The Meaning of Gold's Plummet
Rapidly expanding central-bank balance sheets threaten the global economy.
In finance, “R-squared” measures the correlation between the movements of two things. Their movements are perfectly correlated if their R-squared is 100 percent; they are uncorrelated if their R-squared approaches zero percent.
The relationship between the increase in the price of gold and the growth of the central bank balance sheets of the United States, the European Union and Japan had an R-squared of approximately 95 percent over the last thirteen years. In the real world, it’s hard to find higher correlation factors than that. As the big Western central banks have increased their purchases of bonds, mortgage-backed securities and other “assets” with newly created fiat money, the nominal price of gold has increased in lock step. Indeed, for every trillion dollars of collective central-bank balance-sheet growth (and concomitant fiat-money printing), gold has increased by $210 per troy ounce.
But then came Mario Draghi. On the morning of Friday, April 12, the European Central Bank president put a financial gun to Cyprus’s head, essentially telling that small, bankrupt Mediterranean island nation to sell its gold reserves (nearly fourteen metric tonnes, worth about half a billion U.S. dollars) or the previously promised bailout money just might not be advanced. The brief statement by “Super Mario”—as Draghi, the Ben Bernanke of Europe, is often called (sometimes admiringly and sometimes derisively, depending on the politics of the writer)—ratcheted down the previously uncanny correlation between gold and the central banks’ collective balance sheet. Within minutes of Mr. Draghi’s statement, the COMEX June contract for bullion dropped by $50 per troy ounce. By the end of the day, after continuous waves of selling, June COMEX gold was down $84, to $1,475.
Why would the potential sale of fourteen tonnes of gold cause the nominal price of gold to drop by more than 5 percent? After all, this represented less than one one hundredth of 1 percent of all the world stock of the yellow metal, which amounts to 165,000 tonnes. The answer is that the market is concerned that what Draghi told Cyprus, he will tell Spain, Italy, France and all other debt-challenged EU members. Together, those countries hold thousands of tonnes of gold.
Of course, Draghi cost Cyprus a significant amount of money, at the very moment it needs every euro it can find. Fourteen tonnes of gold, or 450,000 ounces, were worth nearly $38 million more before Draghi opened his mouth. He could have avoided a public statement and issued his “request” directly to Cyprus, allowing Cyprus to arrange for a private sale at a higher price. China, Russia and Turkey, among many other nations, have been increasing their gold holdings for several years and likely would have been in the market for Cyprus’s bullion. Now Cyprus faces a falling market—and one that will become weaker when Cyprus attempts to sell its gold.
But Draghi is not concerned about Cyprus. Like his fellow central bankers, he is concerned about fiat money and sovereign-bond rates. Their fear is that markets will begin to realize that the emperors of fiat funds (the Federal Reserve and the Bank of Japan, along with the European Central Bank) have no clothes, meaning that there is no way for them to “reel back in” the trillions of currency units they continue to print, in order to finance unprecedented and ever-increasing national budget deficits. If it is seen that the emperors really have no clothes, then major currencies will be dumped, and interest rates will increase rapidly.
Consider the United States. The Federal Reserve is monetizing $85 billion per month (more than a trillion dollars per year) in U.S. Treasury debt and mortgage-backed securities. In effect, the Federal Reserve is purchasing 60 percent of all newly issued Treasuries and essentially all of the mortgages written to finance the latest housing “boomlet.”
As a result of these purchases, with dollars derived essentially out of thin air, interest rates remain at historic lows. In FY 2012, the average interest rate paid on all outstanding Treasury debt was 2.1 percent.
Even at that low rate, the lowest ever for any extended period, the Treasury’s debt service for FY 2012 was $432 billion.
If the Fed ceased its “quantitative easing,” who would purchase the more than $540 billion in new Treasury debt currently being purchased by the central bank, at the rate of $45 billion per month? No one, at least not at an average rate of 2.1 percent. As recently as 2002, the average interest rate on Treasury debt exceeded 5 percent. That is 2 ½ times the current rate. If rates simply returned to that level, the interest incurred on the national debt would exceed a trillion dollars annually. That would necessitate cuts in spending equal to more than twelve times this year’s dreaded “Sequester.”
Obviously, the Fed cannot cease its easing. Indeed, it will have to increase the size of its monetization programs, because Japan has just leapfrogged the Fed. The Bank of Japan (BOJ), under its new governor, Haruhiko Kuroda, just announced that it will purchase 7.5 trillion yen (that’s $US 75 billion) per month in Japanese government bonds. Yes, $75 billion is less than the Fed’s $85 billion, but Japan’s GDP is only a third the size of the U.S. GDP. So the BOJ’s monetization program is much more aggressive than even Ben Bernanke’s. In fact, the BOJ’s actions will double that nation’s monetary base over the next two years. How do you spell “inflation” in Japanese? Perhaps “G-O-L-D.”
From the point of view of rational finance, meaning market-based decision making, there is at least one glimmer of sanity emerging as a result of the BOJ’s actions. Instead of boosting the price of Japanese government bonds, as would be expected when the BOJ prints trillions of yen and purchases bonds, thereby increasing the demand for such securities, the BOJ’s massive bond buying program has caused the bonds’ prices to plummet. It seems that investors realize that all of those yen being printed will reduce the purchasing power of each yen they already own. So they are abandoning Japanese government bonds, and yen, to seek safety elsewhere, including the U.S. stock market, which just hit a new high (in nominal dollars).
Will investors realize that U.S. Treasuries are no better than the Japanese bonds that they are fleeing? If so, we might witness the bursting of the largest financial bubble in world history, the collapse of the Treasury market, followed by the hyperinflation of the dollar to “pay off” all of the debt that no longer can be serviced.
Jay Zawatsky is the CEO of havePower, LLC (a natural gas infrastructure developer) and a professor of business, economics, and finance at Montgomery College in Rockville, Maryland.