Why Eurobonds Are Pointless

Wednesday, July 18th, 2012

The Euro area seems to have drifted into something of a fiscal backwater with the debate over Eurobonds. German Chancellor Merkel has rather melodramatically declared that Eurobonds will not be an option as long as she lives. As UBS’ Paul Donovan notes, European politicians go back and forth over the merits, necessity, and preconditions for Eurobonds. He sees this as “a waste of time”. Eurobonds are not a necessary condition for the survival of the Euro, even though (in our view) fiscal union in some form is a necessary condition. The Eurobond debate is diverting valuable political and economic resource into what is at best an irrelevance, and at worst may actually undermine the stability of the Euro area.

Paul Donovan, UBS: Why Eurobonds are pointless

What is a Eurobond?

There is no single accepted definition of what a Eurobond would represent, although there are some common concepts. A Eurobond would be a collective liability of the Euro area governments. A Eurobond would be used to raise money for Euro area governments at a “pooled” rate of interest. Around this common ground there are then debates about how such a bond could be used.

Should the bond apply to cover national government borrowings of up to 60% of GDP (the Maastricht criteria)? If so it raises some interesting questions about how GDP is calculated, given the frequency of revisions. Should the Eurobond apply to new national government borrowing that has first been sanctioned by the Euro area heads of government? Should the bond supply funds to the ESM which are then parcelled out to the member states in case of need – which was indeed the original concept of the Eurobond when proposed at the May 2010 summit to save the Euro?

Is a Eurobond necessary?

The short answer to this question is “no”. The long answer is “no, of course not, not like this”.

What the Euro area needs, to tackle its dysfunctional monetary union, is some kind of fiscal transfer union. A fiscal transfer union does not solve the dysfunction of the monetary union, but it blunts the damage occasioned by a common monetary policy. Where monetary policy is inappropriate, the automatic stabilisers of fiscal transfer can rein in the economic divergence of the components of the monetary union area. This is why every single functioning monetary union on the planet, for over two millennia, has had a transfer union of sorts alongside the common currency. A Eurobond is a very clumsy fiscal transfer union. Those economies that are more creditworthy are surrendering some of their credit status to lower the borrowing costs of those economies that are less creditworthy. It seems reasonable to assume that the common Eurobond will have an interest rate that is higher than that of the best credits in the monetary union and lower than the interest rate levied on the worst credits of the monetary union.

This is all very well, but it is hardly precise. A strong credit may not be a cyclically strong economy, for instance. Transferring benefit from Germany (a very weak economy for much of the last fifteen years) to Ireland (a relatively strong economy for much of the last fifteen years) would have exacerbated the dysfunction of the monetary union and the common monetary policy; it would certainly not have mitigated the ravages wrought by a shared interest and exchange rate.

So what would happen without a Eurobond? A country in the Euro area could face mounting debt costs, and in the absence of a collective bond issue at a lower interest rate could be forced into default. So what? As California has so admirably reminded us (with a third municipality filing for bankruptcy just last week), there is no necessity for a collection of subsidiary monetary union governments to have common issuance or common liability for individual state debts. The point is that when default or bankruptcy occurs, the damage from the local economic fallout is partly offset by the fiscal transfer mechanism, leaving the local government to stand or fall in fiscal terms on its own merits. Citizens of San Bernardino in California will have lower services (economic stimulus) from their local government now that it is bankrupt. The unemployed of San Bernardino will still receive their benefits, however. The economic impact of the government’s bankruptcy is thus mitigated.

The damage Eurobond discussions could do

The Eurobond threatens significant damage to the Euro area. The concept of the Eurobond as currently envisaged is easily characterised as “rich countries helping poor countries”. The very notion of the Eurobond at the moment rests on the idea of national sovereignty as a driving force for the Euro area. National governments receive collective assistance by relying on the positive credit attributes of other national governments. There is a potential sense of intergovernment obligation. This view of the Euro area is potentially quite poisonous to the health of the Euro as an entity.

