RE: Paper & GoldDon Coxe
December 5, 2003
Conference call from Quebec City, Canada
https://www.jonesheward.com/commentary.cfm
Chart: Gold
Comment: “$400 Gold at the time the US Economy is on a Tear”
The chart that we faxed out was of gold and the comment was: “$400 Gold at the time that the US Economy is on a Tear”. Well I guess I shouldn’t have said that because of course right thereafter what we get is a disappointing employment number for the US.
But I don’t think anybody’s is going to suggest that this is a sign that the US economy is going to roll over and fall, maybe even Stephen Roach won’t suggest that. Why did I choose this topic today? The reason is because I want to talk about the way in which the signals from gold are telling us about the change in the world.
Now, it is unfashionable in intellectual circles to talk about signals from gold. Central bankers, of course, despise gold. When you’re in the business of printing money, then you have the same attitude to gold that manufacturers of artificial Christmas trees have to the real pine which shed needles and is a fire hazard. Their attitude is “We can do it better than God.” So, therefore, when gold makes the kind of move that it has, it’s something that most central bankers will shrug off. After all central bankers have been trying to get out of their gold as fast as they can. They’ve got a virtually intact fifty year record of being wrong about gold and so why should they change now? What is significant is that gold has turned upward and the US dollar has continued to go down, even though the economic statistics in the US have turned, at least up until today, decisively upward.
Now that is a really major development because one of the arguments that was being used 12 months ago for buying gold was the US economy was in trouble, it ain’t gonna come back and gold is the only safe asset out there. Stocks aren’t any good and a lot of the gold bugs were predicting the demise of capitalism as we knew it and that the only safe place was to be in gold.
Now, apart from the paranoid, this was an argument a lot of people had for investing in gold and in fact one of the arguments that I used back then, was that gold stocks were trading inversely to the rest of the stock market so you had built-in portfolio insurance. That really worked well.
Now, ordinarily, if you’re talking about life insurance, the way in which you collect the full face value is only by doing something unpleasant. It’s like the Christians reward which is heaven, but you’ve got to go through one rather major event first. So, what is amazing here is that the insurance policy that you’ve got in gold bullion has now become something that trades upward along with the economy and along with cyclical stocks.
That’s truly a remarkable transformation. So, is it for real? And if it does happen, if it’s come in on little cat feet that we move from it being just a foul weather friend to being a fair weather friend, what is it telling us? Well, it’s telling us that it’s still is really basically correlated to the dollar and the dollar isn’t going up, even when the US economy’s turned strong and that is the big change.
You see, the economists assured us that the weakness in the US dollar was temporary because once the economy came back, which it would with the Bush tax cuts and with the 1% Fed funds rate that the US economy would once again outperform the world and everybody’s going to want to invest in the US.
Well there’s no doubt at an 8.2% third quarter that the US economy outperformed every economy in the world except maybe China although a 9% figure, which is the one they used for China, is so close to 8.2 that it’s not much outperformance but…the US dollar went down. The Euro went up.
Now as you know, I was in Europe at the time that the Euro was moving back up again towards the 1.20 level, which it broke through after we got the news that the US had just put in the best economic performance that it had in twenty years. So, if the US dollar goes down to new lows when the economy goes to new highs - at least in the short-term economic indicators - what does that tell you? It tells you that the problems for the US dollar are MUCH more serious than the shills and the mountebanks have admitted.
It wasn’t just a cyclical phenomenon where the US economy was struggling. No, no, what it is, is that investors around the world are way overweight the dollar and they’re not comfortable about it anymore and they’re taking every opportunity to reduce their exposure.
And so, we aren’t going to keep putting in 8.2% quarters in for US GDP. So that raises the question, what’s going to happen to the dollar and then to gold when we slide back to the 3% or 3.5 or 4% range which is what the economic consensus tells us is unfolding?
What gold is telling us really is that we are really in the position where the US dollar is going to lose its status as the world reserve currency. That we are going to move into some kind of multi-polar or triangular world and these hints from OPEC that they’d like to diversify their pricing structure, Russia which is saying that it’s going to price its oil in Euros, that what we’re going to see is the rest of the world has gradually come to the conclusion that the dollar’s day is over.
It doesn’t mean that the dollar disappears. What it does mean is that people will make their own arrangements. And as I told you when I just came back from Europe in that first call, that I was hearing lots of talk about the new triangular currency world which would emerge which would be the Eurozone, which would include both the Euro and economies directly tied to it which would include Britain and Switzerland, then the Dollar zone, which would include the US dollar and the Canadian dollar and the Peso and then the Yen-Renminbi zone. And you may say that the Yen and Renminbi are not the same currency and they aren’t freely convertible so how could that work?
