A lot of confusion on gold going into backwardation. I wrote about this in October in this blog where a commentator got confused. Recent articles by Professor Fekete have spawned more confused comments, see Brad Zigler’s article for an example (and also my comments to it).
People get all confused about it because they aren’t thinking of gold as money. What was the Yen carry trade? Borrow JPY at bugger all, do an FX to sell JPY-buy USD and invest the USD at a higher rate and pocket the difference in interest rates but have exposure to the FX rate. Interest rate differentials exists for all currencies and they are not arbitraged away because there is risk to the change in the FX rate, the FX rate being the “price” of that currency in terms of another. An alternative way I look at it is that differences in interest rates exists because of the markets assessment of the risk of one currency inflating or deflating relative to the other, wiping out the profit from the interest rate differential.
Lets assume USD rates of 2%, AUD rates of 4% and an exchange rate of 0.65.
1. You borrow USD 650 at 2%, which means you have to pay back USD 663 in 1 year.
2. You sell USD 650 / buy AUD 1000 at 0.65 now.
3. You lend AUD 1000 at 4%, which results in AUD 1040 in 1 year.
4. If the FX rate doesn’t change, you then sell AUD 1040 one year later for USD 676.
5. Repay USD 663, leaving profit of USD 13.
If you ask a bank for a 1 year forward AUD/USD FX rate, they do steps 1 to 3 and then calculate
4. In one year’s time you will have AUD 1040 but owe USD 663, so the FX rate that this equates to is 0.6375.
Now there is nothing stopping you from borrowing AUD at 4% and selling it for USD to invest at 2%, but as you are negative cash flow you really need a big move in the FX rate to come out ahead. This means that the lower interest rate currency tends to have more borrow and sell pressure on it because the higher interest rates of the other currency mean you have a bit of a “buffer” if the FX rate moves against you.
Anyway, just think of gold as a currency (ie money) and the lease rate as the interest rate on gold(money). Therefore, one can borrow gold at lease rate, sell it and invest cash at LIBOR. Therefore the difference in these two interest rates is your profit, assuming no change in the gold/USD FX rate (ie the USD gold price).
For 1 Dec 08 for 1 month at LBMA:
Lease Rate = Gold Interest Rate = 1.69875
LIBOR = USD Interest Rate = 1.91125
GOFO = 0.21250
All this tells me is that there is a slight advantage to borrow and sell gold for USD, but the small advantage does not seem to outweigh the risk of the gold/USD price moving against you (ie up). If gold interest rates go higher than USD rate then what? Well to me this “backwardation” as it is called, just means that there is a slight advantage to borrow and sell USD for gold, as long as you don’t expect the gold price to drop.
Probably worth noting here that as at 1 Dec you could have borrowed gold at 1.7% and sold it for AUD, investing the AUD cash at 4.25%. So this means that while USD gold may be toying with backwardation, AUD gold is firmly in contango.
Now interest rates for currencies change all the time and go above and below each other all the time. When that happens it is noteworthy but not exclaimed as extraordinary. Why is it different for gold? Well in my AUD/USD example we are talking about fiat currencies.
In the USD vs gold situation, however, we are not talking about “equal” currencies – one cannot be created, the other can. Think about it, in regards to my earlier comment that “differences in interest rates exists because of the markets assessment of the risk of one currency inflating or deflating relative to the other.”
We are so used to talking of 1oz = xxx dollars when it should really be $1 = xxx ounces. Then you see that gold hasn’t went into backwardation, but that USD has went into contango. Ouch, my brain hurts, but that is to be expected as we move into a world where you price things in ounces, not dollars.
I have been analyzing real estate and construction since 1991. I can’t even say that our current real estate collapse is unprecedented, because to me it’s not – I went through the Asian Financial Crisis, and this is like that. As a matter of fact, the Hongkong real estate slump of 1994-95 was pretty serious even before the Big One two years later. And Japan’s real estate collapse has been both huge and enduring.
