The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick
Kevin: You know, David, we’re in a unique position here this last few weeks. We haven’t felt this way in about three years. Gold is up about 9% since the beginning of the year. Silver is up about 12%. And even gold stocks, which we have just seen decimated last year. What are they up? Over 20%.
David: Yes, 23% from January 1st. Gold 9%, silver 12% off its lows. So the winners of last year are this year’s losers, and vice-versa, and the two areas that gold reached in 2013, and then fell back from, that’s $1362 and $1433, those are areas that we would like to see some greater progress. If we could top those numbers it would be great. Above those numbers it opens up the door to revisiting $1540 and $1695. I think what a lot of folks don’t realize is that 40-80% moves after a major consolidation are not uncommon.
Kevin: So don’t get too eager right now. There will be some consolidation to the downside, but it could be that we have some large moves at this point.
David: I think we either finish this year up 40-80% in the metals, or maybe that bleeds into 2015, but again, after going through a 2½ year consolidation, I think the worst is behind us. We tend to think so. If you look at 2013’s manipulation of the metals market, it left a good bit of scar tissue. So we will certainly operate with caution over the next couple of months until we get confirmation, but again, confirmation for us of this being a sustainable move considerably higher would be topping $1362 initially, $1433 on a secondary basis. After we clear those numbers, frankly it’s blue skies. That is, I think, very exciting for the gold-owner.
Kevin: Dave, your dad owned this business from the 1970s on, and gold has gone up some of those times and it has gone down some of those times, but the accumulation of gold has mainly been for hedge purposes. It has been for insurance against the dollar. And that has paid off over the long-run very, very well. But this dynamic that we’re in this year, over the last year, really has to do more with supply than price. Being focused on the price of gold is a little bit like when Joseph was putting the wheat and the corn away for seven years, he wasn’t looking at the price of it, he was putting it away because it was going away. He knew it wouldn’t be there. The same thing seems to be happening with the gold supplies right now.
David: One thing that is very different than the 1970s, even though you could look at 2013 and say, the manipulation that occurred, there, why can’t it continue on? I think what people have to realize is that unlike the 1970s, where U.S. governmental organizations stepped in and literally brought in the FBI into the Hunt Brothers’ offices, with guns drawn.
Kevin: And they weren’t going to see silver go any higher.
David: Walk away from your computers. The trade is over. And for anyone who was involved in the silver trade, they were banned for life from trading commodities. You look at that and say, okay, strong-arm tactics, certainly that can be redone. Yes and no. That can be done here in the United States, still, but it cannot be done on a global basis. The U.S. government does not have that kind of reach. When you see this mass migration of tonnage, in gold terms, from the West to the East, what you realize is that we have slipped out of the control position here in the West, and no longer can we do anything but very short-term cyclical manipulations. The structure of the market, the supply and demand dynamics, will ultimately be controlled by the greatest number of buyers and sellers, which are outside of U.S. and European borders. So I think, frankly, the gold and silver move that we see ahead is going to be very problematic for the ECB, very problematic for the Fed, and it is going to redefine the world monetary structure, it will be to the great benefit of the Chinese and the emerging markets, who are, even as we speak, spending their foreign currency reserves on tonnage and diversifying away from treasuries and away from dollars. This is really the underlying story of 2010 to 2015, the very quick erosion of dollar supremacy from monopoly status to something far less than that by the time we get to 2015.
Kevin: David, I think back to the 1960s. The dollar was on a gold standard, but there was a gentleman’s agreement amongst the countries in Europe that were using the dollar as the gold standard, not to really take delivery of the gold. It started to become known amongst those nations that maybe the gold isn’t as there as they thought it would be, or there’s not enough gold for the dollars. So France, especially, but a lot of the European countries, started breaking, gently, that gentleman’s agreement until Nixon had to close the gold window because there were 15 tons of gold per hour coming out of Ft. Knox at that time.
David: Everyone remembers 1971, but far more important was 1968, when that gentleman’s agreement was underscored with very strong language from the treasury, and we said, specifically, if you are a friend of the U.S., you will settle these debt obligations in greenbacks, not in ounces. Those were the actual words used. “Friends of the U.S. will take greenbacks.” And the French, in good self-interest, and national self-interest, said, “That’s all well and good. We care about you, but frankly, we care about we more.”
Kevin: (laughter) “So send us our gold.”
David: Yes. “So send us our gold.”
Kevin: China is doing the same thing. The West has controlled, with the futures markets – sometimes 100 times the amount of gold that actually exists on deposit will trade in the futures markets, and everyone, being gentlemen, says, “Let’s don’t take delivery, and we can play this game, and when it goes up we make money, and if we’re selling puts, when it goes down we can make money, but don’t ask for the gold. Don’t do that.” The Chinese have been breaking the gentleman’s agreement and buying or taking delivery of everything that is not nailed down.
