Moneyization Part Thirty
Moneyization: The global financial phenomenon of individuals and businesses moving their funds to monies in which they have the highest confidence, or money in which they have a higher store of faith.
Or, Is the U.S. Alone In The World?
The answer to the above question has been received. We, meaning those of us in the U.S., are alone in the world. Nothing exists beyond the shorelines of the Atlantic and Pacific oceans are reached. Minutes of the FOMC, the rate setting committee of the Federal Reserve System, confirm that U.S. economic policy is set in isolation. No interaction with rest of the world is presumed to exist. The U.S. does not owe the rest of the world trillions of dollars and does not rely on foreign investors to finance a deficit created by excessive spending.
That aside, the Federal Open Market Committee did Gold investors another favor on 20 September. The FOMC left interest rates unchanged. With only one member committed to a sound dollar, the remainder showed their political stripes. The stripes have to be political as the economic pronouncements coming out of this group are dubious at best. The FOMC is fundamentally committed to erring toward ease. The FOMC will attempt to lower rates at the first realization of how sick the U.S. housing industry is becoming. That view can only exist in a group that believes the U.S. economy exists in isolation. Everything else in the world is deemed to be exogenous, and therefore irrelevant to U.S. economic policy.
Despite the policies of the Federal Reserve being supportive of the Gold market, a high level of concern seems evident in the hearts of Gold investors. The pessimism has not been this high since early 2005. On the flip side is that optimism on the U.S. dollar has likewise not been this high since early 2005. With the structural nature of the U.S. financial outflows increasing, the only reasonable direction for the value of the U.S. dollar is down. False rallies such as the dollar has recently experienced should be used as an opportunity to sell dollars and buy Gold.
Markets have been clearly distorted by the Hedge Fund Mania that has swept across the U.S., and much of the rest of the world. A trillion dollars, guided by childlike mis-managers, has flowed in and out of markets in a manner that has distorted the pricing function. This giant pool of money is frantically searching for returns to justify its existence. Mob psychology has taken over this group. Group think leads to money flowing disproportionally in one direction and then another, usually all at the same time. That distortion is making it hard for investors to make rational investment decisions. Rational technical analysis in such markets is difficult, as the classic rules were built on naturally functioning markets. With hedge funds running rampant, we do not face naturally functioning markets. However, the swan song for the hedge fund mania is starting to play.
The collapse of Amaranth in about a week shows the lack of discipline that exists within this sector. Clearly the industry's attempt at risk management is in a near bankrupt state. While most of us have lost money sometime in our investment activities, few can claim to have lost $5 billion in a week. All the talk about risk management is clearly just smoke to make it easier to mislead investors. The process of vetting fund managers lacks the sophistication of the process used to determine the sex of chicks. Imagine trusting your money or the money of your company or the money of your clients or the money of your college to a hedge fund. Or imagine doing something really wild and crazy, like putting the money in some firm's fund of funds. Send a cold chill down one's back to the wallet just thinking about it.
But why does it matter? The activity of hedge funds has been dominant in the trends of various markets. The runs experienced in Gold and Silver that have since given way to declines were driven by the activity of hedge funds. Do not believe that the move of oil to $75 and then down to $60 is how a natural market for oil should function. The abrupt slide of Silver about two weeks ago, which coincided with the demise of Amaranth's portfolio, certainly was not a natural market action. More likely it was the result of hedge funds scrambling elsewhere to participate in the picking of Amaranth's bones.
Hedge funds magnify risk through leverage. That leverage is how Amaranth managed to lose $5 billion in a week. Each "Amaranth" will have an incremental impact on investor psychology, or in the case of hedge fund participants, "speculator psychology." Given the massive leverage in hedge funds and the results of Amaranth, ultimate losses to speculators in hedge funds could be in the range of US$200-400 billion. That implosion will have a dramatic impact on paper asset markets in general. The beneficiaries will be the holders of Gold and Silver.
Recent action in the Gold market has been blamed on optimism on the U.S. dollar. One would seem to have real trouble developing any really optimistic arguments on the dollar, but anything is possible. Remember that the mangers of funds are only concerned with performance over the next ten minutes. For that reason, any chain of thinking on the dollar is possible, and will be traded with enthusiasm.
The first graph is of an index for the U.S. dollar created using the median changes in exchange rates of the U.S. dollar against a basket of important national monies. For that reason and others, it is superior to the trade weighted dollar index in assessing the dollar's strength or weakness. The Dollar Median Index is attempting to break out to the downside. Should it fall below 92 we can expect a period of material weakness in the dollar, and strength in $Gold. The move from about 99 in the middle of 2005 was followed by an irregular move lower. $Gold moved higher the entire time. The slam to below 94 helped to create the move in $Gold to more than $700. While covering only a short time period, no evidence of support for the dollar can be found in that chart.
