What Does Gold Have Going For It?
Commodities / Gold and Silver 2012 Sep 28, 2012 - 10:41 AM GMTBy: Richard_Mills
Gold no longer has a legal role in the world's monetary system, but because of a collapse of faith in sovereign obligations - fiat currencies/paper money - and a coming complete lack of trust in governments and financial institutions, gold is going to quickly become a core banking asset.
So why do I believe gold is going to become a core banking asset, what exactly does gold have going for it to make this possible?
"Gold, measured out, became money. Gold's beauty, scarcity, unique density and the ease by which it could be melted, formed, and measured made it a natural trading medium. Gold gave rise to the concept of money itself: portable, private, and permanent." A brief History of Gold, onlygold.com
Historical Risk
"The history of reserve currencies reveals that the position of a country as a superpower (whose currency acts as a reserve currency) tends to rotate in a natural cycle of around 100 years. Will history repeat? From 1450 to 1530 it was Portuguese (80 years). From 1530 to 1640 (110 years) it was Spanish. From 1640 to 1720 (80 years) it was Dutch. From 1720 to 1815 (95 years) it was French. From 1815 to 1920 (105 years) it was British. And then the US dollar gradually dominated the scene...." Richard Russell
A Fiscal Cliff
"Gold has firmly established itself as a portfolio asset. Investors are not likely to abandon it...Gold is the only insurance available to protect one from the Obama fiscal cliff set to cause the U.S. economy to fall into recession in January." Gold Thoughts, Ned W. Schmidt
Increases in taxes and, to a lesser extent, reductions in spending, the infamous $600 billion "Fiscal Cliff" that's looming in the new year, will reduce the US federal budget deficit by 4 - 5.1 percent of Gross Domestic Product (GDP).
The US Congressional Budget Office (CBO) analyzed two different scenarios if the fiscal cliff was left in place:
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As measured by Fiscal Year - the combination of policies under current law will reduce the federal budget deficit by $607 billion, or 4.0 percent of gross domestic product (GDP), between fiscal years 2012 and 2013. The resulting weakening of the economy will lower taxable incomes and raise unemployment, generating a reduction in tax revenues and an increase in spending on such items as unemployment insurance. With that economic feedback incorporated, the deficit will drop by $560 billion between fiscal years 2012 and 2013.
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If measured for calendar years 2012 and 2013, the amount of fiscal restraint is even larger. Most of the policy changes that reduce the deficit are scheduled to take effect at the beginning of calendar year 2013, so budget figures for fiscal year 2013--which begins in October 2012--reflect only about three-quarters of the effects of those policies on an annual basis. According to CBO's estimates, the tax and spending policies that will be in effect under current law will reduce the federal budget deficit by 5.1 percent of GDP between calendar years 2012 and 2013 (with the resulting economic feedback included, the reduction will be smaller).
Under those fiscal conditions, which will occur under current law, growth in real (inflation-adjusted) GDP in calendar year 2013 will be just 0.5 percent, CBO expects--with the economy projected to contract at an annual rate of 1.3 percent in the first half of the year and expand at an annual rate of 2.3 percent in the second half. Given the pattern of past recessions as identified by the National Bureau of Economic Research, such a contraction in output in the first half of 2013 would probably be judged to be a recession.
Safe Haven/Preservation of Purchasing power
Institutional investors tend to prefer investments that are thought to contain the potential for growth, growth = sprouts. An investment has to produce a growing revenue stream - if it doesn't grow it doesn't compound. Gold is rejected as an investment because it doesn't produce sprouts, meaning the steady income and systematic growth so sought after by institutional investors just isn't there.
Gold performs two jobs that fiat currencies, or any other financial innovation, cannot do; gold acts as a safe haven in times of turmoil - to escape Nazi Germany, or buy food and water in a crisis. Perhaps even more important gold preserves your purchasing power. In 1913 (the year the US Federal Reserve was born) the US dollar was well a dollar and gold was US$20 an ounce. Today, at almost the 100 year anniversary of the Fed the dollar has lost over 95 percent of its purchasing power and gold is almost $1800.00 an ounce.
In 1913, US$1000.00 would of bought you 50 ounces of gold (that's $88,150.00 worth of today's paper money). A thousand of today's dollars will buy you 17 grams - just over half an ounce of gold.
Gold, sprout-less yes, but irreplaceable in its functions.
