by Keith Weiner
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We got hate mail after publishing Silver Backwardation Returns. It seems that someone thought backwardation means silver is a backward idea, or a bad bet. “You are a *&%#! idiot,” cursed he. “Silver is the most underpriced asset on the planet,” he offered as his sole supporting evidence. He doesn’t know that backwardation means scarcity, not that a commodity’s price is too high.
Since we wrote that on March 2 (our Reports are always based on the prior Friday’s close, in this case February 28), the price of gold and most especially silver has dropped. Silver was $16.67, and now it is $14.75. This is a drop of 11.5%. It is all the more scary when you realize that this drop occurred entirely over two days: Thursday and Friday this week.
The price action in gold was less dramatic, though its price did drop from $1,586 to $1,530, or -3.5%. Also on those same two days.
The question many people are asking us: is now a good time to buy? We have a few ways to answer that, in this two-part Report. We will show a detailed graph of the silver supply and demand fundamentals during the crazy market action of Wednesday through Friday.
Non-Reasons to Buy
First, let’s address the marketing material of the bullion industry, ever seeking arguments to get the public to line up to buy its products. For example, a headline this week is blaring, “Gold Shortages – Price of Physical Gold Decouples from Paper Gold”. The body of the article does not deliver on this claim. Instead, it says:
“By now it is abundantly clear that the physical gold market and paper gold market will disconnect.”
Will. Future tense. As our old friend Aragorn could tell you, “Today is not that day.”
Anyways, the meat of the article is that this bullion dealer has a spike in customer demand. It cannot restock products as fast as they are selling out. And it has widened its bid-ask spread to protect it from higher price volatility.
Then we get to this:
“Both of these markets [London and COMEX] are derivative markets and neither is connected to the physical gold market.
…
This means that the physical gold market is a price taker, inheriting the price from the paper market…”
What is the word for the concept that one would have to be lacking, in order to accept this? Meritage? No, that’s a wine. Dressage, no, wait, that’s a fancy kind of horse riding. Décolletage? Aaah, umm …
Ahah! Arbitrage!
Arbitrage, the most powerful force in the market, is what keeps the price of gold derivatives tied to the price of gold metal.
Let’s look at another way to understand the error. If you want to sell your gold Eagle, then what is it worth (and let’s face it, all complaints about price manipulation come from would-be sellers, frustrated that they can’t fetch as many dollars as they want)? The answer is simple.
If you want to sell, it’s worth whatever someone bids.
If you need to sell right now, it is you who are the price-taker. You either accept the bid, or you keep your gold. This has nothing to do with paper gold (if you have a gold Eagle).
If the demand for Eagles were really so strong, so decoupled from the demand for paper then why is no one bidding above $1,530 (plus the coin premium)?
Monetary Metals can buy as much gold as we want at the price everyone sees on their screens. If you think that gold is really worth more, then we have two questions for you. How much more will you pay? And how much do you want?
Arbitrage connects the price of gold and the price of gold derivatives. If it didn’t, there would not be gold derivatives, full stop. We note that most dealers go to the gold derivatives market to hedge the price risk of holding their inventory (except the ones who lease it from Monetary Metals, and thus have no need to hedge).
Sometimes, the best way to begin a discussion of the reasons why one should buy gold right now is to look at non-reasons. We encourage everyone to be skeptical of these incredible claims, often from dealers who promise that the gold price will soon be in the tens of thousands of dollars.
A Reason to Own Some Gold, at All Times
We believe that most people know (or reasonably should know) that the government is a profligate spender. Its spending is much greater than its tax revenues, so it makes up the difference with borrowing. It may be less well-known that, in addition to outright borrowing, the government is also making promises to pay in the future which it has no means to honor. That is, it is accruing liabilities without setting aside a corresponding asset to cover them. These are called unfunded liabilities.
Unfunded liabilities are a form of debt, though some people quibble they are not technically “debt” as Congress has the right to renege on these promises. According to an article from Truth in Accounting, published by the Foundation for Economic Education, the Federal Accounting Standards Advisory Board policy states:
“Until benefits become due and payable, there is no binding commitment over which a worker has control and so no liability can be recognized.”
We are not political prognosticators, though we believe it to be unfeasible to repeal a benefit as popular as Social Security or Medicare. Nor are we accounting experts, but we insist that accounting should describe a conservative picture of the state of an entity. If current policy says that the government must pay a dollar next year, then the balance sheet should have a liability of one dollar (minus the discount rate). It is extremely disingenuous to say just because the law could theoretically be changed, then there is no need to recognize any liability.