But I well remember my first AFC trip to the region. I had been correctly bearish in 1997 and I was analyzing from afar, unwilling to allow myself to make the trip in case my natural sympathy with people should overcome my brutally harsh analysis. So instead of my usual five-times-a-year Asia trips, I took no trips in 1997. Finally in the first quarter of 1998 I was sure things were as bad as they were going to get, and I did not have to worry about personal contagion any longer. I flew into Seoul, and was driven immediately in a black car to the Bank of Korea. Along the way I saw the debris from anti-government demonstrations and grafitti saying “IMF = I AM F**KED”. The last two hundred yards of the way to the BOK, the car went slowly enough for me to see the sad, sunken faces looking with deep suspicion at a foreigner in a limo on his way to the central bank.
From Seoul I flew to Singapore on a Singapore Airlines wide-body aircraft with exactly three passengers on it, just me and a honeymooning couple.
In Bangkok, I visited the offices of one of the big commercial real estate brokers, where the Englishman in charge appeared a broken man. We looked out over the vast city with its forest of cranes all idle for the first time in memory. “No one will build another class A building in Bangkok for fifteen years,” he said.
But he was wrong. Capital did re-form in the real estate markets, and things were humming again inside of three years.
That’s good, and I expect we can look forward to some similar unexpectedly rapid recovery. But enough talk already. What do the data say we can expect here? Let’s dig into the housing market data.
For a long time I have resisted the popular Case-Shiller 20-City Housing Index, for many reasons. I think Shiller’s nutty professor act is off-putting, as is the false precision in the reports, the short history, and my sense that it is hard to index lumpy and illiquid stuff like houses. But everyone now uses it, so I have to relent.
I refer to short history — Professors Case and Shiller only reach back to 1987, which misses the booms and busts of the seventies and early eighties. I can’t deal with that, so here’s what I did. I took their data, and lined them up with Census data going back to 1959, data that HUD also reports. I did some regressions and other hand-waving trend analysis to try to extend the Case-Shiller Index back in time.
Hey, if hand-waving is good enough for the Treasury Secretary, it’s good enough for me.
I got GDP, PCE Housing, and 10-year Note Yield data (the latter my mortgage interest rate proxy) from my good friend Fred at the St. Louis Federal Reserve Bank, and lined that up with the housing index stuff reported by the good professors and massaged by me.
Six recessions have been observed since 1959. Twenty quarters (five years) after trough recessionary conditions, the average increase in the price index has been 46.3%, the median increase 55.2%, the maximum 79.8% and the minimum -0.3%.
Eight interest rate spikes over the same period have seen the average price increase 30.0% twenty quarters later, or 34.5% on a median basis. The maximum increase was 75.9% and the minimum -22.3% (i.e. a more than 20% drop, in the period in which we now find ourselves).
There have been only five episodes of declining prices, of which this is by far the worst. Twenty quarters after the midpoint of these episodes, prices are 18.8% higher (average), 17.1% (median), 75.7% higher at best and down 28.3% at worst. But leaving out the current episode, which I suppose is not finished, the figures are respectively 46.3%, 55.2%, 79.8%, and -0.3%.
Food for thought.
In standard consumer lingo, a recession is never good. By economic definition, it means a slowdown in spending, which leads to a slowdown in production, which leads to unemployment and so forth.
The United States has seen its share of recessions since its inception over two hundred years ago. A quick review of Wikipedia’s “List of Recessions in the United States” provides a concise synopsis of the phenomena. While today’s perceived panic may be widespread, it is not uncommon.
More to the point, the current global recession is led by the United States. Few have the overall global impact that an American-led recession entails in this and the last century. The reason is simple. Until recently, the U.S. was simply the world’s largest producer and consumer.
Even China can feel the impact of the global recession.
According to an October 30, 2008 report of the Economist Intelligence Unit, China’s GDP is expected to slow to 8% in 2009, and 7.5% in 2010. Moreover, the drop from recent Chinese GDP in excess of an annual eleven percent was hardly unexpected.
That, however, did not stop the world’s largest trade show, the China Import & Export Fair, in Guangzhou (Canton) from attracting some 200,000 international buyers in the three weeks of October 15 to November 8 this year. More than twenty-five percent of China’s 2008 exports, or $38 billion, resulted from the show.
