June 19, 2017
The big news this week comes from the Fed, which announced
two things. One, it hiked the Fed Funds rate another 25 basis points. The
target is now 1.00 to 1.25%, and there will be further increases this year.
Two, the Fed plans to reduce its balance sheet, its portfolio of bonds. It
won’t do this by actually selling, but by not reinvesting some of the principle
repaid as the Treasury rolls over each bond at maturity. This is like reducing
the workforce by a hiring freeze and attrition, rather than by layoffs.
We are no Fed insiders, but if we were to take an educated
guess, we would read the last part as a shuffle between the Fed and the banks.
No one can afford rising long-term bond yields, as the banks hold plenty of
them and this would be a capital loss. Also, if bond prices drop then all other
asset prices would drop too. Banks would take another hit.
Right now, the banks are lending to the Fed at 1.25%. The
Fed uses this cash to finance its purchase of long Treasury bonds. The 10-year
bond closed on Friday at a yield of 2.16%. If the Fed can arrange for the banks
to swap, basically slowly draw down their excess reserves and buy the bonds, then
it would not cause the bond market to crash. At the same time, the Fed can say
that it has shrunken its balance sheet. There would be no change in the bond
market, but the banks can bypass the Fed, while increasing their net interest
by about 0.9%.
This move would have one non-obvious side effect. The
duration risk moves from the Fed to the banks. This is the risk of capital
loss, if the interest rate should move upwards. At least the risk moves to the
banks nominally. In practice, the Fed will have to bail out the banks should
they get hit by this (or assure the banks that the Fed will do everything it
can to prevent long bond yields from rising).
We present the issue in these terms, because bank solvency
(and the Fed’s own solvency) is the real motivation of the Fed. Price
stability—defined to make Orwell proud, as rising prices of 2% per year—is not
occurring right now. That is, the Fed has failed to stimulate the price
increases that it wishes.
And the Yellen Fed does
wish for rising prices. In a key paper she wrote in 1990 with her husband
George Ackerlof, Yellen presented her theory of inflation and the labor market.
Let’s strip the academic regalia, to see it in plain terms.
employees don’t work hard, and may even sabotage machinery.
companies must overpay to keep them from slacking.
pay per worker means fewer workers, because companies have a finite budget.
Yellen concludes—you guessed it:
provides corporations with more money to hire more people.
It’s not much as a theory of labor, but does rationalize
money printing rather neatly.
The mainstream belief held by Yellen, along with her most
trenchant critics, is that rising quantity of money causes rising prices. Never
mind that it has failed to work out that way since the Fed turned on the
printing press afterburners in 2008. It remains the prevailing belief. So it is
somewhat amazing that, with consumer prices falling short of the Fed’s official
policy goal of 2% per annum, the Fed is decelerating.
Maybe, Yellen feels that jawboning—saying the economy is
getting stronger, etc.—will be more effective than another round of
quantitative easing. Maybe. The Keynesians have a cherished belief that so
called animal spirits animate markets (and Yellen is a member of the New
Or, it could be that banks are getting strangled. Banks
don’t care about unemployment, nor about consumer prices. They don’t even care
about the dollar, being both long and short. That is, they are both borrowers
and lenders. They borrow short to lend long.
While the short-term rate has been rising, the long-term
rate is back to falling again (which has been the trend since 1981). The effect
on banks is: margin compression. The banks are choking, for lack of net revenue
oxygen. They will breathe a bit easier if they can make 2.16% rather than the
1.25% as now.
What does this have to do with inflation? Another news item this week illustrates. Amazon bought
Whole Foods. Amazon has unlimited access to credit through the bond and stock
markets. The lower the interest rate, the more access the big corporations have,
to dirtier cheaper credit. They can’t necessarily use this credit to grow their
real businesses (one cause and also effect of it being so cheap) but they can
use it to make acquisitions. Acquisitions that would not be economic at higher rates.
What will Amazon do with Whole Foods? We would guess that
they will pursue Jeff Bezos’ stated vision for the future: that people will
always want faster delivery and lower prices. Amazon will use its superior
information technology, logistics, scale—and dirt cheap credit—to drive down
costs, prices, and margins at Whole Foods. And all other grocers will likely
have to follow suit.
So much for higher prices. An expansion of the credit supply
(the dollar is not money, which would be gold) is supposed to stoke higher
prices, and here is a case where it causes lower prices.
By the way, lest anyone think that this is good because
consumers get lower prices, it’s not. Sure, consumers benefit for now. But the
real damage comes from the fact that the whole process is fueled by burning
investor capital. That is the real nature of too-cheap credit.
And this right here is the indictment of the dollar. Not
rising prices, skyrocketing prices, or hyperinflation. At least not now nor the
foreseeable future. Falling interest, capital consumption, wage pressures, and
unfair advantages handed to crony corporations. All managed by a Fed Chair with
a frivolous theory on inflation who knows not what she does.
What does this have to do with the price of gold? Well, the price
jumped up early on Wednesday as weak retail sales and
inflation data numbers came out. But when Yellen spoke, the gold
price fell back down, giving back the whole move and then some.
Which is all just noise. Speculators gonna speculate, but
the fundamentals of gold supply and demand do not change with an inflation data
report or a Fed Chair monetary policy announcement.
Over time, if people perceive gold as an inflation hedge, and continue to see a
inflation, maybe they won’t
buy gold or even sell it. If so, they are betting on the dollar as it continues
on in its ultra-low interest rate (and long-term falling) environment.
We will take a look at the Wednesday intraday gold basis
overlaid with the gold price, below.
This week, the prices of the metals fell. Gold went down about $13, and silver about 50
cents. As always, we are interested in the supply and demand fundamentals. But
first charts of their prices and the gold-silver ratio.
Next, this is a graph of the gold price measured in silver,
otherwise known as the gold to silver ratio. It moved up a sharply.
In this graph, we show
both bid and offer prices. If you were to sell gold on the bid and buy silver
at the ask, that is the lower bid price. Conversely, if you sold silver on the
bid and bought gold at the offer, that is the higher offer price.
For each metal, we
will look at a graph of the basis and cobasis overlaid with the price of the
dollar in terms of the respective metal. It will make it easier to provide
brief commentary. The dollar will be represented in green, the basis in blue
and cobasis in red.
Here is the gold graph.
We had a rising price of the dollar (the mirror image of the
dropping price of gold). The abundance fell (the basis) and the scarcity increase
Our gold fundamental price shows a decrease of about $10 (to
Here is the intraday graph of Wednesday (all times are
London) showing the gold price overlaid with the August basis.
The basis starts a little over 0.6% and droops along with
the price from about $1,266 to $1,265. As the price shoots up $12, the basis
shoots up 12bps. Later, the price begins to drop and so does the basis.
While the amount is coincidence, the relationship is not. It
is causal. This is what first speculative buying, then speculative selling,
looks like. All in one day.
Now let’s look at silver.
In silver terms, the dollar rose more (i.e. the price of
silver fell more). The decrease in abundance and increase in scarcity were
Our silver fundamental price increased two cents (to $17.54).
That gives us a fundamental gold-silver ratio of 76.07 (chart available on the
website). Not too far from the close on Friday of 75.12 bid and 75.29 offer.
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