Up and Down Wall Street


Is Bad News Still Good News for Gold?


Despite Wednesday's dip and deflationary debt fears, central-bank money printing likely means continued loss of value of paper currencies vs. the metal.


"More than at any other time in history, mankind faces a crossroads. One path leads to despair and utter hopelessness. The other, to total extinction. Let us pray we have the wisdom to choose wisely."

Woody Allen's conundrum aptly describes the effects of the fiscal crises faced by governments all over the globe on the price of gold. History shows bankrupt governments will clip coins or print money to cover their debts, which is why gold has served as a store of value for centuries. But recent crises have been different; gold's value has made it an asset that can readily be sold to meet liquidity needs.

So, while gold prices typically rise in troubled times, they have plunged in recent years whenever market risks mounted, notably plunging 25% during the 2008 financial crisis.

Now, two economists who are both concerned about the fiscal crises on either side of the Atlantic come to diametrically opposite conclusions about what they mean for the price of gold.

Not to keep you in suspense, Leigh Skene of Lombard Street Research thinks the European debt set off a serious chain of defaults, which makes deflation inevitable and will send the dollar soaring and gold plunging. By contrast, John L. Williams, who heads Shadow Government Statistics, thinks that beyond the fiscal cliff lies the U.S. government's insolvency, which will set off a run on the dollar that will result in hyperinflation and launch gold into the stratosphere.

In other words, a choice between despair and utter hopelessness or total extinction.

"The European crisis makes gold's near-term prospects poor," LSR's Skene writes. "It will cause a serious rash of defaults, some of which will be too-big-to-bail-out.

Global bad debt could total 10 times as much as the now swollen central bank balance sheets, so defaults will swamp governments and central banks, so deflation is the only possible outcome. Real interest rates and the dollar's foreign exchange price will soar.

Low-to-negative real interest rates and a weak U.S. dollar caused the explosive rise in the price of gold. Their reversal will weaken it. Silver's price is more volatile than gold's, so [it] will fall further from current levels."

Gold's longer-term prospects, Skene continues, will depend on the public's desire for stable currencies through a return to the gold standard in reaction to central banks' poor performance over the past century. Based on numerous assumptions that the dollar's link to gold would be restored over the next decade, he comes up with a gold price of $2,170 an ounce.

"This is not a forecast," Skene emphasizes. The numerous assumptions that go into his calculation -- the ratio of gold to the U.S. money supply, the rate of deflation, how long it takes to reestablish the gold standard plus the discount rate applied during the period leading up to monetization of gold -- all affect that price. He reckons the return from gold would be about 10% per annum leading up to monetization, but the probability of monetization is the main determinant of future gold prices. All of which are unknowable.

Williams, by contrast, sees the dollar collapsing as international investors abandon the greenback as the global financial system's main reserve currency and transaction medium because of the insolvency of the U.S. government, which he predicts will become apparent by 2014.

Beyond the brouhaha over the fiscal cliff, he asserts the federal government has been running deficits that would total $5 trillion a year if measured by generally accepted accounting principles. The present value of federal-government obligations -- including the promises to pay entitlements such as Social Security and Medicare -- totals some $90 trillion, Williams calculates. That is close to the $87 trillion indebtedness cited by former Securities and Exchange Chairman Christopher Cox and former House Ways & Means Committee Chairman Bill Archer in their recent Wall Street Journal op-ed article calling for Congressional action to address these liabilities that are ignored in the fiscal-cliff discussions.

Williams, for his part, is pessimistic anything can be done after the U.S. government has lived beyond its means for so many years. "No amount of spending cuts, outside of the politically untouchable social programs, and no amount of tax increases, can bring the GAAP-based annual U.S. budget deficit into balance," he writes.

The inevitable result is for debt monetization -- that is, for the Federal Reserve to print money to cover the deficits -- according to Williams. That has been the remedy of kings from ancient times to cover the gap between what they wanted to spend and the taxes they could exact from their subjects; they clipped the coins to expand the supply of money, with hyperinflation the inevitable result.

