Posts Tagged ‘central banks’

How are bond vigilantes neutered?

Sunday, December 13th, 2009

In our previous article, Rating agencies doing the job of bond markets, we said that bond vigilantes are being neutered. It didn’t occur to us that we had skipped a few steps and some of our readers were wondering why is it so. Our apologies. Here, we will explain why…

First, you have to understand that bond yields and bond prices are inversely related. Why is this so? As we explained in Rating agencies doing the job of bond markets,

For example, if you pay $100 for a newly issued 10-year government bond that pays 6% per annum, you are sacrificing $100 of today?s consumption in order to receive $6 per year for the next 10 years. That 6% is your rate of return on your investment. Now, let?s say you decide to sell your government bond to Tom at $90. The rate of return for Tom is 6/90 = 6.67%. Let?s say Tom sells the bond to Dick at $110, the rate of return for him will be 6/110 = 5.45%. Thus, the rate of return of the bond is inverse to the price paid for it.

What the bond vigilantes do to keep governments accountable is that whenever they perceive governments to be too foolish with their finances (e.g. printing too much money, borrowing too much, etc), they sell off their holdings of government bonds. That in turn will depress the price of government bonds, which imply increases their yields.

The free market is supposed to determine the price of the longer-term government bonds, which implies that long-term interest rates are set by the free market. Therefore, long-term government bond yields are supposed to be an indicator of the trustworthiness of government borrowings. For example, if the free market expects high inflation, then it will be reflected in high bond yields. Conversely, if the free market expects deflation, then it will be reflected in low bond yields.

However, in reality, the price of long-term government bonds are not totally free. Central banks of major nations (e.g. Federal Reserve, Bank of England and Bank of Japan) interfered in the price of long-term government bonds by creating money out of thin air to buy up those bonds. That created additional demand for government bonds, which pushes up its price, which in turn imply lower bond yields than otherwise.

Because central banks is the only authority allowed to create money out of thin air, they can conjured up infinite quantities of money to support bond prices (i.e. “do whatever it takes” to prevent bond prices from falling). Bond vigilantes as a whole do not have infinite resources to push down the yield of bonds. That’s why they are neutered by the central banks.

What happens to the bonds that the central bank purchased? It enters their balance sheet as an ‘asset.’

Has gold moved on to a secular shift?

Thursday, September 17th, 2009

Since we wrote Explosive gold price movement ahead. But up or down? more than 2 weeks ago, gold prices had moved up from US$953 to US$1020 at the time of writing. In terms of Australian dollars, gold prices had not moved much. This break-out of gold prices from a narrow trading range had sparked excitement and derision among the proponents and opponents of gold. But beneath all these chatter and excitement, there are a few interesting trends that we would like to highlight to you:

Declining central bank gold sales
For decades, central banks were net sellers of gold, culminating in the Bank of England’s sale of half its gold holdings in 1998 at the bottom (‘perfect’ timing for the British right?). But over the past couple of years, European central banks are getting less keen to sell their gold. Between 2004 and 2009, under the Washington Agreement, central banks can sell at most 2500 tonnes of gold on a net basis. But only 1867 tonnes were sold. In September this year, another 5-year agreement was signed, permitting at most 2000 tonnes of gold to be sold. In 2009, only 140 tonnes of gold were sold. So, among the signatories of the Washington Agreement, there is a falling trend in the quantity of gold being sold by central banks. At the same time, the central banks of emerging countries (e.g. Russia) are making clear their intention of increasing their gold reserves. For example, Russia announced their aim of increasing their gold reserves from 2% of total reserves to 10%. According to specialist gold analyst Jeff Nichols, the world may be at a turning point whereby central banks is moving from being net sellers of gold to net buyers of gold.

China increase its gold reserves through domestic production
Last year, China suddenly announced that they had increased their gold reserves by 76% since 2003 (454 tonnes) through domestic purchase of their gold production. Over that time, China became the world’s largest gold producer. It is reported that China exports none of their domestic gold production and even banned the export of silver.