Well, I believe that over the next five years and no longer, that the Renminbi will become convertible and that what will be crucially important to both Japan and China to have an exchange rate as between the Yen and Renminbi that is not wildly volatile. Because Japan is now the number one foreign direct investor in China and what we can see is that Japan is going to be taking a greater and greater involvement in the evolution of the Chinese economy.
So, it seems to me then, that if you look at that, the Dollar zone is tiny compared to the Asian zone and it’s even small compared to the Euro zone because when you add in these new ten countries that have come in there and if you assume that Russia will be basically tied in to the Euro zone then what we’re talking about is that this will be the smallest zone and the dollar will function primarily as a vehicle for the Eurodollar market and for servicing all the global debt out there because the overwhelming amount of internationally traded debt is still denominated in dollars.
Now, all of this means a shrunken role for the dollar and that if you don’t need to hold the dollar as against debt liabilities, you might do something else. And if you don’t have 100% confidence that commodities will continue to be denominated solely in dollars, you might not hold them.
Now, what is likeliest, frankly, and this is what’s really a fascinating development this week, is that OPEC indicated they were taking the cap off their prices to reflect the decline in purchasing power of the dollar. Now, I was asked this question on a conference call about a week or two ago and I pointed out that having been in the Gulf states, that it wasn’t the purchasing power that concerns them because what they’ve got to do is service their debts, which are dollar denominated. But what they were doing was introducing something else into this, which is a notional dollar where you adjust the price of your commodity to reflect its purchasing power in the world even though that’s not where you’re doing a lot of your shopping.
Now, a rumor that’s going around this week which I got off our trading desk was that China may be showing interest not in acquiring Treasuries the way they were, but in starting to build strategic oil reserves and to start putting money directly into commodities that it needs. Now I don’t know - these are the kinds of stories that could be created by hedge funds who are long oil stocks or commodity stocks - but it’s the kind of strategic thinking that wouldn’t surprise me.
Because if you conclude that we’re moving from the 90’s where the best asset to hold was the US dollar into a decade in which the best asset to hold is commodities while we sort out how it is you’re going to price them, then maybe what you do is you solve that problem by not just moving from the dollar into another currency but by going to the asset class that is clearly going to be short.
Now, you may say “Well wait a minute now, everybody needs paper and China isn’t going to just get loaded up with oil tankers and filling up with tons of copper” and that’s true. But of course you get pieces of paper that relate to ownership of these things. So, it’s quite possible to diversify out of paper assets into hard assets while still having freely tradable pieces of paper. That’s one of the lovely things about derivatives.
And so, if we think that something like this could be unfolding, where you don’t have to take a direct bet on the value of the US dollar but you do it by acquiring other assets, then gold becomes a very logical part of the strategy. Now, not because you need gold to operate your economy, not because gold is going to come back, that we’re suddenly going to start using gold bars for everyday trade rather than checking accounts. But it’s simply a highly sensitive commodity which will respond to the price direction of commodities as a group.
So, if you think that something like this is unfolding, then what you’ve got to certainly say, is that when I’m looking at what my exposure is to gold stocks, that I need to have perhaps more than I had before when I was using them primarily as a hedge against a blow-up in the mortgage-backed securities market, a crash in the US dollar or another crash in the US stock market. Maybe I need it to reflect the total share that commodities will have in the growth in wealth in the world in this decade, which is going to the most commodity-oriented decade since the 1950’s.
Well, some of this is speculative but certainly the price action we’re getting on gold here is enough that you know, you’ve got to rewrite some and I’ve got to rewrite some of what I had written before.
I realize I’m at risk here from somebody who says “Come on, you haven’t gotten the story right, you’ve just been lucky. You told us to buy gold and gold stocks because of the bad stock market you predicted and yes that worked out and then you said well, it would trade inversely to the dollar and the stock market and on days the stock market sold off, gold always went up and the dollar always went down. So, you are looking good on that and now you’re saying oh well it’s just going to do well in these circumstances so even on days when the stock market goes up, so will gold. Therefore it’s lost its meaning.”