That, in essence, is what Williams expects. And the Fed so far has financed much of the federal deficit with its so-called quantitative easing -- the purchase of securities to expand the U.S. money supply. That has absorbed the lion's share of the supply of new Treasury securities, although under so-called QE3 the Fed has committed to purchasing $40 billion of agency mortgage-backed securities per month.

The central-bank's net holdings of Treasuries hasn't expanded significantly under its current maturity-extension program, aka Operation Twist, which involves the purchase of longer-term notes and bonds, offset by the sale of shorter-dated securities, which is supposed to wind down by year-end. Wednesday, the Wall Street Journal reported the central bank is likely to approve the continued purchase of Treasuries -- without any offsetting sales -- at its next meeting scheduled for Dec. 11-12. Once again, there was no attribution to any source for the information; such stories don't get into print unless it's the straight dope from the top.

For now, global investors are unconcerned about Washington's fiscal plight. That was evident from Tuesday's auction of two-year notes, in which the Treasury received $4 of bids for every $1 of securities being offered.

Indeed, a plunge over the fiscal cliff would likely set off a market crisis that would spur a flight to quality -- into U.S. Treasury securities and the dollar -- just as after Standard & Poor's stripped Uncle Sam of his triple-A credit rating. Treasury securities yields fell to record lows subsequently and are still substantially lower in the wake of the downgrade.

Williams doubts this can go on forever. At some point -- he says by 2014 -- investors will cease to accept as their primary liquid asset the ever-growing stock of U.S. debt and by extension the dollar. The flight from the greenback will spark hyperinflation, as has been the case through history in banana republics or Weimar Germany.

So, who's right? Does the insolvency of European governments cause deflation, which sends the dollar soaring and gold plunging? Or does the insolvency of the U.S. government cause a collapse in the dollar and hyperinflation?

Probably both and neither. European governments and international institutions are likely to connive in any way possible to avoid the defaults and the resulting deflation from Europe. The most expedient way is for the European Central Bank to buy the bonds of the heavily indebted economies of Spain and Italy. That would both finance their deficits and lower the value of the euro, which would boost the competitiveness of the peripheral economies of the euro zone.

Does this violate every precept of the founding of the single currency? Of course it does and Germany will object vociferously.

But ECB President Mario Draghi has pledged to do whatever it takes to save the euro. Since he made that pledge last July, that in itself has restored confidence. The ECB can only buy bonds when a government accedes to harsh conditions, which none has had to do. So far, Draghi's mere declaration has lowered the funding costs for Italy and Spain, but actions may eventually needed to back up his words.

Meanwhile, the Fed has effectively inaugurated QE infinity, buying securities until unemployment is brought down to some satisfactory level. So, the U.S. central bank will be churning out greenbacks, which will effectively fund the federal budget deficit. In addition, the Bank of Japan is being urged to engage in quantitative easing until deflation turns into inflation by the leader of the opposition Liberal Democratic Party, which is likely to regain power in elections next month.

Bottom line: every major central bank around the globe is likely to continue printing money to stave off any deflationary undertow induced by the massive debt of their governments. Notwithstanding short-term sell-offs such as Wednesday's $25 drop, central-bank policies should keep interest rates near zero and negative in real terms, which in turn ought to keep gold in its long-term uptrend. As long as authorities try to do whatever it takes to hold the system of fiat currencies and indebted governments from flying apart, paper money will continue to lose value relative to the traditional store of value, gold.

Copyright 2011 Dow Jones & Company, Inc. All Rights Reserved

Egypt: loud, messy and in charge of its destiny

Mohamed El-Erian

November 29, 2012


President Morsi’s decree granting him more power has acted as a catalyst for widespread protests in Egypt and a rupture in relations between the executive and judicial branches of government. It has also placed Egypt’s allies in an awkward position. The renewed turmoil will also inevitably raise questions about the recent agreement with the International Monetary Fund, which many view as essential for the economy’s wellbeing.

Egypt has turned to the IMF not out of choice but of necessity. Its economy is yet to gain proper momentum. Unemployment is too high, especially among the young.

Foreign exchange reserves have stabilised but show little sign of returning to prior levels. The budget deficit is under pressure.

Local interest rates have risen. And foreign investors remain hesitant, adding to the financial rationing that is holding back the private sector’s considerable potential.