David: What is interesting is that this week I read two reports from gold analysts in London, one with Société General, one with UBS. These are folks that I met with in Shanghai late last year, and had some interesting conversations with. They predicated lower gold prices on one particular thing. “Growth in the U.S. economy and recovery in the global economy.”
And on the basis of trending economic variables which were positive in their books, they assumed that there would be no reason for investors to be moving to gold, and that frankly, the demand in Asia would continue to dwindle, and I thought, “Continue to dwindle? It’s actually increasing.” They said, “No, no, no, that’s not how it works.” What is interesting is that in the last several days the Société General analyst was quoted again in Bloomberg, this morning, if I am not mistaken, as saying, “No, we still believe that the price of gold is going to be considerably lower for this year, and again, quoting the same things because the U.S. economy is in recovery, the global economy is in recovery, therefore….” And he was quoted as the best gold analyst for the last two years. I mentioned this on a commentary a few weeks ago….
Kevin: Is this the guy you talked to when you were over there?
David: Yeah, and this is the guy that I asked, “What were your projections for the gold price,” because he had been doing this since the 1980s. “What were your projections for the gold price in 2000-2002? Was there any bullish sentiment at Société General about gold in that fledgling stage of the bull market, which has given us 500% returns?” He said, “No, no, no, we were quite bearish.” I said, “Okay, what was the bank’s position on gold in 2009 and 2010 and 2011, as the price was soaring as much as 60% in a year?” He said, “Well, we were, quite frankly, quite bullish.” I said, “Wait a minute, there’s nothing predictive in nature about the work of a gold analyst, you’re simply looking at the price trend and extending a line from, “It’s gone from high to low, it’s going even lower. It’s going for low to high, it’s going even higher.” Again, my contention, the thing that annoys me, is that he is paid a healthy six-figure salary for doing what is really garbage in terms of analytic work.
Back to this contention that gold is a terrible bet this year, on the basis of U.S. recovery. Last week, a very important series was revised lower. We had retail sales for January, which declined 0.4%, and what was expected by the market was an unchanged number. So we had that January number, disappointing.
Kevin: Yes, but didn’t they say weather was the blame? Dave, we’ve had a rough winter, so is that what is really causing this contraction in the economy?
David: Let’s grant January’s numbers as a weather-related issue. But then, as the numbers settled out for November and December, retail sales had to be adjusted lower, as well. November’s were lowered to 0.3% instead of 0.7%, so a pretty significant reduction.
Kevin: More than half.
David: And December’s was revised to a negative number, negative 0.1% instead of a positive 0.2. The problem with the other downward revisions is that it begs the question: What is really going on? Is it the weather after all? Now we have 90 days, are you telling me we were socked in because of bad weather on the East Coast, that that affected everything nationally, for 90 days?
Kevin: So is that why some of the big brokerage firms are starting to say, “All right, well maybe our growth estimates are a little ambitious, so let’s call them smaller.”
David: Right, they are looking at 4th quarter GDP numbers and saying, “Well, listen, and this is Goldman-Sachs, they started with 3.2% growth for the 4th quarter, and they have revised that down to 2.4%. That is a 25% reduction in growth estimates for the end of year 2013. And yet the stock market had the assumption, when Goldman was saying, “No, no, no, we expect to finish the year with 3.2% growth.” The stock market said, “Well, of course, and that’s why we’re priced so well. Now they’re reducing their growth estimates, and yet the stock market marches higher. Do you see the disconnect?
Kevin: Well, a bull will be a bull, and if the stocks want to continue to rise, they’re going to continue to rise until the bubble breaks.
David: But now you have the Philly Fed’s downward revision for Q1. Their GDP growth estimates are at 2%, down from 2½%. This is where, I think, again, people have to come to terms with the world as it is, not as we hope it to be.
The last point on this is that the National Bureau of Economic Research watches these numbers, the retail sales figures, as one of the key inputs into determining what is an official recession, along with industrial production numbers, and personal income and of course employment numbers. And of course, on Friday we had the industrial production numbers, which were ugly, as well. So you have these things which economists look and say, “Well, we were hoping for better numbers, but it’s not turning out that way. Maybe it was just one month.” You remember Yellen’s comments. Yellen basically said, “Yeah, but that was just one month’s numbers.” Well now we have three numbers coming from retail sales that say negative, negative, negative. At what point do you step back and say, “There’s a trend here.”
Kevin: Let’s talk about jobs then, because jobs are a key element as far as economic growth goes. Are we growing on jobs? I know Obama would tell us that everything’s fine.
David: Ian McAvity looked back at a recent report to January of 2000 and from that point, January 2000 to January of 2014, payrolls are up 6½ million. That is an improvement over that 14-year period of 4.9%. So do the math, 4.9% divided by 14, not big annual growth. In fact, if you’re looking at population growth, it pales in comparison with population growth. Meanwhile, you have the “not in the labor force” number, which is up 22.3 million in that same time frame. That’s an increase of over 32%.