No, I don’t think so, I think that what’s happening is the world is rapidly reassessing what kind of economic recovery this is going to be. And it’s having to face the idea which is something like an adolescent who’s left home and proud of the fact that he’s left home but now is trying to cope. He’s got a job and he’s suddenly coping with the idea that mom and dad can’t look after everything for him. He’s going to have to make all these decisions on his own, going to have to figure out how to allocate his resources.
The US dollar has been the mom and dad for the world. And, mom and dad in this case are getting long in the tooth. They’re Social Security cases. And so, yes, they’re still smart, they’re still fun to be around and they’ve got longevity – but the adolescents and the 20-year-olds are the ones that are driving the economy and that’s the basically young economies of the world.
So, in this kind of environment, something that’s tied to gerontocracy which is all these bits of US dollar paper which arose during the time we had expressions like “As sound as a dollar” – those pieces of paper are going to become more and more suspect.
The final point before we get to questions is that what may actually be the big challenge for the dollar is the 1:8 ratio. You see, what we’ve got here is that for the third quarter, through that third quarter, when the US grew at 8.2% the Fed funds rate was at 1%.
Now this is unprecedented in the history of monetary policy, probably almost anywhere you can think of, to have the central bank rate that’s 1/8th of the rate that the economy grows. If you go back through monetary history and there’s virtually always a premium. The central bank rate is almost always higher than the rate of growth. Sometimes it’s close to it, but the idea that it trades at a gigantic discount to it is totally contrary to monetary theory and it would suggest a wildly inflationary bent.
Now we were told that this was to fight deflation. Well you certainly don’t get deflation if you’re borrowing from the central bank at 1/8th the rate of growth. And the Fed indicated that it was going to stay at this rate for a considerable period of time.
Well…holy cats, even if we go back to 4% growth that would still be four times the rate at which you can borrow money. Which of course, invites the carry trade, where you borrow at 1% and you buy the two-year note and you double your money or double your yield - more than double your yield - and that’s been a huge prop.
As a matter of fact you can look at the Treasury bond market and you can say that in the last six months it’s been supported by the carry trade and by Japan, China and Korea. And other than that, it’s hard to find people who have any reason particularly to buy Treasuries. They’re buying an asset that’s going down, now admittedly you’re fully hedged if you’re borrowing in the dollar and then investing in these but we don’t have a true investment case to be made in Treasuries. And we certainly don’t have it when you realize that the economy is now growing at this rapid rate and meanwhile the central bank is pumping out money at this bargain rate – the kind of rate that you would have in the midst of a great depression.
Now, admittedly, if you listen to Democrats rhetoric you might think we were on the edge of a great depression but I don’t think of the central bank policy as being set by political rhetoric which is seen mostly by people on CSPAN.
So, I think that you can make the case that probably one of the factors that’s gradually working it’s way into gold, is the recognition that there’s a quiet desperation in Washington that the Fed is part of, which is the recognition that the costs of the triple waterfall era are so great and that having everybody’s who’s converted their mortgages into the lowest rates in a generation, that what you have is the makings of an explosion when the economy comes back and the Fed has to raise rates.
Because we saw in 1994 the collapse of the mortgage-backed market, when the Fed tightened rates four times. Well, they never got rates down to 1/8th the growth rate of the economy, they were always higher than the growth rate.
Now, they’re faced with the fact that mortgage-backeds are more than double the weight in the Lehman Aggregate Index that they were back then and they’ve already extended their duration from 3 ½ to 5 ½ years and if they had to get the Fed funds rate back to a normal rate, let’s say there’s 4% GDP growth next year, so normal fund rate would be about 5% (gasp). A 400% increase in the Federal funds rate? At a time that you’ve got all those levered players in mortgage-backeds and that more than half of them are owned by Fannie Mae and Freddie Mac who are revealed to have lousy accounting?
This is the stuff of nightmares.
All of these things I think, are part of the story on gold. What it’s telling us is that leadership in the world is shifting both in terms of economic growth and in terms of currencies. We haven’t yet found where all of them come down. The players are still up dancing. We haven’t seen which chairs they’re going to be sitting on, but it’s the kind of world in which you say gold is something that is unlikely to lose out against who the eventual winner is. And that means you don’t have to know how this book ends. You are going to prosper. That’s the story, any questions?
Q&A
Stephen Peck: I think this is immensely interesting. As the shift takes place, the possibilities it seems to me are somewhat explosive in terms of the price of gold. You have this mountain of financial assets and sort of a molehill of all the gold bullion in the world together with the value, the marketplace of all the gold stocks in the world. And the one dwarfs the other. What are the implications of that in case there’s a shift out of financial assets just on the margin into gold-related and other commodities as well?
