New From Sprott: "Have We Lost Control...Yet?"

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Fri, Jun 28, 2013 - 9:30am

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Have we lost control yet?
By Eric Sprott & Etienne Bordeleau


Recent comments by the Federal Reserve Chairman Ben Bernanke have shocked the world financial markets. It all started on May 22nd, 2013, at a Testimony to the US Congress Joint Economic Committee, where he first hinted at tapering the Fed’s quantitative easing (QE) program. Then, on Wednesday, June 19th, during the press conference following the FOMC meeting, the Chairman outlined the Fed’s exit strategy from QE.

Since the first allusion to tapering, volatility has been on the rise across the board (stocks, currencies and bonds) (Figure 1A). Moreover, the yield starved, hot money that had flown to emerging markets has been rushing for the exits, triggering significant declines in emerging market (EM) equity and bond markets (Figure 1B). Finally, the prospect of the end of monetary accommodation has triggered rapid and significant decreases (increases) in the price (yield) of longer dated Treasury bonds (also Figure 1B).

FIGURE 1A: VOLATILITY INCREASING FIGURE 1B: ASSET PRICES DECLINING


It has been clear to us for some time that the Fed was uncomfortable with the relative certainty (i.e. Bernanke Put) that has prevailed in the markets since the introduction of QE-infinity last fall. Officials definitely wanted the market to start thinking about a future without non-conventional monetary policy. However, we seriously doubt that the resulting chaos is what they had anticipated. This was evident in the Chairman’s response to a journalist’s question about the rapid rise in rates, saying the FOMC was “a little puzzled by that”.1 The genie is really out of the bottle now.

Indeed, we believe that the recent “market appeasement rhetoric” by James Bullard and Narayana Kocherlakota (Presidents of the St. Louis and Minneapolis Federal Reserve, respectively)2,3 are further proof that the Federal Reserve has realized it went too far and that it is now in damage control mode. (Update: William Dudley, President of the New York Fed mentioned in a June 27th speech that “asset purchases would continue at a higher pace for longer” if the economy was to grow slower than the FOMC’s estimate)4.

However, as the Bank for International Settlements (BIS) so elegantly put it in its most recent annual report, “[…] central banks continue to borrow time for others to act. But the cost-benefit balance is inexorably becoming less and less favourable.” To this they add: “expectation that monetary policy can solve these problems [deleveraging, financial stability] is a recipe for failure”.5 Clearly, the Federal Reserve knows this and wants to exit their QE program. But can they really?

A large portion of the current economic growth depends on housing. However, mortgage rates are closely tied to long-term treasury rates. While housing affordability is still relatively good because of low house prices, significantly higher mortgage rates might slow the housing market. Furthermore, banks are still very cautious about lending and most borrowers have difficulty accessing credit. While gentle increases in yields are good for banks (who lend long and borrow short), meteoric increases in yields (as in Figure 1B) are damaging because they are hard to hedge and create large losses on the banks securities portfolios (mostly composed of government bonds and mortgage-backed securities) as well as mark-to-market losses on their derivatives portfolios. So, the large and rapid increases in rates the talk of tapering has engendered will damage the economic growth the Fed has been working so hard to engineer, potentially requiring even more stimulus down the line.

The US government itself would also suffer from increases in yields. In its Annual Report, the BIS shows that even a small increase in interest rates would have a large impact on the projected government debt-to-GDP ratio. As shown in Figure 2, under the CBO’s base case scenario (bottom line), the US debt-to- GDP ratio would hover around 110%, whereas a 1% increase in rates would take it to 118% in 10 years (middle line). According to the Chairman’s comments, the fiscal drag that has been partly to blame for the lackluster performance of the economy should subside going forward. But, larger debt servicing costs (because of higher rates) will put more pressure on government finances, forcing it to spend an ever increasing portion of its budget on interest payments. This will have the effect of increasing the fiscal drag, going against the hopes of the Fed.

FIGURE 2: U.S. GENERAL GOVERNMENT DEBT PROJECTIONS UNDER ALTERNATIVE SCENARIOS - AS A PERCENTAGE OF GDP


To add to all this uncertainty, the situation in the Euro Zone’s periphery is far from stabilized. Following the surprise Cyprus bail-in, international bank regulators have made a push for a democratization of this alternative to outright government bail-outs of banks. This idea is quickly gaining traction amongst central planners. We recently discussed the shortcomings of the BIS’s “Template For Recapitalising Too-Big-To- Fail Banks”.6 The BIS, again in its annual report, reiterated that “we need resolution regimes to make it possible for large, complex institutions to fail in an orderly way.” As uninsured depositors and bank bond holders realize that they do not benefit from government guarantee anymore, bank funding costs will rise and funding might dry up for peripheral European banks.

