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Eurozone
Driving the Markets
There is no
doubt that the European sovereign debt crisis is a major factor driving the
global markets lately. The imminent Greek default and the loss of confidence
that Italy can avoid contagion and its own severe debt crisis has toppled
both governments and set the stronger Eurozone nations on a path to
socialized bailouts and eventual monetization (printing trillions more
Euros). These actions may forestall immediate catastrophe but also create
other serious economic problems, such as inflation, recession or both
(stagflation) across the Continent.
The Eurozone
crisis pushed global equity markets up and down in triple digit waves, as
drama played out first in Greece with the resignation of Prime Minister
George Papandreou, and then the ouster of Italy’s Silvio Berlusconi,
who resigned over the weekend.
The bond market
had forecast the Italian capitulation, as we identified in the last issue of The Gold Speculator. The bond
vigilantes attacked the Italian 10-year note, driving its yield to over 7%,
the signal used by many that the end had arrived. Portugal required bailout
funds when its bond yield hit 7%, a full 4 points above the German Bund.
The new
governments in Greece and Italy are expected to pass and implement severe
austerity measures in return for debt relief from the new European Financial
Stability Facility, the co-investment fund that is soliciting investors to
establish a 1 Trillion Euro firewall to stem contagion in the Eurozone, the
ECB and the IMF.
And
there’s the rub. Greeks have already begun to riot to protest deep cuts
to entitlement benefits. Italian citizens may also turn to the streets and
shut down essential services in a general strike. Italy is now forced to cut
programs that support much of the population at the same time that economic
growth is stalling. It’s a classic death spiral. It is unclear that any
amount of debt restructuring can fix the fundamental problem for the dying
social welfare state.
US markets seem
fixated on the travails of the Eurozone debt crisis. The fact is, US banks have relatively little direct exposure to
Italian debt, with $47 billion in exposure, compared, for example, to
France's $416.4 billion. But larger U.S. banks may be carrying vastly more
indirect risk from struggling European economies as a result of the credit
default swaps, or CDS. U.S. banks are holding almost three times as much as
their $181 billion in direct lending to the five countries at the end of
June, according to the most recent data available from BIS. Adding CDS raises
the total US bank risk to $767 billion, an amount reminiscent of the mortgage
backed securities meltdown.
One outcome
resulting from continued uncertainty in Eurozone is the flight to safety.
We can see this
in the price of gold, which has moved up to challenge the $1800/oz level.
US Debt Policy
and the Markets
Fear of
Eurozone debt contagion is not the only factor driving the markets. There is
also a major event looming for the US economy, namely the showdown of the
Super Committee. With the deadline to craft the $1.5 Trillion debt reduction
deal now nine days away, there seems to be little progress by the select
lawmakers. In fact, the talks broke down when Democrats walked out this last
week after ignoring the latest Republican proposal. The US budget battle is
likely to reach center stage once again over the next ten days. An impasse
will roil the markets once more.
The credit
agencies may act before the Super Committee does. Many analysts believe a
further downgrade of US sovereign debt is probable. Rather than taking the
lead at this critical juncture, the president is taking a trip to Hawaii and
Asia. It is becoming more apparent that the Administration would rather there
is no deal; another example of the “do nothing opposition”. There
was a time in this country when our leaders put needs of the country before
politics. Those were the days…
So fasten your
seat belt. We’re in for a bumpy ride. The stock market will remain
highly volatile with daily triple digit swings. The bond market offers no
escape. Treasury prices are bid up as funds flow out of Europe and equities
into “safe” US notes, despite negative real interest rates for
the instruments, and bid down when investors flood back into higher yielding
stocks. Each trade represents a loss of capital (as well as a tax event).
It’s no
wonder that prudent investors are once again turning to gold as the true
safe-haven trade.
Fed to the
Rescue?
It is
inevitable that the Federal Reserve will implement more Quantitative Easing
in a last ditch attempt to jump start the ailing US economy. Chairman Ben as
much as said so in remarks this week before a military audience in Texas when
he pointed out the economy could “tolerate a little more
inflation.” He was referring to the ancient belief held by Keynesians
that there is a trade-off between inflation and employment, as embodied in
the Phillips Curve. The theory, which dates back to 1958, states higher employment
comes at the expense of higher inflation. No one would argue that 9%
unemployment today is trivial. The true measure (U-6) is 16.2% as of October.
To the contrary, the Fed chief called the US unemployment a “national
crisis.” Likewise, the Chairman characterized 2% inflation as
“tame.” So, given the Fed’s mandate to support full
employment, it could easily justify creating a bit more inflation by printing
more money, as it did under QE1 and QE2. Using the calculus of the Phillips
Curve, implementing QE3 at about $1 Trillion would bring unemployment down to
6% or so.
The problem
with that logic is that QE1 and QE2 failed to create net new jobs over that
last three years. The other problem is the Phillips Curve theory fails in
general to account for the coincidence of high inflation and high
unemployment, as occurred in the 1970s’ stagflation under Carter.
But facts have
never dissuaded the Chairman from pursuing his preferred political policy.
Besides, QE3 would be good for Wall Street.
Inflation and
the Money Supply
We know from
Nobel Laureate Milton Freidman that inflation always and everywhere a
monetary phenomenon. We also know that commodity prices are a good proxy for
inflation. That is higher commodity prices reflect higher inflation. So we
can examine the Commodity Price Index in comparison to the money supply for
correlation.
We see that
after the meltdown of 2008, commodity prices have climbed higher propelled by
QE1 beginning in 2009 and later in 2010 by QE2. Commodity prices started to
decline when the end of QE2 was announced earlier this year.
 
We also see
that the Fed increased the Monetary Base dramatically, adding nearly $2
Trillion to the Fed balance sheet by purchasing bonds under QE1 and QE2. QE3
(and QE4 and QE5) will push inflation to record levels.
So how will the
debt crises in Europe and the US affect the price of gold? Gold will continue
to climb in price as investors seek relative safety from volatile markets and
a hedge against devaluation of fiat currencies such as the Euro and the
Dollar through continued central bank intervention.
Investors from around the world benefit from timely market analysis on
gold and silver and portfolio recommendations contained in The Gold
Speculator investment newsletter, which is based on the principles of free
markets, private property, sound money and Austrian School economics.
The question
for you to consider is how are you going to protect yourself from the
vagaries of the fiat money and economic uncertainty? We publish The Gold
Speculator to help people make better decisions about their money. Our Model
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