Both the anecdotal evidence and fundamentals for the U.S. dollar continue to point to a lower value. The Streets can have fantasies over soft landings and the next rate move by the Federal Reserves, but the facts on the dollar are pointing down. The second graph is an example of just one small piece of the negative fundamentals. Plotted in that chart is the amount of U.S. currency in circulation. The world, perhaps for a long list of reasons, is losing interest in using the U.S. currency. Around the world, consumers have higher faith in other monies, including Gold, are switching to them. This shift to monies of higher faith out of dollars is the essence of the moneyization process. Another problem with the U.S. dollar is that it is over owned, by almost everyone.
One day a week or so ago that old story that scares Gold investors so much came up again. Fear of central banks selling Gold lives in the heart of every Gold trader. Central banks own a lot of Gold, and if they did sell in size the price of Gold would likely go down in the short-term. The third chart, below, uses the latest data from the IMF, and does include China. Note clearly that chart. Yes, central banks have been reducing their Gold holding for a number of years. However, the price of Gold has not gone down as a result of that selling.
The price of Gold went up despite this central bank selling. Why? The deteriorating fundamentals of the U.S. dollar are bigger than the market impact of central bank selling. Second, some central bankers are brighter than those in England and Switzerland. That higher level of understanding has actually restrained the selling. Gold has provided a higher return than all those holdings of U.S. debt. Additionally, every ounce they sell now means fewer ounces to sell in the future. Markets focus on tomorrow, not yesterday or today. What investors should also know is that central banks own far more paper assets than Gold. The situation is shown in the next graph. The motivation for this graph was a recent article, "The changing composition of official reserves," by Phillip Wooldridge in the September 2006 issue of the BIS Quarterly Review.
In the fourth graph is plotted the percentage of central bank reserves represented by Gold and paper assets. The small green portions of the bars represent the percentage invested in Gold. Over the years shown in the graph, the approximate percentage of central bank reserves invested in Gold has been about 9-10%. That level is down from 100% in 1900 and about 60% in the 1980s(Wooldridge,2006). The red parts of the bars represent the percentage invested in paper assets, or about 90%. Therefore, the really worrisome portion of central bank reserves for the markets should be the size of their paper holdings.
The largest piece of this paper asset overhang is U.S. government and agency debt. A far greater risk exists to the market for U.S. debt from the $1.7 trillion mass of U.S. debt held by the central banks than that which their Gold holdings represent to the Gold market. This data can be further explored, and will be in the October issue of The Value View Gold Report. In that report will be argued that the data suggests China may buy more than a 100 million ounces of Gold in the coming years.
If any source of risk really exists for the Gold market from these central bank holdings it is that held by the U.S. government. When central banks begin to reduce their exposure to U.S. debt, the U.S. dollar will fall in value. A crisis is likely to develop in exchange markets, sending the value of $Gold materially higher. At that time the U.S. may need to use part of its Gold holdings to support the dollar. The offset to this development will be that $Gold will be priced much higher. However, a possible scenario could be that the U.S. will swap Gold for the U.S. debt holdings of foreign central banks. Could China and the U.S. simply swap U.S. debt for Gold?
Inappropriate optimism on the U.S. dollar and unnatural market action brought about by hedge funds are coming together to create an opportunity in $Gold rarely seen before in the past year. The selling down of $Gold has created a level of pessimism that has not existed since 2005. Investors should be using these bargain price levels to add to positions, or if new to the market to start a position. See next graph on $Gold and one on CN$Gold which follows.
The last graph is of CN$Gold. A clear price opportunity is being created. With hedge funds pushing down the price of oil and Gold unnaturally, a chance to buy Gold should not be ignored. Currency contagion caused many Asian national moneys to plunge in value during that area's currency crisis some years ago. Currency contagion is likely to impact the Canadian dollar when the U.S. dollar falls into crisis. Now is the time to use those over priced dollars to buy Gold. Charts are also available for Euro Gold and GBPGold.
This article was not intended to be about the collapsing housing & mortgage bubble in the U.S., but habit seems to require some comments on the subject. On Monday, the report on existing sales of homes in the U.S. was released. Sales were down 13% from a year ago, and prices fell 2%. (How can prices fall?) The momentum of the U.S. housing bubble has been broken. The U.S. housing industry is about to enter free fall. Canadians that think they are insulated from this problem have one big question to answer. Who will buy those two-by-fours?
International Monetary Fund(2006,August).International Financial Statistics. Washington, D.C.: International Monetary Fund.
Wooldridge, P.D.(2006,September). The changing composition of official reserves, BIS Quarterly Review, 25-38.