While shipments to the United States and Europe slowed in tandem with the credit crisis, those to wealthier nations, such as Russia and the Middle Eastern countries increased substantially. Even less-developed nations of Latin America and Africa contributed to continued gains from Chinese export trade.
While the global recession may be especially bothersome to American consumers who are used to profligate ard irresponsible spending, there may be a silver lining.
The recession certainly provides the world with a slight respite from the selfish, myopic intent on growth without adequate regard for mankind and our common biosphere. It provides a rare opportunity to take a cue from the late German-born economist, E. F. Schumacher (1911-1977). In his renowned book, “Small Is Beautiful” he suggested “Perhaps we cannot raise the wind. But each of us can put up the sail, so that when the wind comes we can catch it.” The winds of change foretold more than a quarter of a century ago that the world would see rapid changes which to many were unthinkable. The quadrupling of oil prices by OPEC, the failure of communism, the economic growth and influence of China and India pale by comparison to the inherent dangers of what New York Times columnist Thomas L. Friedman calls “The World is Hot, Flat and Crowded” in his latest best-seller. Unfortunately, a negative response to the historic blip of the recession may engender revisionary, nationalistic political policies. A solution must, can and will be achieved, whether by Washington or Beijing, Paris or Riyadh. It will take the necessary combination of all the world’s economic and intellectual powers to move the world forward to its inevitable victory over the problems spawned by previous centuries. As Bob Dylan sang nearly a half century ago, “The Times They Are A-Changing.”
I am bringing back an old thought that first occurred to me in 2001 after the collapse of Enron. Businesses exist to create real value for real people. Any business should be able to explain how the are adding value and for whom. Ideally, this should be a simple process; a sentence or at most a paragraph. If a company can’t explain this that should raise a red flag.
Of course, some companies provide genuinely obscure products or services. These companies profits should reflect the esoteric nature of their business. The largest most successful businesses from McDonalds to Microsoft should be those companies that are serving vast swathes of the population. If a business claims that its operations are so complex that mere mortals couldn’t possibly comprehend them, that should raise about 10 million red flags.
“Talent Is Overrated” by Geoff Colvin is an inspirational book that puts exceptional performance into perspective. It presents a solid case that great performance does not come primarily from innate talent, or even hard work, as is supposed by most people.
The thesis of the book reminds me of a theme that I heard many years ago from Albert E. N. Gray called the “Common Denominator Of Success.” Successful people do the things that failures don’t like to do. It is not that successful people necessarily like doing them any more than anyone else, but rather that, by doing the things that unsuccessful people don’t like to do, they are able to get the results that come from doing those things.
All great performers get that way by working long and hard, but hard work and long hours obviously don’t make people great. Many people work long and hard and stay mediocre. The meat of the book describes what the author calls deliberate practice, and presents supporting evidence in a convincing manner. It matters what kind of practice, not just how long and how much sweat is spilled.
The practical value of the book comes from the practical application of the thesis. In talking about world class figure skaters, he said that top skaters work on the jumps they are worst at, whereas average skaters work on those they are already good at. In his words, “Landing on your butt twenty thousand times is where great performance comes from.” Each of those hard landings is able to teach a lesson. Those who learn the lesson can move on to the next hard lesson. Those who don’t pay the price and learn the lesson never progress beyond it. In other words, hard work and dedication is necessary but not sufficient in itself for developing higher level performance at any endeavor.
The book is very readable and very entertaining, stocked with examples that anyone can relate to. The book itself will not make great performers or great organizations. The ideas in the book may, however, free the reader from the bondage of the talent or hard work myths. It is worthwhile for anyone to digest if they want to move beyond stagnation.
While everyone will not choose to make the sacrifice to be truly great at what they do, Colvin ends with the encouraging conclusion that great performance isn’t reserved for the pre-ordained few. “By understanding how a few become great, anyone can become better.”
There is an old saying that I remember first hearing back in my college days. I remember it from a funny looking word – TINSTAAFL. It is an acronym for “There is no such thing as a free lunch.” It originated long before I was around, but it is as true today as it was one hundred years ago. It deals with a fallacy that often distorts the decision making process of individuals, as well as political leaders.