So fast forward to the crisis period, and we’re still behind the eight ball. Jobs are still 866,000 below January 2008 levels, while the “not in the labor force” in the shorter period of time, not the 14-year stretch, but more like five years, January 2008 to January 2014, that number has increased by 12.9 million. These are people who were in the labor force? They were workers that got factored into number of employed, compared to those who are unemployed?
Kevin: And they’re not even being counted, so it changes the ratio.
David: It changes the ratio.
Kevin: Okay, but we were talking about the stock market. It just continues to go up. Amazon … Look at Amazon! If you were to go home and your family were to say, “Okay, David, how much money are you making? Why don’t you own Amazon?” We’ve talked about price earnings before, and a good price earnings ratio is about 14-to-1, selling a company for about 14 times what its annual earnings is, that’s a nice average. Amazon, I think, is about 1,000 times more than that?
David: In the last 30 days it has been as high as 1,454, and that’s a 12-month trailing PE.
Kevin: What that means, Dave, this is what I was taught when I was younger, if you buy that stock and you just want to earn back what that stock costs, in earnings….
David: Earnings from each year.
Kevin: 1,454 years. That would take us back, if we were to go backward, it is easier to conceive backward, we would have bought that stock at the fall of the Roman Empire. And now, just be breaking even. Amazing!
David: Well, but Jeff Bezos is more than breaking even, he sold 2.1 million shares last year for pre-tax proceeds of 711 million dollars. Insiders are selling, we’ve talked about insider selling throughout last year. It has been very aggressive, particular in shares like Amazon. When my dad worked on Wall Street, he would talk about this at home, one of his observations was that the big corrections in the stock market usually came shortly after the refurbishment of an office. He was in brokerage offices all the time, and he just had this sense that when they’re replacing the carpet, something bad is getting ready to happen. Somehow it signals a top, because frankly, expenses like that get pushed through when the office is most flush, again, prior to a major correction. Things have gone well, you’ve got a little money to spend, you redo the office.
What does it signal, in the present tense, for the tech giants, when in one year, 2013, Apple, Facebook, Google, and Amazon, are all breaking ground on new corporate offices? Amazon is adding 3.3 million square feet, this is sort of multiple terrariums for the people to go and eat lunch, and enjoy the ambiance.
Kevin: Oh, it’s the new feel, it’s the new economy, yeah. Legos to play with at lunchtime, just like Google.
David: 38-story buildings, right alongside downtown Seattle. And they’re not giving any cost estimates. I just…. Log this. If you’re taking notes, write this down. Amazon has earned, cumulative, net income of less than 2 billion dollars since its founding in 1994.
Kevin: That’s amazing.
David: And they may very well spend the equivalent of all their cumulative net income on the trophy headquarters. (laughter)
Kevin: You know what it reminds me of? Remember when you went to Dubai, and every movie was made in Dubai about 8 or 9 years ago because of the beautiful, huge, complex high-rises. But they were see-through by the time you got there.
David: Just for comparison. Apple is a company that is actually making some money, right? Apple has net income of over 2 billion dollars in any three-week period last year.
David: We’re not talking about 20 years…
Kevin: Amazon goes back to 1994 and that’s all they’ve made.
David: And the company is still priced, the market cap is 164 billion dollars. If you took the combined market caps of FedEx and UPS, you’re still less than the market capitalization of Amazon. Again, they’re earning nothing. They’re earning nothing over a 20-year period.
Kevin: This brings up a good point because we just saw that China bailed out another one of their hedge funds, and you are sitting there saying, “Okay, these guys look like they are making huge money. I know, I get on the computer, if I want something, I’ve got Amazon gift cards from Christmas, I click on, I buy a lot of stuff from Amazon, I know you do, too. But just because something is popular, it doesn’t necessarily make it profitable.
David: Right. Well, the Second Trust Structure in China defaulted this last week.
Kevin: But they were bailed out, they didn’t really default, did they?
David: Well, this is the issue. You have a 1.7 trillion-dollar edifice of trust products, and it is cracking. A lot of them are coal-related investments which are blowing up right now, and infrastructure projects, real estate. We’re on to the next stage of financial instability in China. Much of the credit expansion we are seeing right now is what they would call capitalizing interests. To put that differently, imagine not being able to pay interest on a loan that you have. So you bundle those interest payments into a brand new loan, or add them to the principle owed in what, at least here in the U.S., we call forbearance.
Kevin: Isn’t that what we did with derivatives, about 6, 7, 8, 9 years ago, we bundled various portions of the investment. But what you are talking about here is the interest that they can’t pay, they bundle it up and sell it again as a debt.
David: Well, it offers relief in the short-run, but it shifts the burden to the future. So, no, you don’t have a default, but it follows the whole kick the can down the road…
Kevin: So it’s taking your credit card up, paying for another credit card, in a way.
