Let's take a look at a few graphs of the dollar, from Feb 1, 2013 through
Friday May 17, 2013. Yes, I said graphs of the dollar. I've priced the dollar
in gold first (of course), then silver, the euro, and even the yen. The pattern
is obvious. The dollar is going up.
I did not show copper, lumber, or wheat though they show the same trend. These
commodities are not money, of course.
My point is simple. It's not gold that is going anywhere. In past articles,
I've used the analogy of measuring a steel ruler using rubber bands. Using
the dollar to measure gold is like that. In this article I show that it's
not just gold, but silver, other currencies, and commodities. The dollar is
rising now matter how we measure it.
The question not to ask is: "how are they manipulating gold?" The question
is: "why is the dollar rising?"
To answer that, we first have to understand why the dollar had been going
down. Most would say that it's because the Fed has been "printing" and increasing
the quantity of dollars. If that is so, then why would the dollar ever rise,
as it has before (e.g. in the 1980's), and as it is doing now? The Fed cannot
and does not "un-print" dollars. This stock explanation is not satisfactory.
In one word, the answer is: arbitrage.
Let's take a step back and look at the Treasury bond. The government pays
for net expenses above tax revenues by borrowing. To borrow money, the Department
of the Treasury sells bonds. This is an important aspect of our current form
of government, as voters have demanded far more government expenditures than
they are willing or able to pay for via taxes. In this aspect, the Treasury
bond is a tool of fiscal policy, or spending, and cash flow to pay for it.
There is another aspect to the Treasury bond. It is the key asset of our monetary
system. It is the asset on the Fed's balance sheet (increasingly, post 2008,
there are also mortgage bonds) to back its liabilities. The liability of the
Fed is the Federal Reserve Note, commonly called the dollar. The Treasury
bond is also a significant backing for the liabilities of commercial banks,
pension funds, annuities, and insurance funds. Finally, the Treasury bond
is used as collateral to enable borrowing.
The monetary system today is entirely based on credit, and the Treasury bond
is the base of it. The peculiar characteristic, one could even say the shabby
little secret, is that the Treasury bond is payable in dollars but the dollar
is the liability of the Fed which is backed by the asset of the Fed which
is ... the Treasury bond. It's circular and self-referential.
People often use the shorthand of saying that the Fed is "printing" dollars.
It is actually borrowing them into existence and lending them.
It is true that there is no actual lender. The Fed has sole discretion to
create these dollars, unlike any normal bank, that must persuade a saver to
deposit his capital in the bank. The Fed's expansion of credit involves no
saver. The Fed's credit is counterfeit.
The dollars appear ex nihilo at the Fed, and they use them to buy an
asset, basically a bond, or to otherwise lend. Thus the Fed creates both a
liability and an asset in this process. If the value of its assets should
ever fall significantly, the market will not accept the Fed's liability --
the dollar -- at face value. When gold
owners refuse to bid on the dollar, the dollar will collapse.
Let's get back to arbitrage. If a bank borrows money from the Fed, they will
use it to buy an asset or lend it to a third party who will. This is an arbitrage.
The short leg is the loan from the Fed, and the long leg is the asset purchased.
As with all arbitrages, it will act as a force to pull the two values towards
one another. Market price is always pulled down by the short leg, and pushed
up by the long leg.
In the case of all borrowing from the Fed, the short leg is the dollar itself.
I define arbitrage as the act of straddling a spread in the markets. The
arbitrager is often trying to profit from the interest rate spread directly,
as in borrowing from the Fed at the discount rate and buying a Treasury bond
that offers a higher yield.
Another strategy is to try to profit from a change in the spread, as in borrowing
dollars to buy gold. In this case, if the dollar price falls, this will be
a profitable trade. This is a weaker arbitrage than buying a bond, as gold
does not have a yield.
As I noted above, the very act of arbitrage pulls down the price of the short
leg and in the case of borrowing from the Fed the short leg is always the
dollar. Whether a bank borrows dollars, to buy Euros and from there to buy
Greek government bonds; whether it lends to a hedge fund to buy gold; or whether
it lends to a consumer to buy a home, the dollar is pulled down. On the other
side of the trade, these assets are pushed up.