"The FED's QE3 will stoke the stock market and commodity prices, but in our opinion will hurt the US economy and, by extension, credit quality. Issuing additional currency and depressing interest rates via the purchasing of MBS does little to raise the real GDP of the US, but does reduce the value of the dollar (because of the increase in money supply), and in turn increase the cost of commodities (see the recent rise in the prices of energy, gold, and other commodities). The increased cost of commodities will pressure profitability of businesses, and increase the costs of consumers thereby reducing consumer purchasing power." Credit Rating Agency Egan-Jones
Collateral
Lenders loan money based on the criteria of:
- The borrower's ability to service the debt - cash flow
- The borrower's collateral
- A combination of both cash flow and collateral
"Given the regulatory pressure to collateralize exposures, regardless of transaction type, there is a greater need for collateral. But going forward, there may be a risk of a shortage of good-quality collateral." Olivier de Schaetzen, director, Euroclear
Debt has a maturity, and when maturity is reached borrowers look to roll it over. Unfortunately for borrowers the value, and high levels of esteem, of what has traditionally been thought of as good collateral (sovereign obligations - currencies) has collapsed.
According to Bloomberg borrowing costs for G-7 nations in 2012 will rise as much as 39 percent from 2011.
"The great corollary of over indebtedness is the relative scarcity of good collateral to support the debt load outstanding. This imbalance of debt to collateral is impacting the ability of banks to make loans to their customers, for central banks to make loans to commercial banks, and for shadow banks to be funded by the overnight Repo market. Hence the growth of gold as a collateral asset to debt heavy markets is inevitably in the cards and is de facto occurring. Gold is stepping up to the plate as "good" collateral in a world of bad collateral." Professor Lew Spellman, former economist at the Federal Reserve and former assistant to the chairman of the President's Council of Advisors
In February 2011, J.P. Morgan Chase & Co. said gold is at least as good an investment as triple-A rated Treasuries. J.P. Morgan started allowing clients to use gold as collateral in some transactions where traditionally only Treasury bonds and stocks have been accepted.
On May 25, 2011, the European Parliament's Committee on Economic and Monetary Affairs (ECON) agreed to accept gold as collateral.
Real Interest Rates
The demand for gold moves inversely to interest rates - the higher the rate of interest the lower the demand for gold, the lower the rate of interest the higher the demand for gold.
The reason for this is simple, when real interest rates are low, at, or below zero, cash and bonds fall out of favor because the real return is lower than inflation - if your earning 1.6 percent on your money but inflation is running 2.7 percent the real rate you are earning is negative 1.1 percent - an investor is actually losing purchasing power. Gold is the most proven investment to offer a return greater than inflation (by its rising price) or at least not a loss of purchasing power.
Gold's price is tied to low/negative real interest rates which are essentially the by-product of inflation - when real rates are low, the price of gold can/will rise, of course when real rates are rising, gold can fall very quickly.
There's a saying that "six percent interest can draw gold from the moon," undoubtedly true, but rates below two percent draw investors to gold.
The Feds interest rate is 0.25 percent and the Fed, in starting its third round of quantitative easing, has said rates will remain low for several more years.
"The FOMC is attempting to drive money out of bonds and INTO equities based on the fact that they have guaranteed practically no return as far as yields go on short term Treasuries for at least two years. Think about that. As an investor would you want to lock up money for that long for that kind of yield or would you want to buy stocks and attempt to capture a bit better return on your investment capital. After all, something beats nothing as far as returns go, especially if you think that this easy money policy is going to feed into further asset appreciation as the Dollar further succumbs to the news...the Fed is obviously sacrificing the Dollar in an attempt to keep a low interest rate environment in which stocks are rising." Dan "Trader Dan" Norcini
Tier 1 Capital
"Tier 1 capital is the core measure of a bank's financial strength from a regulator's point of view. It is composed of core capital which consists primarily of common stock and disclosed reserves (or retained earnings) but may also include non-redeemable non-cumulative preferred stock. Banks have also used innovative instruments over the years to generate Tier 1 capital; these are subject to stringent conditions and are limited to a maximum of 15% of total Tier 1 capital." Wikipedia
The Basel Committee for Bank Supervision (BCBS), the maker of global capital requirements and whose Basel III rules form the basis for global bank regulation, is studying making gold a bank capital Tier 1 asset.
"Gold has historically been classified as a Tier 3 asset. When determining how much money a bank can loan, the bank's gold holdings have traditionally been discounted 50 percent of the current market value. With value cut in half, banks have little incentive to hold gold as an asset." Frank Holmes, usfunds.com
If gold is made a Tier 1 Capital asset banks could operate with far less equity capital than is normally required. Gold would be the new backstop for debt, currencies and bank equity capital.