David: (laughter) It’s bizarre, but that is where a lot of credit expansion is happening in China right now. In five years, Bloomberg reports, this was on February 14th, that Chinese banks in the last five years, have added 14.6 trillion dollars in assets. Now, remember, a bank looks at a loan as an asset. That is what they call that debt. That’s actually an asset on the bank balance sheet. That is the equivalent, 14.6 trillion dollars. That is the equivalent of the entire U.S. commercial banking complex.
Kevin: Wow, and that’s how much they’ve added, in how long?
David: The last five years.
Kevin: Five years.
David: Yes. It’s staggering growth, and unfortunately, it is very unstable.
Kevin: A couple of nights ago, Dave, we were out, and we were talking about something that you did last Thursday.
David: Well, as you know, I love to ski.
Kevin: And there’s a mountain I have never skied. I ski and snowboard, you ski and you also do the telemark thing. So you like the back-country as well, you like extreme things. I found out that you had gone up to Silverton Mountain, which is an extraordinarily steep mountain, and at this time of year, it is an avalanche danger, and at this time of the year, they aren’t going to let you get up there without a guide, and probes, and radios, but you did that last Thursday. I was talking to someone else who went with you later, and I said, “What was the avalanche danger?” And he said, “Well, we were very aware of the potential instability that day.” So talk about that a little bit.
David: Well, it’s staggering growth, very unstable. That’s China. But when you go to a place like Silverton Mountain, we had, in a 2-week period, 80 inches of snowfall. You know I love to ski, I love to ski steep mountains, and deep, fresh snow, and this is the problem. You have too much snow that gets layered in a short period of time, and that’s highly unstable. It’s not integrated into the snowpack, and it slides quite easily. We know a lot about this here in the San Juans because the snow is good, the mountains are unusually steep, so a blessing, lots of powder, can also be a curse, because you have to handle this with caution. If you don’t you get into trouble.
Kevin: Yes, we have more avalanches in this area than any place in the world. People fly in from all over the world, not just to ski Silverton Mountain, but to take the avalanche courses.
David: Right. I did that starting at age 16. We’ve spent a lot of time in the mountains, we have a great mountain just north of us, you mentioned Silverton Mountain, and it requires round-the-clock avalanche control because of the quantity of snow, the specific pitch of the slope. Again, it’s like loans layered on in a short period of time, where there is an insufficient time for lenders to qualify the quality of the buyer.
What we see in China, frankly, reflects the kind of environment we had here in the U.S. in 2004-2007. They have the same high volumes of lending. And now we have the extend and pretend. Remember, we’re talking about capitalization of interest.
Kevin: Yes, you package it up and sell it again.
David: It’s very interesting. There is an official from the China Trustee Association who was quoted in Bloomberg last Thursday as saying, “Asset quality is quite sound, and systemic risks are impossible with 9 billion yuan of reserves set aside.” Let’s do the math on this real quick, 9 billion yuan, that sounds like a lot, right? Well, do the exchange rate on that, you divide by 6, and you end up with about 1.5 billion dollars at the current exchange rate. That is 1.5 billion dollars on 1.8 trillion dollars in exposure.
Kevin: Dave, that’s less than a dollar per 1,000.
David: Yes, exactly. It makes the FDIC looks like they’re truly grand, in terms of their reserves. (laughter) They’ve just got pennies on the dollar. In this case you are talking about 1/1000 of a penny, exactly, on the dollar.
Kevin: No wonder they’re having to bail these guys out. It seems obvious that any of these could take the whole thing down.
David: Exactly right. It’s a house of cards. It explains why the bailouts have occurred, without question. You add to this, Bernstein research is finding that 40% of those loans, Kevin, are coming due this year.
Kevin: (laughter) Almost half? Now wait, are we talking 40% of what number?
David: 40% of the 1.7 trillion dollars has to be repaid or renewed this year. So any instability, today, in these trust structures, will feed these institutions’ inability to match up the maturing paper with fresh investor dollars, the refinancing that needs to take place in the market. This is what rollover risk is all about. You don’t want a lot of debt coming due at once, or first of all, you can see a liquidity squeeze, which very quickly can then move to a solvency crisis.
Kevin: Which is what we are seeing, in a way, in Argentina.
David: It is echoes of 2008, in the sense that we saw this happen in the commercial paper market, where every company assumed that they could just roll over their commercial paper. Today, even, commercial paper is 955 billion, something like that. It’s not an insignificant sum, but it was even more circa 2008, and everyone assumed that you could just roll the paper over. The money markets froze up, there was no rollover of commercial paper, you ended up with that same step-sequence of liquidity squeeze moving to a solvency crisis.
Kevin: But where are they getting this money? Is it the foreign currency reserves? China does have quite a bit of cash right now.