Hong Kong recall its gold from London
Recently, Hong Kong recalled its physical gold from London (see Hong Kong recalls gold reserves from London) to be stored in its own storage depository facilities. It is widely believed that this will help Hong Kong be a regional trading hub. There are marketing plans to convince Asian central banks to transfer their gold reserves to Hong Kong. At least one company is planning to launch a gold ETFs? that stores its gold in Hong Kong’s new depository.

Chinese government pushing gold and silver to the masses
Before 2002, it is illegal to own gold in China. Today, the situation is completely reversed. As?China pushes silver and gold investment to the masses reports,

Apparently China is pushing the idea of buying gold and silver for investment purposes to the general population in the way that Western television sells soap powder.

The report notes that China’s Central Television, the main state-owned television company, has run a news programme letting the public know how easy it is to buy precious metals as an investment.? On silver investment the announcer is quoted as saying ” China has introduced its first ever investment opportunity for silver bullion. The bars are available in 500g, 1kg, 2kg and 5kg with a purity of 99.9%. Figures show that gold was fifty times more expensive than silver in 2007, but now that figure has reached over seventy times. Analysts say that silver has been undervalued in recent years. They add that the metal is the right investment for individual investors and could be a good way to cash in.”

This has fuelled a belief that since the Chinese government are convincing the masses to buy gold, then they will not allow gold prices to slump in order not to alienate the masses.

China openly expressed its lack in confidence in the US dollar
China, with US$2 trillion of US dollar assets are not happy with the Fed’s policy of currency debasement. Six months ago, Chinese Premier had already expressed his worry of the US dishonouring its debt through the path of monetary inflation (see Nations will rise against nations). In this article, Cheng Siwei, former vice-chairman of the Standing Committee and now head of China’s green energy drive openly expressed the Chinese government’s dismay at American monetary policy. He said,

We hope there will be a change in monetary policy as soon as they have positive growth again.

If they keep printing money to buy bonds it will lead to inflation, and after a year or two the dollar will fall hard. Most of our foreign reserves are in US bonds and this is very difficult to change, so we will diversify incremental reserves into euros, yen, and other currencies.

Gold is definitely an alternative, but when we buy, the price goes up. We have to do it carefully so as not to stimulate the markets.

This is leading many to believe that China will scoop up to buy gold at the dips, thus a ‘put option’ for gold.


This is getting interesting. Notice the two opposing forces (by two different groups of big boys) at work?

Real economy suffers while financial markets stuff around with prices

Thursday, October 9th, 2008

In yesterday’s ABC 7:30 Report, Associate Professor Steve Keen commented that in the context of today’s global financial crisis,

Well I think Kerry I can actually make a reference to what’s happened to the Australian dollar say every price you see is crazy.

There is no way the prices of anything make any sense at the moment.

Prices in the financial markets are extremely volatile right now. Even prices of commodities (e.g. base metals, oil), gold and silver are moving much more rapidly then we expected (remember a few weeks ago when gold rose by almost US$100 in 2 days?). Currency exchange rates are also very extremely volatile, as we witnessed the fall of the Australian dollar from around US$0.97 to US$0.64. It was just a couple of days ago when the Aussie dollar was around $0.73. Now, at this time of writing, it is US$0.70.

Such volatility and irrationality of prices, if sustained over a much longer period of time, can eventually damage the economy structurally. To understand why, consider what we said in The myth of financial asset ?investments? as savings,

… saving and the resulting accumulation of capital goods are at the beginning of every attempt to improve the material conditions of man; they are the foundation of human civilization.

The accumulation of capital goods requires a time lag whereby current consumption is postponed for future benefits. Improved standards of living come to the public from the fruits of capital investment.

For example, producing metals is a very capital-intensive activity. The stages of production includes:

  1. Exploration
  2. Digging large quantities of dirt, which requires expensive, complex and expensive equipment.
  3. Construction of nearby infrastructure (e.g. roads, railways, power stations, development of water supplies and townships) due to the remoteness of mining projects.
  4. Protection of environment, which increase capital and operating cost.
  5. Extraction of ore from dirt.
  6. Processing of ore.
  7. Refining of metal concentrates.
  8. Shipping and transporting to destinations.