"Anyone who understands gold's historic role will grasp the importance of the argument behind extra bank leverage. Direct ownership of bullion by a bank is superior to holding the fiat money issued by a central bank. It should increase confidence in any bank and the system as a whole. Given relative values, bank purchases of bullion will drive the value of gold as Tier 1 capital up relative to other qualifying assets, increasing its desirability for regulatory purposes further without a gold-owning bank doing anything." Alasdair Macleod, resourceinvestor.com
If the Basel Committee agrees to banks using gold as Tier 1 Capital it would create substantial demand for physical bullion and be an important step toward gold's re-monetization.
Central Bank Gold Buying
Following many years of net annual sales in the 400 to 500 tonne range, central banks, underweighted in gold and overweight in dollars and euro's, became net buyers of gold in 2009.
In 2012 countries have continued the trend of gold buying reducing the "free-float" available to meet future demand.
Names on the list of recent central bank buyers include:
Mexico, Russia, Turkey (bought 6.6 tons in August), China, Argentina, Bolivia, Kazakhstan (bought 1.4 tons in August), Ukraine (bought 1.9 tons in August), Colombia, Venezuela, Thailand, Turkey, Belarus, Sri Lanka, Mauritius and Bangladesh.
Paraguay is the latest country to begin buying gold, their reserves went from a few thousand ounces to over eight tons.
South Korea's gold reserves increased nearly 30%, from 1.750 million troy ounces in June 2012 to 2.260 million troy ounces in July - a 70 metric ton increase.
North Korea has exported more than two tons of gold to China over the last year.
Russia increased its gold tally to 30,113 million troy ounces in July 2012 from 29,516 million troy ounces in June.
In 2009 China purchased four tonnes of gold bullion from Hong Kong. In 2011 China purchased 46 tonnes of gold bullion.
China is also buying up the production from its own gold mines, as is Russia.
According to the World Gold Council (WGC) nations bought 96.7 tonnes of gold in the first quarter of 2012. Gold buying accelerated in the second quarter with central banks buying 157.5 tonnes of gold, up 63 percent quarter-over-quarter and up 137.9 percent year-over-year.
The European Central bank kept its gold reserves at 16,142 million ounces.
The U.S. kept its reserves the same from June to July - 261,499 million ounces.
The IMF said that central bank demand in 2012 may be even higher than the 456.4 tons they bought last year - the most in almost fifty years.
"The International Monetary Fund (IMF) is planning to purchase more than $2 billion worth of gold on account of rising global risks. The IMF currently holds around 2800 tonnes of gold at various depositories.
The Fund is facing increased credit risk in light of a surge in program lending in the context of the global crisis. While the Fund has a multi-layered framework for managing credit risks, including the strength of its lending policies and its preferred creditor status, there is a need to increase the Fund's reserves in order to help mitigate the elevated credit risks. Bloomberg quotes a report by an IMF staff while also adding that a $2.3 billion gold purchase is in the planning." IMF to buy Gold worth $2.3 billion as credit risk increases, inverlochycapital.com
Gold and Drunken Sailors
"It will come as no surprise to those who know me that I did not argue in favor of additional monetary accommodation during our meetings last week. I have repeatedly made it clear, in internal FOMC deliberations and in public speeches, that I believe that with each program we undertake to venture further in that direction, we are sailing deeper into uncharted waters. We are blessed at the Fed with sophisticated econometric models and superb analysts. We can easily conjure up plausible theories as to what we will do when it comes to our next tack or eventually reversing course. The truth, however, is that nobody on the committee, nor on our staffs at the Board of Governors and the 12 Banks, really knows what is holding back the economy. Nobody really knows what will work to get the economy back on course. And nobody - in fact, no central bank anywhere on the planet - has the experience of successfully navigating a return home from the place in which we now find ourselves. No central bank - not, at least, the Federal Reserve - has ever been on this cruise before.
This much we do know: Our engine room is already flush with $1.6 trillion in excess private bank reserves owned by the banking sector and held by the 12 Federal Reserve Banks. Trillions more are sitting on the sidelines in corporate coffers. On top of all that, a significant amount of underemployed cash - or fuel for investment - is burning a hole in the pockets of money market funds and other non-depository financial operators. This begs the question: Why would the Fed provision to shovel billions in additional liquidity into the economy's boiler when so much is presently lying fallow?...
One of the most important lessons learned during the economic recovery is that there is a limit to what monetary policy alone can achieve. The responsibility for stimulating economic growth must be shared with fiscal policy. Ironically, and sadly, Congress is doing nothing to incent job creators to use the copious liquidity the Federal Reserve has provided. Indeed, it is doing everything to discouragejob creation. Small wonder that the respondents to my own inquires and the NFIB and Duke University surveys are in 'stall' or 'Velcro' mode.