David: Right. This is where there is a sort of incestuous relationship between the central bank and the commercial banks in China. Who owns the commercial banks in China? They are predominantly owned by the government. So the bailout schemes, and what not, they do have money. They can print like we do. But they also have these vast foreign currency reserves, and I’m sure the Chinese government wasn’t planning on spending their vast horde of foreign currency reserves bailing….
Kevin: Some of those are treasury bills, Dave. How does that affect us?
David: Right, right. If they needed to raise money, they do have a few treasury bills to cash in, and that’s not uncommon. In fact, what we are watching right now with the emerging markets is an attempt to prop up their emerging market currencies, and in recent weeks they have aggressively bought the home currency while dumping U.S. dollar assets and treasuries, specifically, Turkey, Russia, and a few others. This is what is happening, in order to support their currency from complete freefall, they are liquidating U.S. assets, which are less important in that moment in time, in order to go buy domestic currency assets.
Kevin: This is what is amazing to me. Last week, talking to William White, that was a great talk, because here was a man, a central banker, who was actually sounding like there was humility there, and he was saying, “Look guys, all we’ve done is the same thing that got us into the crisis since the crisis. We’re just doing it more. I think of Janet Yellen, as she was talking to Congress last week. She was talking as if there was really no major debt growth going on.
David: Yes, well, Humphrey-Hawkins’ testimony last week was interesting. She said, “We don’t see a broad-based buildup, for example, in leverage, or a very rapid credit growth. Asset prices generally don’t appear to be out of line with traditional metrics.” That was her position. She said, “Not out of line with traditional metrics.” And I guess we could set aside the story stocks, your Amazon, your Tesla, your Google, Google averaging better than 2 billion dollars a quarter in net income. Again, very different than Amazon, it’s 2 billion cumulative over a 20-year period, and yet they sell for 164 billion dollars.
Kevin: Whereas Google’s is two months?
David: Exactly. There are companies here that are story stocks that are making money.
Kevin: Right, Facebook.
David: While they’re not the overall market, in a few instances, they do represent the extremes of overvaluation. Amazon may be the extreme of overvaluation. In past months, you and I have talked about the S&P 500, we’ve talked about how you look at the Shiller PE, what others know as the cyclically-adjusted price earnings ratio, taking a 10-year rolling average of the price earnings ratio, or Tobin’s Q, the general equity markets, in these terms, it’s no bargain. I go back to the conversation we had with Andrew Smithers, the British economist that called the market top in 2000, on the basis of Tobin’s Q.
Kevin: This was back in December when you talked to him.
David: Right. And he basically said, in December, “Today, 50-76%, that’s how overvalued the U.S. equities market is.
Kevin: And it is higher now than it was when you talked to him in December, Dave.
David: And I just wonder, “Janet, how much more overvalued does the market have to be for asset prices to have “moved beyond traditional metrics.”
Kevin: Those are her words.
David: What is a traditional metric? If we’re 50-75% overvalued, and in your book, it doesn’t move beyond a traditional metric, what are you looking at? I’d like to know. One last question, credit growth. If you are assuming it’s weak, that’s only if you exclude the Federal government and the Federal Reserve. If you look at the growth in their balance sheet, and growth in government debt, I don’t think credit is not growing at an aggressive rate. One last thing, then you have the expansion of credit to buy stocks. I sound like a broken record here, but 444 billion dollars of borrowed money to go buy stocks that you couldn’t afford? That is, a leveraged position, margin debt used to purchase equities?
Kevin: That’s as high as ever, isn’t it? Isn’t it higher than it has ever been?
David: These are levels that have exceeded very prior bubble peak in 100 years and I would just have to come back to Miss Janet and say, “What are you talking about? What are you talking about? No leverage in the system? Asset prices that fit a traditional metric? Okay, well, let’s see how this year finishes.”
Kevin: That brings me over to Europe, because they were a model that we saw fail. They haven’t failed completely yet, but we are starting to see push come to shove. Look at Italy. How many governments have they had just in the last couple of years?
David: This will be the fourth in two years. Enrico Letta resigned last week. Fascinating. Italian bonds and equities just kind of shrugged it off, no big deal. Why? It’s an easy thing to do when real reform has become irrelevant, and cheap money is still on offer from the ECB and other central banks. And I think the point here is when you look at Europe, when you look at China, when you look at where we are today versus 2008, the point is this: Structural reform isn’t easy.
Kevin: You get addicted to the easy money. If I were Italy, I would borrow at German interest rates, too. What if you actually had to borrow at Italian interest rates, Dave? What would they be, 40%?
David: Well, we got a picture of that in 2011 and 2012 prior to the outright monetary transactions put in place by the ECB. Again, structural reform, one, it’s not easy. But two, there is no incentive to get it done when cheap credit is on offer.
David: Politicians will take that alternative any day of the week, and that’s why not much has changed on the continent, not much has changed in the U.S., not much has changed in China.