Thus, a mining project from start to finish can take several years. Therefore, you can see that the accumulation of capital goods is long term processes in the economy. As such, all these industrious activities require long-term planning.

What if in the interim, prices are extremely volatile, ‘crazy’ and irrational?

As the late Professor Murray Rothbard wrote in What Has Government Done to Our Money?,

Inflation has other disastrous effects. It distorts that keystone of our economy: business calculation. Since prices do not all change uniformly and at the same speed, it becomes very difficult for business to separate the lasting from the transitional, and gauge truly the demands of consumers or the cost of their operations.

Right now, deflationary forces are acting on the economy while at the same time, central bankers and governments are attempting to inflate. Consequently, the result is extreme volatility in prices. Volatile prices hinder business calculations, which in turn hinders long-term planning.

For example, place yourself in the position of a mining company executive today. Commodity prices are falling precipitously over the past few months as the global economy is staring into a possible depression. At the same time, you know that China and India is still going to demand lots of commodities in the very long run in the coming decades (see Example of a secular trend- commodities and the upcoming rise of a potential superpower and The Problem that can throw us back into the age of horse-drawn carriages). Besides knowing these two basic facts, there will still be great uncertainty in prices as the forces of deflation and inflation battles each other for supremacy, regardless of which forces will eventually win. Will we even be using US dollars to calibrate prices in the future? Who knows? In such an indeterminate environment, it is clear that many more mining projects will have to be shelved. Some have to be abandoned. You may be scratching your head, wondering whether to push forward your project plans.

With long-term planning made much more difficult, how is it possible to engage in investments that allows the nation to continue to accumulate capital goods? Without the ongoing accumulation of capital goods and too much monetary capital wasted on either hoarding, bailing out bad investments and patching a dysfunctional financial system, there wouldn’t be a proper and efficient allocation of monetary capital. The economy will be engaging on capital consumption. If a nation starts to consume its capital, how can there be real economic growth. Without real economic growth, how can future generations enjoy a more plentiful and prosperous existence?

As we ponder on the long term implications of today’s volatile, ‘crazy’ and irrational prices, we saw a sampling of such a phenomenon in one of the news article today, Volatile economic conditions unsettle farmers,

UNDER normal circumstances, an interest rate reduction coupled with a devaluing of the Australian dollar would make farmers very happy indeed.

But not this time, according to National Farmers Federation vice-president Charles Burke.

“There are some other factors at play at the moment that none of us really know how to measure,” Mr Burke said.

“Nor do we know how to deal with it because we don’t know how long it will last.”

That’s why the Austrian School of economic thought advocate a painful deflationary liquidation of mal-investments (read: severe recession/depression) in order to clean out the rot in the system, put on a sound monetary system so that the economy can get back on its feet as soon as possible from a clean slate. But central bankers and governments are trying their utmost to drag on this war between deflation and inflation indefinitely, which means more uncertainty ahead for the foreseeable future.

One potential trouble-maker to watch out for in 2007

Wednesday, January 3rd, 2007

As 2006 closed with stock markets around the world in record high with an eerie calm in terms of volatility, it is very tempting to assume that 2007 will bring more of the same. From the news report, many fund managers have such optimistic view. With the supply of money and credit still expanding, it is indeed very much possible for the good times to continue in 2007. But this does not mean there are no dangers. Hence, today, we will look at a possible danger scenario: the sustained downtrend of the US dollar. As we said in Will the US dollar collapse?, it is only a matter of time before this scenario will happen. The question is, will it happen in 2007?

At this point in time, both the US bond and stock market (especially the bond market) are expecting interest rates to decline in 2007. We said before in Are you prepared for the coming storm?, the ?market seems to be spell-bound by some kind perfect wonderland myth?it ?thinks? that the economy is so weak that the Federal Reserve will cut interest rates next year (which is good for stock prices) and so strong that a recession will be avoided.? If events turn out to contradict the markets? expectation, we can be sure that the results will be very unfavourable.

