Alasdair Macleod – 7 October 2010
A very interesting thing happened last week: in Europe we woke up on Tuesday morning to a strong gold price. This was noticeably different from the established pattern of not much overnight change from the New York close. This strength exacerbated physical shortages of both gold and silver, propelling gold to nearly $1,350 and silver to $23. Put another way, buying in the Far East dictated the price, taking the initiative away from Western markets.
The underlying momentum is extremely strong, as shown in the chart below where gold is following a neat parabolic course. This means that any pull-backs will be limited in both duration and extent.
From a technical point of view, the major pull-back everyone is still waiting for occurred in 2008. This is a market that will not be bought by the cautious, who will feel they have missed the rise. Interestingly, the most likely Elliott Wave count shows running corrections in different wave magnitudes, which complete above where they started – a peculiar concept for the uninitiated, but a portent of strong price gains to come.
There are important positives for gold and silver. Besides the strong technical analysis reading, price actions are confirming acute shortages of physical bullion, which are getting worse by the day. And importantly, there have been dramatic monetary developments early this week in both the US and Japan.
Forthcoming elections to hand more power to the Fed
Last Monday Ben Bernanke gave a speech before the Rhode Island Public Expenditure Committee, where he expressed concern about the course of public spending, warning that it would either be curbed by “a careful and deliberate process”, or by a “rapid and painful response to a looming or actual fiscal crisis”. Put another way, he is saying the Keynesian lever of fiscal deficits is expended, leaving monetary policy as the only tool to save the economy. He is anticipating perhaps the results of the upcoming elections, where the Democrats are likely to lose legislative control to Republicans less tolerant of government profligacy. The result of a legislative stalemate will be to hand more power to the Fed, which will implement QE on a larger scale to compensate for any cuts in public spending, while keeping interest rates at zero for a considerable time.
The Fed therefore joins the Bank of England in pursuing this strategy. The currency markets are waking up to the implications of the next wave of American QE, and all other currency-issuing central banks are considering their monetary policies accordingly. What makes this so dangerous is that an important element of input prices, raw materials, is rising rapidly, with the Reuters CRB Index up over 60% since November 2008. The rapid expansion of raw money is also exacerbating the shortage of physical gold and silver bullion for the bullion banks and the shorts on Comex. They have all been caught, in effect, betting the house on deflation. But that approach does not allow for Asian buying by both the central banks and hundreds of millions of the new middle classes. This leads us to the second major development, which is in Japan.
Japanese QE is desperation
On Monday night the Bank of Japan announced a new round of QE with interest rates to be held even closer to zero. There is little doubt it was this development that generated Far Eastern demand for gold on Monday night, and for good reason. The BoJ is going further than any other central bank, and will buy in their words:
Long-term government bonds, treasury discount bills, commercial paper (CP), asset-backed CP (ABCP), corporate bonds, exchange-traded funds(ETFs), and Japan real estate investment trusts (J-REITs). As a fund provisioning method other than the purchase of assets, the Bank will utilize the fixed-rate funds-supplying operation against pooled collateral. — The purchases of the ETFs and J-REITs are conditional on receiving approval pursuant to the Bank of Japan Act.
This is the widest application of QE by any central bank so far. The stated reason for it is to prevent the economy from entering a deflationary slump. But there are two other important reasons for this policy: it is an attempt to manage the currency downwards against a falling dollar, so it is in effect a response to anticipated Fed QE; and the Japanese government is desperate for the money.
More or less all governments in the developed world are borrowing more than their domestic bond markets can provide, and Japan is now in the same boat. Over time, she has through Keynesian policies almost destroyed her savings culture, and her increasing ranks of the elderly are depleting the savings pool. Therefore, the Japanese government faces a choice for the next year or two: raise interest rates to attract foreign capital to make up for the savings shortfall, or print money. The former can be ruled out, since it would drive the yen up, bring on the collapse of domestic bond markets, and expose government finances to elevated funding costs. So printing is the only acceptable option.
Indeed, for the Fed, the Bank of England and the Bank of Japan the primary reason for QE is not to rescue their respective economies, but to fund government deficits. Without QE, there would be savage competition for international capital which could only be resolved by substantially higher interest rates; and if this happened, governments with high debt to GDP ratios would rapidly go to the wall.
These are precisely the conditions that lead to stagflation followed by a hyperinflationary slump, so it is no wonder bullion prices are at record levels and following that parabolic course.