Conclusion: At the last FOMC meeting, by prematurely announcing the timeline and the specifics of an exit from QE, Bernanke might have lost control of rates and volatility. The current US economic growth is still feeble and hinges on housing, which would be slowed down by raising rates. Banks, while better capitalized than pre-crisis, are still not lending to most borrowers and would be dearly affected by too fast increases in rates. Moreover, European woes still threaten the stability of the international financial system and the recent rush to the exit might further exacerbate funding pressures for weak European banks. Finally, the US government (amongst others) debt load, while already unsustainable, would keep on climbing if rates were to increase only by 100bps.

The chaotic reaction by market participants and the corresponding increase in yields now risks destabilizing this very fragile equilibrium. It is yet unclear whether or not the damage control from the other Fed Presidents will put a lid on yields and market volatility, or if the damage to the Fed’s (poorly executed) exit strategy is permanent.

1 https://www.federalreserve.gov/mediacenter/files/FOMCpresconf20130619.pdf
2 https://www.stlouisfed.org/newsroom/displayNews.cfm?article=1829
3 https://www.minneapolisfed.org/publications_papers/pub_display.cfm?id=5128
4 https://www.bloomberg.com/news/2013-06-27/dudley-says-qe-may-be-prolonge...
5 83rd Annual Report, Bank for International Settlements, Basel, 23 June 2013, pages 4 and 6.
6 We discuss this in the Sprott Thoughts article: “The Dijssel_Bomb”. https://sprottgroup.com/thoughts/articles/the-dijssel-bomb

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  147 Comments

Spartacus Rex
Jun 28, 2013 - 2:32pm
ancientmoney
Jun 28, 2013 - 2:49pm

580 tons of gold from west to east . . .

Watch those bankers' warehouses--should be about 20 semi-loads of gold hitting the road to get to container-loading stations. Or maybe 60 Brinks' truckloads.

OC15
Jun 28, 2013 - 2:50pm

Can someone explain something to me?

How is it that mining companies could make money with gold at $700-800/oz and silver at $10/oz 7 or 8 years ago but at today's levels this is "under the cost of production"

Gold and silver were at these levels as late as 3 years ago and these prices we are told are under the cost of production.

When I consider this, it makes the "under the cost of production" claim sound bogus.

ancientmoneyOC15
Jun 28, 2013 - 2:54pm

@OC15re: mining profits . . .

A big factor is energy. Fuel costs are about 300% of what they were when Obama took office.

Another factor is ppm of ore content. The ores are getting less PM-dense, as better veins are now mined out.

So, it takes more labor, more energy, and more expensive energy to get P:Ms out of the ground.

Urban Roman
Jun 28, 2013 - 2:57pm

Explanation

OC15,

Differences from 7 or 8 years ago:

  1. Fuel is more expensive. Mining operations use lots of diesel, gasoline, and electricity.
  2. Ore grades have declined. The mines dug out the richest veins first.
  3. General cost-inflation. Shirley you didn't believe the 'official' inflation statistics?
ancientmoney
Jun 28, 2013 - 2:59pm
wouldyoubelieve...
Jun 28, 2013 - 3:05pm

miners

they dig what is profitable, so, if a mine, or a good part of one can produce gold at $800 or less /oz, it stays open, any operation costing more gets stopped, likewise, when price goes to $1900/oz, mines that cost $1500/oz get ramped up to take advantage of the ore body while it is profitable and the cheap $800/oz mine gets put on hiatus/skeleton status, maximize profits for what reserves they have. so, yes, some ore will get mined, question is, is it enough for demand?

department of truth
Jun 28, 2013 - 3:07pm

Average in and don't trust the bastards

Despite the utterly clueless Bernanke show, don't put it past the banksters to have created a massive drop here to cash in on puts, etc placed before the "tapering" comments. The one thing these bastards are good at is screwing people, and they can think ahead more than one move.

Plus they can still create as many trillions of dollars as they wish, with the only real limiting factor being the eventual rejection of the dollar as the global reserve currency and all that follows after. Eventual being the key word . . . yes, it is coming, but it may take longer than anyone thinks. After all, they make the rules, they control the "regulatory" agencies, and they have the printing presses . . .

As many have said here before, possession of physical metal should be regarded as a long-term strategy. Great if there is a bounce, but I think the real jumps are going to occur only after the COMEX drops dead, given that they just cannot afford to let the dollar look that bad versus gold and silver.

OC15
Jun 28, 2013 - 3:09pm

I'm not trolling here just playing the advocate

1. Fuel - Gas was $4.00/gallon in mid 2008 before commodities collapsed, so I don't buy this.

2. Ore grades - you are telling me that in the hundreds of years that gold and silver have been mined, that ore grades collapsed in the last 3-5 years? Really?

3. Inflation - I know inflation is worse than they claim but prices haven't doubled

It doesn't add up. When the price of your product is not controlled by you, and you cannot adjust your costs to stay out of the red, you do not continue doing business, simply hoping things will turn around. You close up shop. Companies aren't doing that.

Spartacus Rex
Jun 28, 2013 - 3:12pm

@ OC15 / "Can Someone Explain...?"

Oh, and One thing that ancientmoney left out, and most important:

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