For the Euro to succeed there must be some idea of community. It is not about rich countries helping poorer countries; it is about rich Euro area citizens helping poorer Euro area citizens, wherever each group may happen to live. Eurobonds frames the debate and indeed the solution in entirely nationalistic terms, which is simply counterproductive.

Fiscal unions that are created top down very often have central government guarantees or pooled issuance programs for the local governments. This is because the local governments’ existence is contingent on the will of the central government. Fiscal unions that are created by a pooling of sovereignty from the bottom up (like the Australian Commonwealth or the United States, or the Euro today) have a very different relationship between central and local government. There is generally no necessity to guarantee or assist the local governments with their finances, other than that the central government may through its own independent fiscal policy seek to offset any economic downturn.

The Euro area needs to move away from nationalism and towards integration. Although superficial about integration, the Eurobond debate seems to be taking the Euro in the wrong direction, and giving rise to a perception of nations giving aid to other nations. The Euro is a bottom-up construct. A more integrated Euro area federation can (probably must) take place without collective responsibility for national debts. What is needed is collective responsibility for some aspects of fiscal policy to offset the damage of collective monetary policy. That is a very different concept from the Eurobond.

Tags: Backwater, Borrowings, Common Ground, Economic Resource, Esm, Eurobonds, European Politicians, German Chancellor Merkel, Heads Of Government, Interesting Questions, Irrelevance, Maastricht Criteria, Monetary Union, National Government, Necessary Condition, Original Concept, Paul Donovan, Preconditions, Rate Of Interest, Short Answer
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NYSE Short Interest Rises to 2012 Highs

Thursday, May 10th, 2012

On the surface, the fact that NYSE short interest was just reported today to have risen to 13.1 billion shares as of April 30 could be troubling for the bears, as this just happens to be the highest short interest number of 2012. Indeed, an increase in short interest into a centrally-planned market is always disturbing, as it opens up stocks to the kinds of baseless short covering melt ups that simply have some HFT algo going on a stop hunt as their source, that we have seen in the past several weeks. Naturally, it would be far easier to be short a market in which Ben Bernanke managed to eradicate all other bears, especially when considering that a year ago the Short Interest as of April 30 was virtually identical.

However, courtesy of some recent discoveries by Bloomberg, we now know that his very pedestrian way of looking at short exposure is simply naive, as it ignores all the synthetic means that hedge funds truly express their position these days, mostly in attempts to avoid observation, and to magnify their balance sheets in any way possible. In other words: epic abuse of leverage, but not simply on the books, but through repos, Total Return Swaps, and various other shadow “shadow” P&L enhancement techniques. To wit from Bloomberg:

Citadel Advisors LLC and Millennium Management LLC said their assets soared ninefold when tallied under a new rule that requires hedge funds to disclose investments financed through borrowings.

 

Citadel, run by Ken Griffin out of Chicago, reported $115.2 billion of regulatory assets in a March 30 filing with the U.S. Securities and Exchange Commission, compared with $12.6 billion of net assets. Millennium, founded by Israel Englander, disclosed comparable figures of $119 billion and $13.5 billion as of year-end.

…

 

In short sales, investors borrow assets to sell them in anticipation that they can be repurchased at a lower price later and they can pocket the difference. Hedging includes the purchase of offsetting positions to limit risk in a trade.

 

While some fund managers only gave information on their gross assets, 31 of the 50 largest also disclosed their net assets in a separate section known as the client brochure. For these advisers, gross assets of $949 billion were more than double their net assets of $422 billion.

 

That indicates hedge funds may be using as much leverage as they did prior to the 2008 financial crisis. On average, hedge funds held total assets that were double their net capital as recently as 2007, said Daniel Celeghin, a partner at Casey Quirk & Associates LLC, a Darien, Connecticut, adviser to asset managers.

 

Not all of the difference between net and gross assets may be explained by leverage, because the SEC’s gross number also includes proprietary stakes that money managers hold in their own funds as well as assets that don’t get charged a management fee. The SEC’s calculating method can lead to double counting of assets at funds, such as Citadel, that include multiple entities.

