Monday, November 14, 2011
By Scott Silva
Editor, The Gold Speculator
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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Posted by The Gold Speculator at 11:25 AM