The FOMC is doing everything it can to encourage the U.S. economy to steam forward. When we meet, we consider views that range from the most cautious perspectives on policy, such as my own, to the more accommodative recommendations of the well-known 'doves' on the committee. We debate our different perspectives in the best tradition of civil discourse. Then, having vetted all points of view, we make a decision and act. If only the fiscal authorities could do the same! Instead, they fight, bicker and do nothing but sail about aimlessly, debauching the nation's income statement and balance sheet with spending programs they never figure out how to finance.
I am tempted to draw upon the hackneyed comparison that likens our dissolute Congress to drunken sailors. But patriots among you might take umbrage, noting that a comparison with Congress in this case might be deemed an insult to drunken sailors.
Just recently, in a hearing before the Senate, your senator and my Harvard classmate, Chuck Schumer, told Chairman Bernanke, "You are the only game in town." I thought the chairman showed admirable restraint in his response. I would have immediately answered, "No, senator, you and your colleagues are the only game in town. For you and your colleagues, Democrat and Republican alike, have encumbered our nation with debt, sold our children down the river and sorely failed our nation. Sober up. Get your act together. Illegitimum non carborundum; get on with it. Sacrifice your political ambition for the good of our country - for the good of our children and grandchildren. For unless you do so, all the monetary policy accommodation the Federal Reserve can muster will be for naught." Dallas Fed President Richard Fisher
Banking Up the Wrong Tree With the Phillips Curve
The Phillips Curve refers to the inverse relationship *thought by many to exist between inflation and unemployment - when inflation is high, unemployment is low, and vice-versa.
*Since 1974 seven Nobel Prizes have been given for work critical of the Phillips curve.
"Instead of adopting a "pure" monetarist target -- say a 5pc trend growth rate for nominal GDP -- the Fed is implicitly arguing that a little more inflation is a worthwhile trade-off if it creates more jobs.
Bill Woolsey from Monetary Freedom says we are back edging back towards the `Phillips Curve' temptations of the 1960s and 1970s, which ended with stagflation and the misery index.
"Targeting real variables is a potential disaster. Expansionary monetary policy seeking an unfeasible target for unemployment was the key error that generated the Great Inflation of the Seventies," he said.
Bernanke's attempt to push down borrowing costs is at odds with monetarist orthodoxy. Woolsey argues that successful QE should cause rates to rise -- not fall -- because the goal of such policy should be to put money into the hands of businesses that then invest, spending on machinery and real expansion.
The Fed is barking up the wrong tree with its doctrine of credit yield manipulation, or "creditism", straying far from the quantity theory of money." Ambrose Evans-Pritchard, International business editor, The Telegraph
Global Production Flat, Costs Jump
Investments are not made on profit, investments are made on sustainable margins.
According to the Thomson Reuters GFMS's Gold Survey 2012 Update, global mined gold production was flat, in the first half of 2012, for a variety of reasons:
- Declining grades
- Construction and commissioning delays
- Extreme weather
- Labor strikes
"These are not the only headwinds producers have to face. The relative stagnation of the gold price, coupled with further rises in production costs, has seen producers' cash margins eroded by 16% over the past nine months, while upward revisions to capital expenditure forecasts will place additional pressure on free cash flow going forward." GFMS
GFMS's 'all-in cost' metric reflects the full marginal cost of mine production, it has recently risen to $1,050/oz.
Danger Will Rogers Danger
Consider also:
- A high risk of default of sovereign states
- Gold's bull market has been stealthy - most investors and institutions have not participated
- Geo-political risk is climbing and there are very few deposits of over one million ounces in geopolitically safe areas
Conclusion
Gold is unique, it is the only non-Tier 1 asset to be universally regarded by investors the world over as a flight to safety asset. Gold, if moved from a Tier 3 to Tier 1 asset would be competing as a safe haven investment against un-backed bonds yielding less than zero in inflation adjusted terms and issued by over indebted governments.
Gold is set to become the new "good collateral."
Central banks, while endlessly creating their own fiat currencies, continue to buy up, and hold in their vaults, the world's gold. A few countries are buying up their domestic gold production - even the IMF is buying more gold to reduce their risk exposure. All of this gold buying is drastically reducing the number of gold ounces/grams available to the world's citizens.
The world's central banks and their respective governments are out of sync, monetary and fiscal policies are not being coordinated.
Governments can't print gold, or silver, and no government controls them, that's why precious metals are the only medium of exchange that have survived throughout history.
"QE is not a rising tide that will take all boats. It is good for gold. Gold will move from one of the weakest commodities this year to one of the best performers over the next few quarters." Paul Horsnell, head of commodity research at Barclays
The people who find gold and silver, and the companies they run, should be on every investors radar screen. Are quality management teams on yours?
If not, maybe they should be.
By Richard (Rick) Mills
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