 

“If you are heavily levered, obviously that will result in you having a larger gross asset number,” said Gary Kaminsky, a principal in the business advisory services group at Rothstein Kass, a Roseland, New Jersey, accounting firm that audits hedge funds. That’s because, under the SEC approach, “all that matters is what’s on the asset side of the balance sheet,” Kaminsky said.

 

Hedge funds are relying less on margin loans from prime brokers, the securities firms that provide credit and facilitate trading, and more on repurchase agreements, leveraged exchange- traded funds, and derivatives such as total return swaps, according to Josh Galper, the managing principal at Finadium LLC, a Concord, Massachusetts, investment research and consulting firm.

 

“Leverage is down across the board from the perspective of borrowing from a prime broker,” Galper said in a telephone interview. “It’s tough to measure how much embedded leverage funds are using.”

In other words, while the chart above is useful generically, the reality is that a true picture of outright bullish or bearish appearance is now impossible to be gleaned courtesy of precisely the same synthetic instruments that nearly destroyed the financial system in the fall of 2008. Funds will do anything in their power to systematically boost their leverage at the gross level, while leaving their net leverage appear innocuous, and then spin how gross is not net, even as their Prime Brokers onboard all the risk: after all who bails them out if things go wrong? Why, you do.

And who benefits if they are right? Here’s who, together with an AUM breakdown based on the old and new methodology:

Tags: Anticipation, Balance Sheets, Bloomberg, Borrowings, Citadel Run, Comparable Figures, Enhancement Techniques, Hedge Funds, Hft, Israel Englander, Ken Griffin, Millennium Management, Net Assets, Nyse Short Interest, Recent Discoveries, Regulatory Assets, Return Swaps, Securities And Exchange Commission, Ups, Year End
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LTRO 2: Goldman’s Take

Wednesday, February 29th, 2012

Goldman waited exactly 20 minutes to try to comfort the market, especially the EURUSD which is getting increasingly jittery, that €1 trillion in Discount Window borrowings is a “positive.” We beg to differ that trillions in more debt collateralized by candy bar boxes and condoms will cure an excess debt problem, especially with all the good collateral now gone, and we are confident that ongoing deleveraging needs will put a major cog in the system, especially since the only liquidity expansion move now is “fade”, at least until the next major crisis.

Banks take out ECB “funding insurance”

The ECB has today – through its long-term refinancing operation (LTRO) – fully allotted €529 bn of 3-year funds to 800 banks. Together with the first auction, the ECB has now injected €1 trn of 3-year funds into the system. This is an extremely high amount and equals, for example, 131% of total (249% unsecured) European bank bond maturities in 2012 and 72% (130% unsecured) for 2012 and 2013 combined. European banks are now effectively pre-funded through to 2014.

Funding stabilized, revenues supported

Large take-up is an important positive. Key reasons are: (1) banks are now largely insulated from shocks in the funding market, having prefunded through 2014; (2) consequently, the costs of bank and sovereign funding have now been detached; (3) pressures for forced deleveraging should reduce (first evidence of this is visible in the recent ECB loan data); (4) deposit pricing pressures should fall (this too is already taking place), resulting in a positive revenue effect.

Country aggregates in coming weeks

While the focus is on the aggregate take-up, we see country aggregates as arguably more important. Over the course of the next weeks, we will get disclosure of country aggregates where we expect the Spanish and Italian take-up figures to be high.

ECB’s actions expand the investable group

We derive our group of ‘investable’ banks by: (1) incorporating P&L effects of ECB action; and (2) overlaying these estimates with ‘extreme’ credit losses (as per the EBA stress test). Within this group, our Eurozone top picks are Erste Bank, BBVA, BNP Paribas (all Conviction Buy), and Intesa Sanpaolo (Buy).

We identify banks likely to be “disproportionate beneficiaries” of the ECB LTRO including: Banesto (Buy), Banco Popular Espanol (Not Rated), BancoPopolare, Banca Monte dei Paschi di Siena and UBI Banca (all Neutral).