If someone takes you out to lunch and pays the tab, the lunch was free to you, but it wasn’t free. Your friend bears the cost, rather than you. If the restaurant owner tells your friend that the meals are on the house, the meals are free to your friend, but they are still not free. The restaurant owner bears the cost instead of your friend. If the employees and suppliers donate their time and food, it is still not free. Now, they bear the cost. When real resources are used up, including time, there is a real cost that someone ultimately bears. They have eliminated the opportunity to use the resources for other valuable alternatives.
The concept applies to government programs as well as dinners out. Someone pays for everything. You may be getting a benefit, but if you are not bearing the cost, someone else is. Since government does not produce anything, whatever it gives out in benefits to someone, it necessarily takes from someone else involuntarily. That someone else is the present taxpayer, future taxpayers or all consumers when the tax takes the form of monetary inflation.
We are in the midst of the biggest free lunch program in the history of the world. Millions of businesses, municipalities, educational institutions, development projects and individuals will be getting lunch for free. The problem with it all is that they will be eating from someone else’s lunch bucket. That lunch is no longer available for the original lunch owner.
The multiple stimulus plans and bailout packages totaling trillions of dollars are based on the absurd notion that propping up prices and encouraging irresponsible consumption equals stimulus. For most of the past decade, consumers were ridiculed by moralists for their conspicuous consumption. The big screen TV and oversized mortgage payments were symbolic of the era. A question is begging for an answer from know-it-all politicians: if under-consumption is the root of today’s problems, then why didn’t the conspicuous consumption before the collapse keep the party going indefinitely?
A recession or depression only occurs, without exception, after an inflationary bubble. During a bubble, artificially low interest rates induced by monetary authorities fool entrepreneurs and investors into investing. New money from inflationary credit floods the market, making prices go up. Like a Ponzi scheme, the early profits draw more players into the game, but the available real resources don’t keep up.
New competitors use the cheap money to buy goods and services that do not expand with the money supply. Prices are bid up and, eventually, what looked like a profitable enterprise on paper becomes a big loser in real life. At the peak of the bubble, it becomes obvious that many assets, such as mortgages and financial assets are vastly overvalued. The prices are unsustainable. That is very apparent when an average wage of $50,000 supports the weight of a mortgage on an average $500,000 home. The bigger the bubble and the more overvalued the assets, the bigger the fall and the more pain that will be felt by those that made mistakes.
It is unfortunate when people have to pay the price of their mistakes, especially when the mistakes are induced by government authorities. It is far worse, however, when people who didn’t make the mistakes have to bear the price of the people who did. The free lunch mentality is contagious. It is quite obvious now that everyone is jumping on the something for nothing bandwagon. Taxpayers are forced to take over the losses of toxic bank assets so millionaire bankers can get their free lunch. Recent legislation gives trillions of dollars of free lunches to special interests and pork barrel project owners.
If you are one of the unfortunate ones who didn’t overspend and overextend, who counted the costs and the risks and who did the right thing to keep out of financial trouble, now you get your reward. You get to pay for all of the free lunches for everyone else. What a perverted sense of justice.
Can anyone think of a more value destroying transaction than foreclosing a home in a dead real estate market. There are more than 700 houses in Detroit listed for less than $3000. And there not selling. In this climate banks can’t possibly expect to recover much of anything from a foreclosed. Considering legal costs, taxes and maintenance the banks would surely be better off just letting the borrower stay in the house. And of course all of these foreclosed homes are killing property values, which leads to more foreclosures. And I haven’t even talked about the impact on evicted individuals.
Governments should offer reduced taxes on foreclosed properties if the former owner is allowed to remain in the house. This is a win win win solution. The borrower gets extra time in the home to figure out there next move. The city can stabilize property values by keeping a glut of foreclosed homes off the market. But the big winner is the bank who can hold on to the house at little cost until the market improves.
The essential feature of a tit-for-tat strategy is reciprocity – rewarding cooperation and punishing defection. In his book, “Born to be Good”, Dacher Keltner claims that “tit-for-tat instantiates the principle of cost-benefit reversal”. He argues that a set of mechanisms that reverse the cost-benefit analysis of giving is built into the human organism. He suggests: “These mechanisms might prioritize the gains of others over those of the self, and transform others’ gains into one’s own” (p. 71).