As we elaborated in What can we expect in a US dollar decline?, a sustained decline in the US dollar will show up as inflation in the US domestic front, which will force the Federal Reserve to raise interest rates. With the US economy already faltering, this will lead to a recession. When that happens, the bull run of 2006 will turn into a bear, as it happened before in May 2006 when talk of raising interest rates spooked the stock and commodity markets. Thus, we will be faced with a hard-landing scenario of declining US dollar and rising interest rates. At this point in time, it will be much harder to foresee what will happen next. As such, what follow will be merely our gloomy guesses.

It is possible for a sustained decline of the US dollar to descend into a nightmare rout in the US dollar through a circuitous route of cause and effects (though it is unclear how likely it would be). If that happens, the results will be unpredictably ugly. Though Asian and Middle-Eastern central bankers certainly have the means to set off a disorderly collapse of the US dollar (see Awash with cash?what to do with it?), it is unlikely that they will have the motivation to do so unless some unpredictably drastic developments took place in their domestic front. It is more likely that they will not sell their US dollar reserves out of their own accord?that is, if they should do so, it would likely be because the US dollar is already falling. But whatever the initial cause, if should we see foreign central bankers dumping their US dollars, it will be the sign of the beginning of great global upheaval as there will be great implications on the Middle East and oil (we will talk about that in the future). Since much of the world?s financial assets are denominated in US dollars, there will be a rush to shift from those assets into safe havens?that can only mean old trusty gold, which is humanity?s choice since ancient history.

So, for 2007, watch out for the US dollar!


Will the US dollar collapse?

Tuesday, December 12th, 2006

As we mentioned in The ABCs of hedging, the first step in hedging our investments is to subject our portfolio to ?war-games,? where we work out how it may perform under various economic what-if scenarios and come up with strategies to counter the unfavourable outcomes.

Today, we look at one possible scenario?the decline (or collapse) of the US dollar.

Lately, we are again hearing that central bankers are murmuring about diversifying their foreign reserves away from the US dollar. Does it mean that there is an imminent liquidation of their US dollar reserves? Well, this is not the first time they murmured about it and it is definitely not in their (including the Federal Reserve?s) interest to see a collapse of the US dollar. The Chinese, with their US$1 trillion of reserves, would not want to see their stockpile of US dollars to lose significant value. The same goes for the Japanese and the oil-rich Middle-Eastern nations. The US too, would not want to see their dollar collapse as that would result in soaring inflation in their homeland. Therefore, we do not expect mass selling of US currency reserves by central bankers in the near term.

On the other hand, it is open knowledge that the status quo is unsustainable. This morning, we heard that Alan Greenspan (the former US head of Federal Reserve) warned investors in a business conference in Tel Aviv to expect a few years of dollar weakness. He further said that is imprudent to hold everything in one currency. This prompted a further slide of the US dollar against the Euro. The US has the dubious honour of having the world?s greatest trade deficit. If not for the fact that the US dollar is (maybe ?was? is the more appropriate word) the world?s reserve currency, the US would be consigned a banana republic long ago. The world cannot lend to the US indefinitely. Sooner or later, they will demand a pay back. The moment they decide that the US will not and is unable to repay its debt, what will happen to the US dollar? What will happen to the global financial system when that happens?

Thus, this situation is akin to an individual owning the bank money. If he owes the bank a million dollars, he is in trouble. But if he owes the bank a billion dollars, the bank is in trouble?if he goes bankrupt, a large portion of bank?s loan portfolio will be wiped out, rendering the bank insolvent. The US owes the rest of the world so much money that they cannot afford to let the US go ?bankrupt.? But the rest of the world knows that sooner or later, the US will go ?bankrupt.? (Of course, a country cannot be bankrupt in the same way as individuals do because there is always the option to print money to remain solvent. But the end result will be just as horrible?hyperinflation.) What can be done?

We are all living in a precarious situation. We shudder to think of the day when a black swan event happens. On that day, whoever owns gold will have a lot of friends.