This, rather than the rising quantity of dollars, explains the falling value
of the dollar. And now, recently, the dollar has been rising. The logical
explanation is that these trades are being unwound, either voluntarily or
under duress. My definition of deflation is a forcible contraction of credit.
It is not the shrinking number of dollars (if the number is even shrinking).
It is the closing of innumerable positions, by the opposite arbitrage. Previously
it was sell dollar / buy asset. Now it is buy dollar / sell asset.
Gold is the most liquid asset. Its bid-ask spread does not widen much when
large quantities are sold on the bid or bought at the offer. In contrast,
the bid in other assets can drop precipitously in times of crisis. They are
hardest to liquidate precisely at the time when one must sell. In some extreme
cases, the bid can be withdrawn altogether. Though the spread does not widen
in gold, heavy selling does push down the bid on gold. Market makers will
then pull down the offer to maintain a consistent spread.
Being the most liquid, gold is the most sensitive. It is the first asset,
the "go to" asset to sell when a balance sheet is under stress. Gold therefore
has the least lag in response to a change in the monetary system. Compare
to real estate, where due diligence alone could take weeks or months. Additional
inertia comes from how properties are valued: by looking at recent comparable
deals. Real estate would not be the first asset that a bank or fund would
want to sell, due to several factors including long closing time, wide bid-ask
spread, and high costs to sell such as sales commissions and attorneys. In
real estate, there are no market makers. The offer can remain high even with
the bid plunging, as the typical holder of real estate is not willing to sell
at a loss and holds out for a number that covers all costs and fees and allows
an exit at a profit.
Equities are usually liquid, closer to gold than to real estate in this regard.
However, for the past few years, there have been many flash crashes.
In a flash crash, the bid drops to $0.01 for a brief moment, and typically
at least one market sell order is filled far below the "normal" price for
the stock. These flash crashes prove that there are serious problems, that
there are structural cracks beneath the surface.
An important principle to keep in mind is that in times of stress or crisis,
it is always the bid and never the offer that is withdrawn. While there have
been a few flash smashes (an amusing term) it is not a coincidence
that these are vastly outnumbered by the flash crashes. This is because
stress and crisis always come with a need for liquidity to pay debts that
cannot be rolled over, margin calls, or to be flexible and agile. In bad times,
people prefer to own a more marketable asset compared to one that is less
marketable. They especially prefer to own the asset that is the unit of account
for their balance sheet.
By definition, there is no risk to holding dollars if your balance sheet is
denominated in dollars, and your liabilities are in dollars. This is the reason
for the so-called "flight to safety" for the "risk-off asset". You are not
making, nor losing, money when you hold dollars. On gold denominated books,
holding dollars is quite risky, of course.
Going back to the falling dollar, as the interest rate falls the discount
factor used for an enterprise's future earnings also falls. The same $1 in
earnings in 2023 is worth more at a discount of 3% annually vs. 6% ($0.74
vs. $0.56). The result is rising stock prices.
In addition, the "animal spirits" of John Maynard Keynes have been set loose.
Most people hold the false theory about the quantity of money and its impact
on the price of everything, and it is quite popular to believe that this means
stock prices can only rise. Proponents of this theory should look at Japan.
In any case, deprived of other means of obtaining a yield (i.e. in the bond
market), they must do something. People know the dollar is falling, though
they attempt to measure it by looking at the rate by which consumer prices,
measured in dollars, rise. They should be looking at the rate at which the
dollar, measured in gold, is falling.
Right now, everyone is on the same side of the trade: long equities. This
is dangerous because when it reverses, the market may not find a bid for quite
a distance down. In a normal market, it is the short sellers who make the
bid. By the indications I can see, those who have attempted to short this
market have capitulated by now.
In Part
II (free registration required), we consider why stocks are rising
in this depressed economy, and look at the abyss we are now rapidly
approaching.
[1] My definition of inflation
is an expansion of counterfeit credit, discussed in this paper: http://keithweinereconomics.com/2012/01/06/in...terfeit-credit/
[2] I define and discuss
in my dissertation: target="_blank" A
Free Market for Goods, Services, and Money
