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February 01, 2009

Fed Monetizes Debt, Investors Buy Gold
by Boris Sobolev

In January gold rose significantly against all major world currencies. In most currencies except in the US dollar and the Japanese yen, gold actually made an all-time-high.

January Performance

At the same time, most capital markets have been falling.

January performance

The governments around the world are trying to take initiative while private capital is sitting on the sidelines, preferring the safety of government bonds and precious metals.

Investors typically do not trust the governments to implement any effective economic solutions. Moreover, this lack of faith in central planning continues to grow since the US government has no other plan of action than to save the old, compromised and untrustworthy financial system.

What the Federal Reserve together with the Department of Treasury has shown is that they will inject a vast amount of newly created money into a hugely ineffective financial system.

While in the fall of last year, in fear of devastating deflation, analysts were competing in downward projections for the price of gold, now the competition is to estimate the amount of losses incurred by the financial institutions around the world. The maximum assessment is now at $4 trillion, with Nouriel Roubini coming in close second at $3.6 trillion.

But the main problem is not so much in the amount of credit losses or the amount needed for recapitalization efforts but in that the new government is committed to continue to transfer huge capital into the hands of the same group of people who were largely responsible for the world financial crash in the first place. Wall Street, though transformed, will remain in control.

The lack of trust in the ability of insolvent financial institutions to run the modern financial system is moving investors into gold.

An even more important gold catalyst was the Federal Reserve. In comparing the two latest Fed statements, two things stand out. Here is the evolution in wording:

December Statement: "In light of the declines in the prices of energy and other commodities and the weaker prospects for economic activity, the Committee expects inflation to moderate further in coming quarters".

January Statement: "In light of the declines in the prices of energy and other commodities in recent months and the prospects for considerable economic slack, the Committee expects that inflation pressures will remain subdued in coming quarters. Moreover, the Committee sees some risk that inflation could persist for a time below rates that best foster economic growth and price stability in the longer term".

December Statement: "The Committee is also evaluating the potential benefits of purchasing longer-term Treasury securities".

January Statement: "The Committee also is prepared to purchase longer-term Treasury securities if evolving circumstances indicate that such transactions would be particularly effective in improving conditions in private credit markets".

First, the FOMC sees a threat of deflation and second it is prepared to counter this threat by purchasing longer-term treasuries.

Purchases of long term bonds is the most inflationary move that a central bank can undertake because it represents direct monetization of the government debt and hence an unconcealed debasement of national currency. (This is happening at the same time as the new Secretary of Treasury is chastising China - the main US creditor - for currency manipulation.)

Why did the Fed make such a determined statement, with one member even voting to begin long term treasury purchases immediately? First and foremost, the real estate market is not showing any signs of life. House prices are falling, time required to sell new homes is rising and most importantly, after a steep fall in December, average mortgage rates began to rise again, reaching 5.34% as of last Friday.

Since mortgage rates are closely tied to the 10-year treasury yield, the Fed stands ready to buy government debt and help make housing more affordable via low mortgage rates. The hope is that such action would help put an end to a decline in asset prices and stop the deflationary spiral.

In fact, the latest Fed balance sheet showed that long term treasury purchases have already started, with around $1 billion in notes (5-10-year maturity) purchased for the week ended January 21st. This is a modest amount, but it is a statement that the Fed is ready to do more than just talk. Traders have indeed sensed this development and Treasury Inflation-Protected Securities (TIPS) are also beginning to reflect greater inflation expectations.

Gold investors are also sniffing out the coming price reflation as they piled into the SPDR Gold Shares (GLD) at an increasing rate.

For the month of January, GLD gold holdings rose 8.2% or close to a record setting 63 tonnes. At this rate, GLD will soon surpass Switzerland in its gold holdings, thus becoming the world"s sixth largest gold owner after the US, Germany, the IMF, France and Italy.

If the Fed continues to purchase long term treasuries, it is clear that there is only one way for gold and gold stocks and it is UP.

Boris Sobolev
Denver, Colorado
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