And by disingenuous, we mean dishonest. If a private company kept its books like this, its officers would rightly be sent to prison.
Why is it so important to state that the government has debts and promises to pay that are beyond its ability to pay? It is because the government’s debt paper is what most people call “money”! To hold a money balance, is to be a creditor to this profligate spender who keeps dishonest books.
No one should go all-in to this unpayable pile of debt paper. Not even if they think that its next price move will be up. The price of the dollar is the inverse of the price of gold. When the price of gold falls, it really means that the price of the dollar rises. For example, in the last two weeks the price of gold fell from $1,586 to $1,530. That means the price of the dollar went up from 19.61 milligrams of gold to 20.33mg.
As Goethe observed, “none are more hopelessly enslaved than those who falsely believe they are free.” And we would add, none are more hopelessly financially repressed than those who falsely believe that the dollar is money.
If you don’t own any gold, it’s always a good time to remedy this omission.
The Interest Rate and Stock Market Crash
After the last crisis, the Fed pegged the interest rate for one-day maturity at near zero. Throughout its various rounds of Quantitative Easing, most critics expected rising, if not skyrocketing, consumer prices. And the commonly-accepted remedy is for the Fed to raise interest rates. So in Dec 2015—exactly seven years after it pegged it at zero—the Fed began to hike the rate. Over a period of three years and a month, it pushed the Fed Funds Rate up to 2.4%.
We could talk about “yield curve inversion” (i.e. when the short-term rate is above the long-term rate, which causes the banks to lose money) and other technical topics. But instead let’s ask a rhetorical question.
Look at all the business activity that was financed at rates near zero (of course, even the biggest business pays a spread above the government rate). Oil producers borrowed enormous sums to extract oil from shale rock. Even in towns where retail malls were overbuilt (e.g. Scottsdale, Arizona), big developers have been borrowing to build more. Airlines borrowed to buy new planes. Auto manufacturers borrowed to offer 0% financing as a subsidy to consumers. Corporations borrowed to buy their own shares.
All of this borrowing adds to GDP, though not linearly, as borrowing to buy shares does not, itself, add to GDP. The boost comes from the so-called wealth effect, that shareholders feel free to buy a bottle of champagne or a private jet. And the beverage and airplane companies borrowed to add the capacity to serve this demand.
How much of this borrowing would have occurred at higher rates? Much of it would not have been viable. Profit margins are thin, and return on capital is at a record low.
So, we had the Fed looking at the imaginary threats of inflation and overheating, while the self-fulfilling prophecy of rising GDP confirms that the economy was strong. The Fed did what it was it was supposed to do. Keynesians, Monetarists, and otherwise-free-marketers all agreed. So it hiked interest rates.
All during this time (and long before), we were saying that the long-term interest rate trend is necessarily downward. Our assessment that little borrowing is feasible at higher rates helps lead us to this conclusion. Demand for credit would dry up. Even if the Fed did not care about that, and the resulting drop in GDP, there would be a crisis soon enough.
This is because corporations have been trained to borrow using short-term instruments. That’s the strategy for a falling-interest-rates environment. But it does have the drawback that they have to roll their debts every few years. That is, the old bond is due and they must sell a new one to repay the old one. If they have thin margins, and the new rate is higher, they may be in trouble.
So, January a year ago was the last rate hike. The Fed managed to hold the line for six whole months. And in August, they declared the first rate cut. By November, the rate was down almost 1% from the temporary little high of January through July (and another 0.5% in early March). UPDATE AS THIS ARTICLE NEARS PRESS TIME, THE FED JUST ANNOUNCED ANOTHER 100BPS CUT ON A SUNDAY.
Lest anyone tell you that the economic problem revealed by this episode is entirely due to the coronavirus, we chronicle the abrupt reversal of Fed policy beginning long before said virus.
Contrary to the strong economy belief, the economy has long depended on adding more and more debt. This is not just for growth. It is about staving off insolvency at far too many major corporations, not to mention businesses large and small.
It gives us no pleasure to say now, “We were right.” Watching the epic collapse in the 10-year Treasury yield this week was scary.
In the middle of January, this yield was over 1.8%. A month later, it was still over 1.56%, which is a big drop but nothing compared to what was to come soon after. By the end of February, the rate was just over 1.1%.
Then, between March 4 and March 9, the yield fell from just over 1% to just over 0.5%. The rate was halved. And halved again.
Back to the rising bond price. Does this market move put to bed, finally, the fears of skyrocketing inflation, skyrocketing interest rates, bond vigilantes, and repudiation of the dollar as world reserve currency?