Kevin: Yes, Dave, but Germany, who has been facilitating a lot of this, has been tightening up. They are starting to change the rules.
David: That was probably the biggest negative for the euro in a 20-year span, last week’s German court ruling, that those outright monetary transactions, the unlimited buying of sovereign paper, sovereign debt, by the European Central Bank, that brought the yields down which had been so high….
Kevin: That’s like what our Fed does here. It keeps the interest rates low as long as you buy your own debt.
David: What the court ruling said is that this program exceeds the ECB’s authority. And frankly, that may have implications for the survival of the eurozone project as it is currently constructed.
Kevin: Do you think that’s going to stand, though? When there is a court ruling, do you think that actually is going to hold?
David: Well, ECB is going to fight the German Constitutional Court ruling tooth and tong, the same way the Fed would if somehow someone challenged the existence of the Fed. Was it a legitimate organization, or have they gone beyond the pale in terms of their mandates? Yes, they’ll fight, and they’ll fight nasty, but I think the lower interest rates in the eurozone that we have today, could just as easily return to a very elevated level without this artificial source of buying, if we’re moving into the future. Again, the ECB has created a false sense of reality. Look at Italian rates, look at Spanish rates, and they are all very mellow today. You could say, “Well, the market is pricing in recovery.” Well, that’s one way of interpreting it, but another way of interpreting it is the ECB has stepped in and bought hundreds of billions of dollars’ worth of paper and created an impression of stability, when in fact, the opposite is really the case. Structural reform has yet to be implemented.
Kevin: Isn’t this the problem of human nature and control? You do something to say, “Okay, we’re only doing this because this is an emergency.” The ECB had been buying that debt and doing what they had been doing because of the euro emergency, but I want to go a little before the euro emergency. Let’s go back to our own emergency, the Lehman period of time and right afterward.
David: Sure, 2007, 2008, 2009.
Kevin: When Europe started to be affected by that, we started saying, “Look, the Federal Reserve is not just going to bail America out, but we’re going to offer swap lines to Europe so that the ramifications worldwide can be somewhat controlled by the Fed. That was supposed to be a temporary fix, Dave.
David: What that allowed was the European Central Bank, and other central banks around the world, when they started running out of money, essentially, it gave them access to the lender of last resort.
Kevin: Which was the Fed.
David: Which was the Fed. So, they would never run out of money, the central banks of these individual countries, because they could always tap a greater resource, a bigger printing press, if you will, that is, the Federal Reserve, through these swap lines.
Kevin: But those were supposed to be temporary.
David: And as you noted, this was supposed to be temporary. These were emergency measures. The currency swap lines have just been made permanent, this last week, to the U.K., to the European Central Bank, to the Japanese Central Bank, to the Canadian Central Bank, and to the Swiss Central Bank. They are permanent. I don’t know why, but it’s no longer a crisis arrangement. Note that it’s only the “old boys’ club.”
Kevin: Okay, so this is like the G7. You’re talking about the “old boys” when they really were trying to expand that to a G20 relationship at some point.
David: And that’s not really the case. The insiders’ group still has a better gig. If you think of the countries that have locked in to this arrangement, we have made clear, we’re the lender of last resort, which very curiously, we have not offered the same terms to the emerging market countries. I don’t know if that’s a mistake or not. One, I don’t think that this is appropriate central bank behavior in the first place, but if you’re going to offer it to the 7, you might as well have offered it to the G20. And I think that these dollar swap lines underscore our role in the G7. The question of how the broader G20 view this, being left out, and in a more vulnerable position, it will be interesting to see how the emerging markets respond to that. Because very importantly, the emerging markets make up more than a third of global GDP, and the IMF this last year has suggested 2014 is when the emerging markets may actually surpass the developed markets in terms of their percentage of GDP.
Kevin: William White was talking about that. He said from this crisis period starting at about 2007 we’ve added, as the world, if we’re counting G20 and even larger, a third more in debt, and yet we’re still using the same techniques. Is it any wonder that there is money moving into gold at this point, and it’s not speculative money trying to speculate on price. I mean, let’s get over the price thing for a little while and try to figure out, what do you put dollars and other currency in when this type of thing is happening?
David: Imagine, if you’re a Chinese bank depositor, and you can see, again, these cracks in the credit edifice in your country, and you think to yourself, “Well, maybe I did stretch a little bit, I put $50,000 into the bank, and I didn’t want to earn 1%, I thought 10% guaranteed sounded better, and frankly, the salesman told me it was risk-free. Well, I’m not sure that is going to work out for me. What do I do with my next deposit? Do you take it to the bank, Kevin, or do you put it into ounces? I think that’s what we are seeing right now, is at least demand in China over the last 2, 3, 4 weeks, has picked up, in part because the credit bubble is bursting there.
Kevin: And well, there is another place to go. We’ve not even talked about corporate bonds, but corporations are going into debt, but it seems like the banks are moving away from that, as well.