Keltner bases his claim that tit-for-tat involved cost-benefit reversal on three observations:
- When cooperation is the default setting, tit-for-tat favours mutually beneficial cooperation.
- Tit-for-tat is not envious – the strategy doesn’t change as a partner’s benefits mount.
- Tit-for-tat is a forgiving strategy – cooperation is resumed following the first cooperative action of a defector.
It seems to me, however, that none of these features of tit-for-tat necessarily involves prioritizing the gains of others over those of the self. It is possible for a tit-for-tat strategy to be adopted purely out of self interest. Robert Axelrod recognised this in “The Evolution of Cooperation” (p 173-4) , in his discussion of the experiments that Keltner uses as the basis for his discussion of tit-for-tat.
A tit-for-tat strategy based on self-interest provides a plausible explanation for the emergence of cooperation among strangers who have no reason to trust each other. For example, consider a situation where strangers are considering the initiation of trade in the absence of third party (e.g. government) protection against opportunistic use of force and fraud. From the perspective of each party the possible outcomes would be: a) a potential gain from trade; b) a potential loss resulting from opportunism by the other party – i.e. theft of the goods offered for trade; c) a potential gain from opportunism – theft of goods offered for trade by the other party; d) a stand-off.
If trade occurs in this situation, is it likely to be because one party places higher priority on the potential gains to the other party than on the potential gains to the self? I think it is more likely to occur because both parties consider that, in view of the likely responses of each other, they have more to gain from a series of mutually beneficial exchanges that they would gain from attempting to steal from each other.
If both parties adopt a consistent tit-for-tat strategy, then trade is likely to continue and they may come to trust each other. It is possible to envisage that the relationship could even develop to a point where they each gain some satisfaction from the benefit that they bestow upon each other through the exchange of goods. But this trust and affection is the outgrowth of mutually beneficial cooperation rather than a pre-condition for it.
I don’t understand why Dacher Keltner seeks to denigrate those who see self interest as a motivating force (see: How high was Adam Smith’s jen ratio?) and seeks to eliminate self-interest from the evolution of social cooperation. Perhaps he identifies the self-interest motive with opportunism, greed and selfishness to such an extent that he cannot see that it is good to desire to avoid being a burden on others, to help family members and other loved ones, and to accumulate the means to contribute generously to worthwhile causes. Perhaps he is uncomfortable with the idea that an invisible hand involved in voluntary exchange processes could enable people to benefit from cooperation with each other without actually intending to benefit each other.
Forbes has a fascinating article by Laurence J. Kotlikoff and Edward Leamer, with fundamental thinking about banks.
They trace the problems of banks to the fundamental contradictions of having a highly leveraged financial firm, with assured returns and full liquidity for depositors, and opaque + illiquid assets. I agree with this gloomy prognosis. A more fleshed out argument is in this pair of articles — link and link — which were opinion pieces in 1999.
I stopped chasing those lines of thought because it seemed dishearteningly hard, trying to sell a world without banks as we know ‘em. But if you are persuaded by these arguments, then you will like a world where we do more finance through securities markets, through `defined contribution and NAV-based’ financial firms (i.e. direct household participation in financial markets, mutual funds and DC pensions), and less through `assured returns’ financial firms such as banks, DB pensions and insurance companies.
In a perverse way, India’s prodigous mistakes of policy on banking have helped steer the country into a more market-dominated financial system, which has helped build a better financial system.
Since we’re unlikely to reconstruct the economy in radical ways, we have to confront the problems of banks. I feel the most important element of safe and sound banking is: a proper deposit insurance mechanism. Chapter 6 of Raghuram Rajan’s report is the best blueprint out there about setting up a deposit insurance corporation, and other dimensions of improving systemic risk (see `V. Preventing Crisis and Dealing with Failure’).
You might like to also see this picture on banking reforms.
On 24 April 2009 I was a guest judge on Canada’s national business channel Business News Network’s show Stars & Dogs with host Andrew Bell and Boyd Erman and the exchange is available. The company under discussion was Potash Corporation and I realize some may be wondering what potash is.