Tags: Aggregates, Bn, Borrowings, Candy Bar, Cog, Condoms, Debt Problem, ECB, European Banks, Eurusd, Excess Debt, First Evidence, Goldman, Key Reasons, liquidity, Loan Data, Maturities, Shocks, Trillions, Trn
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European Nash Equilibrium Collapses – Bank Bailout Stigma Is Back At The Worst Possible Time

Tuesday, February 7th, 2012

In all the excitement over the December 21 LTRO, Europe forgot one small thing: since it is the functional equivalent of banks using the Discount Window (and at 3 years at that, not overnight), it implies that a recipient bank is in a near-death condition. As such, the incentive for good banks to dump on bad ones is huge, which means that everyone must agree to be stigmatized equally, or else a split occurs whereby the market praises the “good banks” and punishes the “bad ones” (think Lehman). As a reminder, this is what Hank Paulson did back in 2008 when he forced all recently converted Bank Holding Companies to accept bail outs, whether they needed them or not, something that Jamie Dimon takes every opportunity to remind us of nowadays saying he never needed the money but that it was shoved down his throat. Be that as it may, the reason why there has been no borrowings on the Fed’s discount window in years, in addition to the $1.6 trillion in excess fungible reserves floating in the system, is that banks know that even the faintest hint they are resorting to Fed largesse is equivalent to signing one’s death sentence, and in many ways is the reason why the Fed keeps pumping cash into the system via QE instead of overnight borrowings. Yet what happened in Europe, when a few hundred banks borrowed just shy of €500 billion is in no way different than a mass bailout via a discount window. Still, over the past month, Europe which was on the edge equally and ratably, and in which every bank was known to be insolvent, has managed to stage a modest recovery, and now we are back to that most precarious of states – where there is explicit stigma associated with bailout fund usage. And unfortunately, it could not have come at a worse time for the struggling continent: with a new “firewall” LTRO on deck in three weeks, one which may be trillions of euros in size, ostensibly merely to shore up bank capital ahead of a Greek default, suddenly the question of who is solvent and who is insolvent is back with a vengeance, as the precarious Nash equilibrium of the past month collapses, and suddenly a two-tier banking system forms – the banks which the market will not short, and those which it will go after with a vengeance.

The WSJ has more on this very subtle but so very critical shift in the European bailout game theory equilibrium:

A group of top European banks is disclosing that they didn’t borrow money under the European Central Bank’s bank-lending program, fearful of being perceived as bailout recipients.

The broad participation in the program, known as the Long-Term Refinancing Operation, fueled a sense of euphoria among many bank executives and investors that the worst of the Continent’s two-year banking crisis was over. In a second batch of loans in late February, analysts expect the ECB to distribute as much as €1 trillion in additional funds, partly because the central bank is making it easier for banks to borrow.

But some bankers and observers are starting to warn about unexpected fallout from the ECB’s loan program. A top concern among banks is that the receipt of central-bank lifelines could subject them to potential political or regulatory interference and sully their ability to declare themselves free of any outside help. That sentiment has the potential to damp demand for future ECB loans, at least among the Continent’s strongest banks.

In other words, the market is finally waking up that the LTRO, more than merely carrying the upside of a mechanism preserving the status quo for a brief period of time, also has the downside of implicit stigma associated with any and every bank that is found to use it. And the punchline here is that the second a European “Jamie Dimon” emerges and starts touting their lack of need to use LTRO cash, the whole plan collapses. It appears that Deutsche Bank, the bank whose assets are 80% of German GDP, is just that equilibrium collapse factor.

It isn’t yet clear how many banks declined to borrow but the list includes Deutsche Bank AG and Barclays PLC. While the ECB doesn’t divulge which banks borrowed, most companies are expected to disclose the information as they release annual results this month.

“The fact that we have never taken any money from the government has made us, from a reputation point of view, so attractive with so many clients in the world that we would be very reluctant to give that up,” said Josef Ackermann, Deutsche Bank’s chief executive, explaining to analysts last week why the German lender didn’t borrow from the ECB.