David: Financial Times addressed that last week on the 11th, that banks are wanting to move away from being market-makers. This is really interesting, because you are talking about the underbelly of a multi-trillion dollar marketplace.
Kevin: The banks are the main buyers of corporate bonds in the past.
David: Buyers and reshufflers. I mean, buyers and distributors. To be a market-maker is basically to say, “I’m going to inventory a certain number of bonds, and that way when my clients want to come and buy them from me I can sell them straight from our inventory.”
Kevin: Just like what we do here with precious metals, we’re market-makers.
David: Exactly, so when someone doesn’t want to make a market in a product, not only does that increase the illiquidity in that market, but it may, in fact, be consistent with a major turn in interest rates.
Kevin: So they may be not wanting to touch the hot potato because they think the interest rate may rise.
David: Well, again, who wants to hold inventory subject to sharp swings in value, particularly if it swings to the downside, as a result of a rise in interest rates? Remember all these relationships: 1) Interest rates rise. 2) As a consequence, the value of a bond goes down. If you are sitting on a boatload of bonds as a market-maker, you’re subject to tremendous loss in that kind of situation. So if there is low volume of people demanding corporate credit, that may be one reason why you don’t want to sit on it, because you’re not turning your inventory fast enough. Another reason may be, again, sharp swings as a result of an increase in interest rates. Also of note here, the Financial Times brought this out, that speculators are shifting away from the cash bond market. That is, where you bond a bond, pay the cash, it settles, you own the bond, and they’re moving toward trading derivatives, as well.
Kevin: Okay, so it’s these repackaged instruments, derivative instruments, that they’re buying.
David: And adding some leverage to the mix, because people are looking for greater rates of return. When interest rates are this low, not only do you have more downside because you have more of an increased potential in interest rates. Basically, if you lower rates to zero, where do they go from there? Up, only up.
Kevin: That brings us to our government debt here. We really have to have these repressed rates to be able to afford our government debt, don’t we? What happens when interest rates rise here in America, as far as paying…
David: But before we move past the bond market, keep the corporate debt in mind, and then go back to the discussion we just had on Chinese officials raising cash from the liquidation of treasuries. We should never forget … remember, if they’re liquidating treasuries, or if anyone is liquidating treasuries, that puts more supply on the market.
Kevin: Right. So you have to raise interest rates.
David: More supply on the market drives interest rates higher. That’s just natural supply and demand dynamics in the bond market. Let’s not forget that for every 1% rise in rates here in the U.S., and this is sort of hypothetical as a result of Chinese bond liquidations, or non-rollover of paper coming due, for every 1% increase in interest rates we pay an extra $100-150 billion in interest payments.
Kevin: On the national debt.
David: On the national debt, exactly. So we have the long-term average, again, compliments of Ian McAvity here, 60-year average on the 10-year treasury, at about 6%.
Kevin: So if you were to draw a line through all the moves, it would be about 6% on average. 6% is your average number. We’re at less than half of that now, under 3%. So taking current interest payments at around 400 billion dollars, to, say, 700-850 billion, that puts us between 25% and 29% of all government tax revenues going to making our interest payments. This is not a good position to be in, and it does explain why the Fed has been so active in manipulating and repressing interest rates.
Kevin: Well, and think about that, just from a personal point of view. Think of the listener saying, “All right, one-third of all of my income goes just purely to interest.” That’s not a healthy position.
David: No, and on top of that, Bloomberg ran an article last November 21st, where the Chinese were discussing that they wouldn’t be buyers of our treasuries. So you have that. Couple that with Japan now running trade deficits. What’s the significance of them running a trade deficit? Well, if they run a trade surplus, then they have extra money to recycle into the U.S. treasury market.
Kevin: That’s how we fueled this for years by making sure that these other guys had surpluses.
David: And that’s why the Chinese and the Japanese are two of our largest creditors, because they’ve been running trade surpluses, we’re now talking about a political decision to move away from the purchase of treasuries on the part of the Chinese. We’re talking about a market-related outcome, where they’re running trade deficits and don’t have the extra money to put into treasuries. Now, they are still printing yen and buying treasuries, but we’re talking about, again, the recycling, which has been the normal trade surplus dollar-recycling scheme. This is two of our creditors…
Kevin: Have you ever known a salesman, and it’s a horrible thing when you see this, who has two or three very, very large clients, and those guys go away? It can completely change…
David: Destroy your business.
Kevin: Exactly. Speaking of destroying a business, we’ve been watching the real estate markets and interest rates play a very key role as to how real estate is going to do. Let’s see how it correlates here. What are we talking about if interest rates rise?
David: Fascinating conversation, actually, this last week while I was skiing, with a gentleman who is involved with Fannie Mae, Freddie Mac, and the FHA, and they are doing everything that they can to take the inventory of repossessed homes, foreclosed homes, off of bank balance sheets, and Fannie Mae, Freddie Mac, and FHA pay a fee to the banks. So this is a revenue generator for banks, to basically revitalize the house and put it back on the market, but it’s not them holding the paper or the risk, it’s Fannie Mae, Freddie Mac, and the FHA.