We write often of the capital gains of the speculators. To put this in perspective, over that same time of mid-January through March 9, the 10-year Treasury bond went from about 157 to about 185, or +18%.
Buying Treasurys when the rate was around 3% a few years ago was the obvious play. They’d pay you a lot of interest (as it must be considered in this environment) while you waited for big capital gains. But the question, as always, whither from here?
The case is not so compelling any more. They don’t pay much interest, any more, and the capital gain is not likely to be so big right after this big move.
Everyone else will be asking this question too. Whither from here? They will be pondering where to put capital.
Now we get to the exciting part. The stock market is where the action is. On February 19, the S&P closed at 3,387 (futures). On Thursday, it closed at 2,469, or -27%. Friday was up a staggering 8.7%.
Most astute commentators believe this rip-your-face-off-rally is due to short covering and other ephemeral technical conditions. Massive spikes are a feature of bear markets, not bull markets.
No doubt, the governments of the world are taking actions in response to the coronavirus that are economically damaging. But we insist that the virus is not the cause of the downturn, though it may be the catalyst.
Airlines, obviously, will suffer big losses due to Trump’s ban on travel to America from Europe. And hotels. No doubt, Broadway theaters and production companies will suffer losses from New York Mayor De Blasio’s ban on large gatherings. And many restaurants and bars in Ohio will close their doors permanently, as a result of Governor De Wine’s order for them to close temporarily.
But we cannot overemphasize that during the 11 years following the last crisis, the root cause was never addressed. Instead, monetary policy was imposed to mask it and enable more of what caused that crisis in the first place.
Unproductive debt.
For example, Boeing bought back $43 billion worth of its own shares. Put yourself in the shoes of the CFO. Suppose you could borrow for less than the cost of your dividend yield, e.g. borrow at 2% and buy shares yielding 3%. What would you do? Especially if most of your personal compensation came from a rising share price.
Boeing recently had two 737MAX airplanes crash. It has been spending cash like crazy to keep airlines happy and to redesign the plane. This was already straining the company. Now the virus has led many governments to impose travel bans. And airlines are not ordering more planes (they’re cancelling orders). This one-two punch may knock Boeing out. We make no predictions, but we can say with certainty that Boeing would be better off now if it had not spent that $43 billion.
The other 499 companies in the S&P Index may not have committed a multibillion dollar error. They may not be as deeply impacted by the virus. Yet, all of them will see declines in their revenues, and hence shrinkage of already-thin margins and return on capital. Their liabilities, of course, do not go down. And their interest expense may go up when they are forced to roll over their bonds.
If they can roll them. If the market does not seize up, as it did in 2008.
And this brings us to the next factor, and the last section of Part One of this two-part Report.
The Likely Fed Response
So far, we have seen two moves from the Fed. One, they cut the Fed Funds Rate another 50 basis points in March. Two, the Fed increased its “repo” transactions. Called a “bailout” by many, that is a misunderstanding. A repo is a purchase and repurchase agreement. The Fed buys a Treasury bond from a big bank, with a contract to sell it back to them at a slightly higher price one day later. Repo is like a pawn shop, for banks who hold Treasury bonds.
We expect further rate cuts (UPDATE 100BPS CUT ANNOUNCED AS THIS ARTICLE NEARS PRESS TIME), down to at least zero. But we believe that the Fed will be reluctant to open the door marked “negative” just yet. Though as we will explain, this minor preference will go under the bus if the Fed finds itself backed into a corner. Sooner or later (we expect it will be later), they will, but to quote our old friend Aragorn “Today is not that day.”
The Fed is hyper-aware of how the crisis developed in 2008. They can’t address the root cause (as they don’t grasp it). But they do understand the mechanics of the failures of Bear Stearns and Lehman Bros. They know about Nortel and General Motors, and others.
Companies who thought they could rely on the credit market to roll their bonds when due, were proven wrong. They could not roll. But they still had to pay the old ones, or else be forced into bankruptcy.
The Fed will do—it will have to do—whatever it takes to prevent this from recurring. Let that sink in. GDP, unemployment, and inflation are just numbers. The Fed can justify its policies in light of its dual mandate (unemployment and inflation), and it can talk about how it cares so very much about GDP. But these measures matter little to monetary policy, in the end.
What matters is if banks and corporations cannot access the credit markets. There will be a cascading series of defaults, like Dominoes tipping over. The Fed cannot explain this, even if it were inclined to allow it. So it must take action.
The Fed will feel it must force the credit markets to remain open for business.