Mr. Ackermann said Deutsche Bank still is scarred from its experience borrowing from the Federal Reserve in the first phase of the financial crisis in 2008. U.S. regulators encouraged banks to borrow under the cloak of promised confidentiality, but when the banks’ identities were subsequently disclosed by the Fed, the recipients were dubbed bailout recipients. “We learned a lesson,” Mr. Ackermann said.

Other bank executives privately have voiced similar opinions. Some of that sentiment is likely to surface publicly in coming weeks as banks report annual results and executives face questions from investors about whether they borrowed from the ECB.

English banks are also suddenly scrambling to portray themselves as healthy:

In the U.K., the Financial Services Authority informally encouraged the banks to tap the ECB loan program, although the regulator also made clear that the decision was up to the individual banks, according to executives with several British banks. The goal of the FSA, shared by other European regulators, was to promote broad use of the facility and reduce any stigma associated with borrowing, said people familiar with the matter.

A number of top British banks, including Barclays, Standard Chartered PLC and Lloyds Banking Group PLC, opted not to borrow from the ECB, according to people familiar with the matter.

Beyond the implicit, there are explicit risks associated with being bailed out:

“Those heavily reliant on ECB funding run risks of interference as a price for continued support. This may come to be seen as a form of nationalization,” said Simon Samuels, a European banking analyst at Barclays Capital. He said bank executives are likely to worry that regulators will view their dependence on ECB funds as a sign of a broken business model and will pressure them to restructure operations.

Such concerns are peripheral for banks that potentially were going to have trouble refinancing maturing debt at nonpunitive prices. Virtually every major French, Spanish and Italian bank borrowed billions of euros from the ECB, according to bank disclosures and people familiar with the matter. Among those was Banco Bilbao Vizcaya Argentaria SA, Spain’s second-largest lender by assets, which borrowed €11 billion, the bank’s president told analysts last week.

Some healthy banks also pounced on the opportunity for inexpensive three-year funding. HSBC Holdings PLC was among those that borrowed even though it didn’t need the money, according to people familiar with the matter. Any profits the British bank reaps from investing the borrowed funds will be segregated from HSBC’s bonus pool, one person said.

Yet all these considerations pale before the reality that any banks that borrows even €1 on February 29 will suddenly be perceived as a lower-tier performer, when faced with banks that parade with their “fortress balance sheet.” And as everyone knows, bail outs only work when everyone agrees to be bailed out. Otherwise, it is a shortcut to collapse. Because the last thing Intesa and UniCredit and STD and a whole lot of not so healthy banks will want on March 1 and onward is to be put in the “bailout recipient” category when so many others clearly no longer need the cash…

It appears that European banks, in their vain attempts for short-term capital gains, may have just sealed the fate of the entire financial sector.

Tags: 3 Years, Bank Bailout, Bank Holding Companies, Banks, Borrowings, Capita, Continent, Death Sentence, Excitement, Functional Equivalent, Hank Paulson, Jamie Dimon, Largesse, Lehman, Nash Equilibrium, Qe, Reminder, Stigma, Trillion, Trillions
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Mark Carney: Canada’s Growth in the Age of Deleveraging

Friday, December 16th, 2011

Here, without further comment is Mark Carney’s speech to the Empire Club/Canadian Club of Toronto, from earlier this week, which The Globe and Mail’s Jeffrey Simpson called ”so intelligent in its analysis and perceptive in its recommendations that it stands as the best speech by any public figure in Ottawa in a very, very long time.”

****

from Bank of Canada Governor, Mark Carney’s speech:

Introduction

These are trying times.

In our largest trading partner, households are undergoing a long process of balance-sheet repair. Partly as a consequence, American demand for Canadian exports is $30 billion lower than normal.

In Europe, a renewed crisis is underway. An increasing number of countries are being forced to pay unsustainable rates on their borrowings. With a vicious deleveraging process taking hold in its banking sector, the euro area is sinking into recession. Given ties of trade, finance and confidence, the rest of the world is beginning to feel the effects.

Most fundamentally, current events mark a rupture. Advanced economies have steadily increased leverage for decades. That era is now decisively over. The direction may be clear, but the magnitude and abruptness of the process are not. It could be long and orderly or it could be sharp and chaotic. How we manage it will do much to determine our relative prosperity.