Kevin: It’s you and me.
David: It’s you and me, the taxpayers. Exactly. I think about, “Okay, wait a minute. I’ve been waiting for shadow inventory on bank balance sheets to have to be sort of puked into the marketplace because banks can’t tolerate sitting on that much of a dead asset.
Kevin: Did you know that you’ve been buying fixer-uppers and turning them without even knowing?
David: As a taxpayer, you have a vested interest in the shadow inventory. It was a fascinating conversation, but I would suspect the dramatic re-pricing in real estate won’t begin until the 30-year mortgage is between 5.5% and 6%.
Kevin: But you do see real estate falling when that happens?
David: Well, exactly. And this is the critical issue for homeowners, as well as for equity speculators. The Fed has made a five-year concerted effort to distort asset prices via interest rate suppression. What does normalization of interest rates look like? We talked about 6% being your normal ten-year, over a 60-year period, long-term average rate, and I think this is where you are dealing with catastrophic effects, as and when we see normalization in the interest rate market. Richard Fisher at the Fed, there in Dallas, has said that the cost of continuing on our present course of quantitative easing and a low interest rate environment, they are equally bad. So we have normalization which is dangerous, but if we continue to suppress rates, and if we continue to buy assets the way we are, I think what he sees is a radical shift in inflation expectations on the horizon. And this is, again, where we’ve put a lot of liquidity creation into the pipeline. We’ve begun to see some asset price appreciation. What happens next? I don’t think the hawks at the Fed…
Kevin: Like Fisher.
David: Like Fisher, the folks at Cleveland, Bullard in St. Louis, even the Kansas City Fed, these guys are sort of heartland folks and they’re saying, “Wait a minute, wait a minute, wait a minute. You create trillions of dollars and there’s going to be an inflationary effect. We need to tame this down a little bit.” And the folks on the coasts are like, “Free money? You can take free money and buy assets with free money! What’s not to like about this gig? It’s a little ponzi-esque, but who cares?” That’s the contrast between the hawks in the mid states, and the doves, and Yellen is one of them, on the coasts, driving our Fed policy.
Kevin: Let me ask you a question then, since you’re talking about the hawks and the doves. You would not align, then, with what Janet said when she said, “We are cautiously optimistic in 2014?”
David: No, I would say we might be optimistic in 2-3 years, but that’s assuming that there is a lot more water that gets under the bridge. If we are selectively optimistic, that would only be because we have a healthy allocation and suggest one, into what we categorize as insurance. Ounces of gold and silver, listen, Drew is just back from Europe again. What a set of circumstances.
Kevin: Fourth trip in 7-8 weeks?
David: And there are a few more to come. We’re hand-selecting uncirculated coins that have been resting in a bank vault for 80 years, undisturbed.
Kevin: And he’s in hog heaven.
David: Well, when you look at him, he has a boyish grin from ear to ear. We’re buying them near the lows of the gold price correction, Dutch guilders which, if you sent them in to be certified by a third party, PCGS or NGC, they would consistently be 3-5 grades higher than were invoiced.
Kevin: But we’re getting to buy them as in the 60s and sell them as in the 60s.
David: I am selectively optimistic, but if you say, “Well, beyond gold, what are you interested in?” I am interested in the whole wide world. I’m interested in real estate at the right price. I’m interested in stocks and bonds at the right price, and all that we’ve been served up by the Yellen Fed, by the Bernanke Fed, by the Greenspan Fed, is a manipulation of circumstance which distorts prices, so much so, that it’s only the sucker that wakes up in the morning and says, “Gosh, look at the stock market. This is groovy.” Well, it is groovy, but it’s also incredibly dangerous. And I go back to skiing Silverton Mountain. You have to be aware of the circumstances you’re in. If you went in without an avalanche beacon, without a probe pole, without a shovel, and assumed, that, “Hey, blue skies today. Look, it’s not snowing. I’m completely safe.” Yeah, but what has happened prior to your arrival?
Kevin: Yeah, they’ve set off the avalanches already, Dave. They’ve had to do it over and over and over to stabilize it.
David: If you’re not in a stabilized environment, if you’re in an environment where, just like the Chinese, credit has been layered in, and layered in, and layered in, and we’ve done the same thing here in the U.S., and you’re assuming this is normal, you’re assuming that the impact of that layered-in credit, and its effect on asset prices is healthy, if that’s the game you want to play, be my guest. I believe that someone who takes the other side of that transaction, the other side of that trade today, who puts a focus on cash, who puts a focus on precious metals, who puts a focus on asset preservation, will be buying the world over the next 36-48 months, for pennies on the dollar. That’s an opportunity that is worth waiting for.