see that after the meltdown
of 2008, commodity prices have climbed higher propelled by QE1 beginning in
2009 and later in 2010 by QE2. Commodity
prices started to decline when the end of QE2 was announced earlier this year.
We also see that the Fed
increased the Monetary Base dramatically, adding nearly $2 Trillion to the Fed
balance sheet by purchasing bonds under QE1 and QE2. QE3 (and QE4 and QE5) will
push inflation to record levels.
So how will the debt crises in
Europe and the US affect the price of gold?
Gold will continue to climb in price as investors seek relative safety
from volatile markets and a hedge against devaluation of fiat currencies such
as the Euro and the Dollar through continued central bank intervention.
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