This is my subject today: how Canada can grow in this environment of global deleveraging.

How We Got Here: The Debt Super Cycle

First, it is important to get a sense of the scale of the challenge.

Accumulating the mountain of debt now weighing on advanced economies has been the work of a generation. Across G-7 countries, total non-financial debt has doubled since 1980 to 300 per cent of GDP. Global public debt to global GDP is almost at 80 per cent, equivalent to levels that have historically been associated with widespread sovereign defaults.¹

The debt super cycle has manifested itself in different ways in different countries. In Japan and Italy, for example, increases in government borrowing have led the way. In the United States and United Kingdom, increases in household debt have been more significant, at least until recently. For the most part, increases in non-financial corporate debt have been modest to negative over the past thirty years.

In general, the more that households and governments drive leverage, the less the productive capacity of the economy expands, and, the less sustainable the overall debt burden ultimately is.

Another general lesson is that excessive private debts usually end up in the public sector one way or another. Private defaults often mean public rescues of banking sectors; recessions fed by deleveraging usually prompt expansionary fiscal policies. This means that the public debt of most advanced economies can be expected to rise above the 90 per cent threshold historically associated with slower economic growth.²

The cases of Europe and the United States are instructive.

Today, American aggregate non-financial debt is at levels similar to those last seen in the midst of the Great Depression. At 250 per cent of GDP, that debt burden is equivalent to almost US$120,000 for every American (Chart 1).³

Several factors drove a massive increase in American household leverage. Demographics have played a role, with the shape of the debt cycle tracking the progression of baby boomers through the workforce.

The stagnation of middle-class real wages (itself the product of technology and globalisation) meant households had to borrow if they wanted to maintain consumption growth.⁴

Financial innovation made it easier to do so. And the ready supply of foreign capital from the global savings glut made it cheaper.

Most importantly, complacency among individuals and institutions, fed by a long period of macroeconomic stability and rising asset prices, made this remorseless borrowing seem sensible.

From an aggregate perspective, the euro area’s debt metrics do not look as daunting. Its aggregate public debt burden is lower than that of the United States and Japan. The euro area’s current account with the rest of the world is roughly balanced, as it has been for some time. But these aggregate measures mask large internal imbalances. As so often with debt, distribution matters (Chart 2).

Europe’s problems are partly a product of the initial success of the single currency. After its launch, cross-border lending exploded. Easy money fed booms, which flattered government fiscal positions and supported bank balance sheets.

Over time, competitiveness eroded. Euro-wide price stability masked large differences in national inflation rates. Unit labour costs in peripheral countries shot up relative to the core economies, particularly Germany. The resulting deterioration in competitiveness has made the continuation of past trends unsustainable (Chart 3). Growth models across Europe must radically change.

Use full screen for the easy read:

Mark Carney’s Empire Club Speech -121211

Tags: Balance Sheet, Bank Of Canada, Bank Of Canada Governor, Banking Sector, Borrowings, Canadian Exports, Countr, Empire Club, Financial Debt, Global Gdp, Globe And Mail, Globe Mail, Jeffrey Simpson, Mark Carney, Number Of Countries, Public Debt, Recession, Relative Prosperity, Speech Introduction, Trade Finance, Trying Times
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Gold and Deflation

Saturday, August 14th, 2010

By Frank Holmes, CEO and Chief Investment Officer, U.S. Global Investors.

I have been speaking and writing about gold’s appeal in a deflationary environment – this is a concept that opposes the conventional opinion that the gold price will not rise without inflation.

Those who cling to that singular gold-inflation relationship have not examined the history of gold as money. Whenever there is substantial inflation or deflation, governments tend to either be too slow to react or they overreact with policies, and this is typically good for gold.

Interest earned on 90-day Treasury bills below the inflation rate is a signal for governments to try to stop deflation and reflate the economy. When this happens, gold becomes attractive. We are in such an environment now.

During these periods, governments usually need to increase their deficits by escalating their borrowings to support the economy. This also supports gold as safe money in addition to its beauty as jewelry.