Don Coxe: Well Stephen, I’m delighted you’re on the call and I wish you compliments of the season but one of the reasons I did not suggest anything like this directly in the call is I don’t want to sound like a paranoid gold bug. Because these are the kind of things that they’ve talked about for 25 years. And that doesn’t mean that they’re going to prove to be right.
But I am also, like you, disturbed at the prospects that the…you know, there’s that wonderful Bisuto proverb which was used as the title of the novel on the Mau Mau which is “If you take away everything a man believes in, you must replace it with something of value” and that was the name of the novel.
And what is happening here, you see, is that people have become so comfortable with the dollar – they got uncomfortable with it for a while during the inflation era – but that 45% run-up from 1995 to 2001 against the Deutsche mark and the Euro gave people the faith that it’s back again. Now what’s happening is as we migrate away and meanwhile we’ve added all these zeros to the liabilities…the crash in ’87 came with the horrifying realization that the US was going to run a trade deficit of 79 billion, you remember that…we do that in six weeks now. Okay?
So therefore, like you, I’ve had a sort of a gnawing feeling – and frankly this happened to me this morning as I was lying awake long before I got up, thinking, gee if this story is true, if this is really what’s unfolding here – because gold should have fallen back but it didn’t, okay – and if this is really what’s unfolding then we’re talking about something that is much bigger, because we still have a situation where although it’s being advertised as all these small speculators, that there’s a new gold mania. By the way, we’re always told that there’s a mania for gold it goes above what the economists had predicted. And the assumption is that only idiots would buy it. But when they talk about the mania here, we’re not talking about anything like the market value of Cisco or something like that! Oh no! It’s a trival amount of money. So, yeah, you’re absolutely right, we have something here where the establishment - which is everything, which is the central banks, which is corporations, which is economies – is built around a nice comfortable relation that a group of central bankers who meet from time to time for brandy and cigars in Basel, can somehow manage this fast-multiplying collection of paper in the world and we can ignore, as you say it, this molehill of gold.
And, I hope that’s the case. But in the past, you only worry about this if things were going to seriously wrong…but what if, what if people conclude that we can have prosperity lead by people who do not have all this paper, okay, and therefore what they want to have as their store of value is something that they can trust. In which case we all of a sudden, we turn the pyramid on its apex. And then, yeah we start talking about something where the price rise in gold could be truly explosive.
But, as I say, to even say that out loud – and there’s five thousand people listening to this call – is not to suggest that we’re going to have a mad rush into gold. What I’m saying is that none of the conventional explanations up ‘til now, explain its behavior in the last six weeks. And therefore, what you must allow for is that something else is going on. And I hope in the conversations that I’m having over the next few weeks and months with the people who faithfully tune in on this, that collectively we’ll solve that problem and your question helps move us along for which my thanks.
Adam Gordon: Just curious how this will impact the gold stocks. Will they continue to rally with gold or will there be a disconnect at some point?
Don Coxe: Well, frankly, if you believe that we could be in some kind of fundamental revaluation of gold’s role in the world - and it’s not because governments do it, but it’s because collectively millions and millions of people say “I’ve got to have at least some of this”, which would be enough to create the squeeze - then what happens is the gold stocks acquire a true scarcity value because what they have is a command not just of the gold that’s above ground, but of all the gold that can be produced in the next 20 years.
So therefore, what we’re talking about is a situation in which the net asset values of the gold stocks would rise far faster than the price of bullion. Now, I’m not predicting that, but, you see, the reason for this call was just the fact that I realized that I had been in the position for having appeared to be right for all the right reasons, and all of a sudden the story was changing, the fundamentals of it, and yet the gold was still moving up and I needed to have some kind of explanation so I was really sort of opening it to the audience to say what’s happening here? Something bigger may be happening than I’d realized.
In that case, what we’re talking about is the relative price of the stocks relative to bullion will expand dramatically in favor of the stocks, because of the fact that you don’t have to acquire the inconvenience of bullion. What you acquire, then, is an open-ended call on whatever happens on the upside. And if what people are saying is that they think that something bigger is going to unfold, what they want is that open-ended call. And right now, I’m told that the stocks are discounting $420 bullion. Well that’s not so far off where we are. If you get $420 for now and you have an open-ended call with gold really going up a lot, then why wouldn’t you own the stocks rather than bullion? Does that make sense?
Adam Gordon: Yep.