Potassium carbonate, or potash, has been used since antiquity in the manufacture of glass, soap, and soil fertilizer. Potash is important for agriculture because it improves water retention, yield, nutrient value, taste, colour, texture and disease resistance of food crops with wide application to fruits, vegetables, rice, wheat, grains, sugar, corn, soybeans, palm oil and cotton, which all benefit from the quality enhancing properties.
Potash Corporation of Saskatchewan Inc. (POT) engages in the production of potash from six mines in Saskatchewan and one mine in New Brunswick and the sale of fertilizers and feed products in North America. The company controls approximately 22% of worldwide potash capacity. Obviously, if you own a lot of something it makes sense to engage in behavior to drive its price up which is precisely what Potash Corp. does.
Nevertheless, during The Great Credit Contraction capital has sought the safest and most liquid assets. Like during the Great Depression capital has stampeded into the safest and most liquid assets resulting in tumbling commodity prices and decreased decline for potash with rising stockpiles which are now 56% above the 5-year average. After Boyd presented the bull case and Andy presented the bear case then I was asked for my opinion.
BEARISH OUTLOOK FOR POTASH CORPORATION
I found Boyd’s argument about ‘when’ the economy recovers leading to increased use of potash in essential staples like rice to be unpersuasive. The nature and scope of The Great Credit Contraction is too large, fair value lying with single digit midget banks is rapidly evaporating any remaining confidence and unemployment numbers are soaring. Because of the leveraged nature of earnings with commodity producers the bottom line is horrifically affected by dissipating top lines. Therefore, I sided with Andy the bear.
WHEN WILL POTASH CORPORATION BE A GOOD VALUE?
I did state that we do not know how low Potash Corporation will go but that I would consider purchasing it for between 3-5 ounces of gold per 100 shares. There were some interesting acknowledgements when I briefly explained my reasoning for performing the mental calculations of value using the golden currency.
HOW LONG CAN IT TAKE?
Notice how steep the price decline was from 20 ounces to 10 ounces per 100 shares? If you own a lot of something, like potash, why run a cartel to keep the price suppressed? The central bank’s ability to issue what everyone uses as currency is infinitely more valuable than the price of a portfolio asset. The gold price suppression scheme is ending.
On 8 April 2009 in Global Quantitative Easing I wrote, “The IMF gold sales will be like a single piece of sushi appetizer to a starving dragon.” Since that time China has announced an increase in gold reserves from 600 to 1,054 tons. Given my analogy to Japan with official gold reserves of 765 tons; I was slightly off on my calculations but the balance sheets of the various central banks are not very transparent or China has not reported their entire gold reserves.
If gold were treated as a mere portfolio asset, which it is not, then the case could be made that it is getting fairly expensive at the current price level. Given its seasonality and tendancy to lag during the summer I may even agree.
But as I explain in The Great Credit Contraction political currency illusions are doomed to either implode in a deflationary depression or explode in hyperinflation. Significant amounts of political currency illusions need to evaporate in the coming inferno. The FRN$ is doomed.
The mainstream Western press such as Bloomberg reports that the IMF “is working on a plan to sell bonds to several developing countries as Brazil and China seek more power over its decisions.”
But the real news comes from the East where “India and China may press for the sale of the entire gold reserves of the International Monetary Fund (IMF) to raise money for the least developed countries. The IMF holds 103.4 million ounces (3,217 tonnes) of gold that, if sold, can fetch about $100 billion.”
It appears that stealthy China has been preparing for the coming inferno for many years and has now publicly blasted the clarion call on the golden trumpet signaling the next gold rush. China is not satisfied with flimsy ineffectual substitutes like GLD or SLV which have problems but demand the physical metal. When fiat currency illusions lose confidence it can happen with blinding speed.
While there may be some short term gains to be made by briefly venturing up the liquidity pyramid I would not recommend it. The Great Credit Contraction has only begun and preserving capital in these times will be hard enough. During the end of the interview on BNN I said, “If cash is king then gold is emperor in this particular environment.” The time may come when gold will not be for sale at any price so for now just hoard it and make sure you get cold, hard real physical gold and silver.
Disclosures: Long physical gold and silver with no position in Potash Corporation, TLT, UDN or UUP.