The twin engines of negative real interest rates and government deficits tend to make gold a very attractive investment. Recent research supports our historical findings on what drives gold.

This chart from Deutsche Bank shows that for the past four decades gold (and silver) have performed well in a country’s currency when that country has low or negative real interest rates.

The Federal Reserve’s main interest rate is near zero and inflation is a little over 1 percent, so we now find ourselves in a negative real interest rate situation. The Fed has made it clear that it has no plans to tighten money by raising that key rate any time soon because of the sluggish economy and soft housing market (mortgages are now at a 21-year low), so this condition is likely to endure.

“The decline in core inflation from 2.5 percent two years ago to under 1 percent today will sustain market fears of deflation and hence a more rapid depreciation of the U.S. dollar to arrest any deflationary pressures,” Deutsche Bank’s analysts wrote. “We believe that the road map to resolve deflation is therefore bearish for the U.S. dollar and another factor which will propel gold prices to new highs.”

The Fed this week plotted part of that road map – it said it will pump more money into the system to try to kick up economic activity. As the 2010 midterm election draws closer, there is also a growing call for another round of stimulus spending to try to pull down the 9.5 percent unemployment rate.

Such a move would widen the federal budget deficit, which is already estimated at nearly $1.5 trillion for this year and will roughly be the same in 2011. The U.S. dollar is not only our currency, it is also the world’s reserve currency. Deficit spending puts downward pressure on the dollar, and when the dollar falls, investors tend to turn to gold.

When you add the interest rate and deficit scenarios to the gold seasonality trend – September is historically the best month of the year for both bullion and gold equities – the conditions now appear promising for gold.

We discuss What’s Driving Gold in an interactive presentation – hover/point on the chart to learn more about these critical drivers.

[SWF]http://advisoranalyst.com/glablog/wp-content/uploads/2010/08/WDG_Interactive_0209.swf,500,400[/SWF]

Ready, Set, Redux

My commentary from last week (Ready, Set, Gold) detailing the seasonal patterns for gold and gold stocks seemed to strike a chord with gold investors so we wanted to share it with you another time in case you missed it last week. Here’s another chance to read what September means for gold.

Click to Read “Ready, Set, Gold”

Tags: Attractive Investment, Borrowings, Chief Investment Officer, Core Inflation, Deflation, Deflationary Pressures, Depreciation, Deutsche Bank, Frank Holmes, Gold, Gold And Silver, Gold Bullion, Gold Price, Government Deficits, History Of Gold, Housing Market, Inflation Rate, Real Interest Rate, Silver, Sluggish Economy, Treasury Bills, Twin Engines, U S Global Investors
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The Collapse of Finance

Thursday, December 3rd, 2009

This post is a guest contribution by Bill Bonner, author of two New York Times best-selling books, Financial Reckoning Day and Empire of Debt. Bill is also the driving force behind The Daily Reckoning.

“Dubai sends markets into turmoil,” begins The Financial Times. Dubai is a financial center, built on sand.

Probably a good thing US markets were closed for Thanksgiving when this news came out. In Europe, the Dubai affair caused the biggest drop in 7 months. European banks have lent $40 billion to Dubai.

Jim Chanos, a famous short seller, thinks Dubai is merely the camel’s nose in the tent, so to speak. “China is Dubai times 1,000…if not a million.”

“People are panicking: this whole process counters everything that the rulers have been saying and the way it has been communicated before the holidays is confusing,” said one hedge fund manager.

The ‘rulers’ are the fellows who run “Dubai World,” and incidentally Dubai itself. Whether they are fools, knaves or sly geniuses was what everyone wanted to know. Dubai officials announced that they had raised $5 billion on Tuesday. Two hours later they said they weren’t paying interest on it or on any of the rest of the $80 billion in borrowings. What’s going on? Are they really broke? Or are they playing for some kind of advantage?

“Dubai gambles with its financial reputation,” says one headline at the FT.

Then, on the facing page, the editors think they know how the gamble will turn out:

“A breath-taking blunder in Dubai…Dubai is looking more like Argentina than Singapore – but a lot less predictable,” says the FT editorial.