They are fighting against some powerful forces. There are reasons why investors want to sell the bonds issued by shale oil producers—these companies cannot service their debts at an oil price of $30.
As an aside, the OPEC dispute is no more the cause of lower oil prices than the virus is the cause of the stock downturn. Autocracies, kleptocracies, and welfare states must keep the revenues flowing. If the price of oil drops, they must sell more. It’s that simple. Everything else is just blah blah blah.
There are reasons why investors don’t want to extend more credit to Boeing, or so many other companies. These companies are in trouble. And the market is now starting to call into question if the Fed can fix their troubles.
Assuming not, the Fed must instead try to paper over them. This means getting investors to come back into the market for this debt.
The first gambit is to buy up more and more of the good assets, such as Treasury bonds. Each investor who is displaced from owning this asset is forced to look farther out on the risk curve for another. Perhaps, the Fed can continue the game of the last 11 years. Perhaps with 10-year Treasury yields well under 1%, it can induce investors to buy up other bonds and push the spread back down to what it had been.
Or, perhaps, investors will balk. To quote Saruman (another Lord of the Rings character), “And if that fails, where then will you go?”
We refer to asset purchases. We would not expect the Fed to buy stocks yet (for some of the same reasons we don’t expect them to set the Fed Funds rate below zero yet). But there are many bonds other than Treasury bonds. Boeing bonds, shale oil bonds. Even WeWork bonds and Tesla Bonds. UPDATE: AS THIS ARTICLE NEARS PRESS TIME, THE FED ANNOUNCED MORE BUYING OF GOVERNMENT BONDS PLUS $200 BILLION OF MORTGAGE BACKED BONDS.
“Papering over” is an apt description of such a program. With the bonds tucked on the Fed’s balance sheet, safely away from public scrutiny, it can postpone the problem for years by negotiating longer terms, lower interest rates, and other soft defaults. Without having to write down its losses (especially under a different set of accounting standards than what private companies adhere to).
And the Fed may not have to buy up the entire inventory of such bonds. When investors see that the Fed sets a permanent bid in this market, they will likely come back in themselves. Why not? It’s a promise of risk-free capital gains.
Congress might also act. The Fed cannot dole out subsidies, but Treasury could. To compensate for lost revenue due to the tariffs, Trump paid subsidies to farmers. Why couldn’t there be subsidies to airlines and hotels who suffer revenue shortfalls? How about trucking, restaurants, and theaters? If it’s big enough to be in the public’s awareness, and politically connected enough to have a seat at the backroom table where these deals are hammered out, it could be subsidized.
Congress has long ago run out of taxing capacity. So subsidies will have to be added to the tab, that pile of debt that is never-to-be-paid. With the Fed’s help providing a firm bid, the price keeps moving up / the interest rate keeps moving down. The government continues to be able to finance whatever deficit it chooses to run, by selling as many bonds as it wants. One day, it will run out of other people’s money, and this exorbitant privilege will end. But today is not that day.
There are many reasons why it continues long past where one might think it should end. One reason is that the saver is disenfranchised. That was the real meaning, nature, and consequence of President Roosevelt’s 1933 gold decree. To hold a money balance is to be a creditor to the government. One can trade it for something else, but that other thing is not considered to be money and has price risk. Including gold.
For many people, this price risk is unacceptable. However, for others it is the least of three evils: (1) little to no yield, (2) too much risk of loss, or (3) price risk. We suspect a growing number of people will prefer #3. Especially now that the Treasury bond yield has dropped so much. Whatever calculation people may have performed in January has been wiped off the board by the market action these past two months. In other words, long-term Treasurys yielding well under 1% may seem pretty pointless to many investors. To the marginal investor.
Forget quantity theory of money, inflation, etc. That is not what drives consumer prices or the price of gold.
Think as an arbitrageur. What would you do, if Treasury bonds pay too little? Would you unload your life savings, your family estate, to binge on bourbon, to buy a Bentley? Now suppose that a major bank has a trillion in assets (mostly bonds) financed by a trillion in liabilities (deposits plus its own bonds) at an average cost of 2%. And the Treasury bond yield falls below 1%. What will the bank do? Will they sell Treasury bonds to send their employees on a big bender at Bellagio casino?
That’s not how the world works. Investors who are displaced out of Treasurys when the yield goes too low, will just move to the next investment down the line. It could be one that pays a higher yield for a higher risk.
Or it could be gold.
Change occurs at the margin.
In Part Two, we will look at the data from the silver market this week.
© 2020 Monetary Metals
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