No on is sure what is going on. Most people take from this story what we knew all along: lending to shady characters in sunny places is not an easy way to make money. Especially when the shady characters own the country.

Trouble is, shady characters run near all the world’s countries. If an investor cannot trust the ruling family of Dubai, how can he trust the commies who run China? Or the hacks who run the United States of America?

To err is human. For a central banker, it is practically a professional requirement. Count on a major ‘error’ to trigger a sell-off in the world’s bond market.

But Dubai’s mistake did not infect all other sovereign debt. German bond yields went down, not up. Investors sought safety from Dubai debt in Deutschland debt.

But what is the real meaning of what is going on in Dubai? It’s the story of the collapse of the financial industry. Dubai has no oil…no natural resources…and no real industry. The rulers tried to turn it into a financial center. Entirely financed by debt. And now finance itself is falling apart.

“The camel put his nose in the tent,” says colleague Simone Wapler. “He saw that there was nothing there.”

What will he think when he gets a closer look at Britain’s finances? Britain, too, relies heavily on the financial industry. And Britain, too, is heavily dependent on debt. Its public finances are among the worst in the world. Japan’s public debt, to add another example, is already 200% of GDP. It’s expected to reach 300% in a few years. And yet, Japan – like the US and Britain – just keeps borrowing. How long can this go on? When will Britain, the US, and Japan announce their own moratoria on debt service payments?

This bubbly bounce must not have much time left. And it is surrounded by 10,000 pins.

On Friday, US markets reacted to the Dubai news. The Dow lost 154 points. Gold lost $14. Oil slipped to $76.

Our crash flag is still flying. But that was not a crash. Just a bad day. And today’s news tells us that other Gulf States are rallying around Dubai, ready to extend a helping hand and lend a buck or two. Oil is rallying on the news.

Does that mean this bubbly trend is stronger than we thought? Is this a bubble made of Kevlar? Will it resist other pins?

We wouldn’t count on it. When China pops, we’ll see US stocks down a lot more than 154 points. In fact, we expect to see the Dow in 5,000-ish territory when this bounce is over. And when that happens, emerging markets will probably be hit even harder.

Dubai was a “wake up call,” for investors in emerging markets, says The New York Times today.

But the pin that pricks recovery hopes won’t necessarily be imported. There are plenty of sharp objects in the homeland too. There is, for example, the growing realization that the recovery is a fraud.

“Half a recovery,” says a New York Times columnist, may be all we get.

Today, the press will concentrate on analyzing Black Friday sales results. Already, The Wall Street Journal has rendered its verdict: more shoppers; fewer sales.

If the initial reports are correct, the traffic wasn’t bad on Friday. But retail outlets were only able to snag sales by offering discounts. It’s a deflationary world, after all. Shoppers want lower prices to make up for the fact that they have less money to spend. And they’ll get lower prices too. Because this is a de-leveraging cycle. The world has too much debt, too many factories and too many workers…at least for the real, available purchasing power. Prices will go down naturally until excesses are absorbed…dismantled…or converted to other uses.

But wait…there are also unnatural forces at work. Governments are bailing out bungled companies. They’re supplying zombie industries with fresh blood from the taxpayers. They’re standing in the way of the de-leveraging progress. They’re creating “money” out of thin air.

It’s this last point that is most explosive. As long as government is just stalling the correction, it doesn’t cause too much distortion or volatility. But when it fiddles with the money…oh la la; that’s where it gets interesting.

Traditionally, people buy gold when they think the monetary authorities are up to something. Throughout the world, investors are getting edgy…they’re wondering how it is possible to add so much cash and credit to the economy without sending prices to the moon.

We’ll tell you how it’s possible: there’s a depression. In a depression, the flow of cash and credit coagulates. Even if you increase the cash in bank vaults, it doesn’t circulate into the real economy. Banks don’t lend. People don’t borrow. Consumers don’t consume.

It just sits there…waiting for the end of the depression…like a teenager waiting for Friday…

Source: Bill Bonner, Daily Reckoning, November 30, 2009.

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