The political and social implications of Mr Morsi’s decision are potentially profound. Most importantly, the current situation impedes progress towards the important goal of the grassroots uprising of January 2011: to deliver greater social justice and broad-based economic improvement, as well as reorient institutions towards the common good and away from benefiting deeply-entrenched minority interests.

A derailment of the IMF’s support for Egypt would add to the country’s challenges. This institution is the only creditor able and willing to provide Egypt with fast, low cost financing. Its involvement would facilitate $10bn from other creditors, as well as the reported $4.8bn from the fund itself. The institution’s technocrats can support Egypt in the implementation of its own reform programme via a coherent economic framework.

Getting broad-based local support for the IMF’s involvement was never going to be easy. Some Egyptians still view the institution as an arm of western domination. Many have no desire to return to the days of external dependency. And most worry that the fund’s involvement would complicate already-delicate measures to reform Egypt’s subsidy system and its bloated public sector.

Mobilising external support for a fund programme is also complex. With its involvement in Europe over the last three years, the IMF has sent confusing signals about programme standards, funding levels and the application of conditionality. Some countries expect the IMF to apply the same leniency to Egypt. Others worry that this would constitute yet another step down a very slippery slope.

For now these issues have been crowded out by the political turmoil. But they will soon return.

Once the country regains its footing, which will probably involve Mr Morsi rescinding parts of the recent decree, the government and the IMF will need to move quickly to anchor the agreement aimed at stabilising the country’s immediate economic situation and providing the basis for meeting the medium-term objectives of the revolution.

To this end, the IMF needs to be open and explicit about the trade-offs involved as Egypt attempts to move from a horrid past to a better and more inclusive future. For its part, the government will need to engage in broad discussions on any IMF programme.

This would inevitably involve lots of noise. Yet this is Egypt’s new reality. And fundamentally it is not such a bad one.

For the first time in a very long time, average Egyptians feel empowered and able to influence the destiny of a country that they now own. To outsiders, this comes across as loud and messy. And it is. But it is also an indication of Egypt’s new checks and balances and, more broadly, its bumpy journey towards a vibrant democracy.

Proper engagement with the IMF on an Egyptian-owned program could help the country progress on this important path. In turn, this would increase the likelihood that the Fund would go from being seen as an instrument of western colonialism to a supporter of Egyptians legitimately seeking greater social justice, inclusive growth and fairness.


2013 Bond Market Forecast: Is the Bond Bubble Finally About to Burst?

November 30, 2012

[Editor's Note: Here's a question that has vexed investors for years now. Everyone says rates have nowhere to go but up and all they have done is fall. According to Shah, this actually could be the year the bond bubble bursts.]

By Shah Gilani, Capital Wave Strategist, Money Morning

The Federal Reserve's multi-year prescription of targeting super-low interest rates on federal funds, along with various quantitative easing programs, has pushed yields down on all fixed-income instruments to the benefit of issuers and the detriment of investors.

There is little doubt that the Fed's articulated and executed policies have resulted in a bond-bubble with both short and long-term consequences for investors and the economy.


At some point the bond-bubble will burst. But there is no certainty on when that will happen or what ultimately will cause rates to rise.

What investors need to understand is that while yields and bond prices in 2013 could remain flat relative to closing third quarter 2012 measures, yields are unlikely to fall further and prices are unlikely to rally in 2013, with the possible exception of short-term U.S. treasuries.

However, there is the possibility of what I'm calling a "skyfall."

For fixed-income investors this means there is a chance the bond bubble may finally burst.

2013 Bond Market Forecast: From Flat to Skyfall?


Skyfall is the title of the latest James Bond film, which viewers discover is also the name of Bond's childhood home in Scotland, before it is blown apart in the movie's climactic finish.

Now, because interest rates across the board have fallen to historically low levels, the great bond rally could suffer a similar climax.
Here's where we stand now, why the bond rally is likely over, what could happen in 2013, and what early warning signals to watch for to get out of the way of this skyfall.

As yield-hungry investors have plowed more and more money into bond mutual funds, bond ETFs, and, for institutions, individual bonds, issuers from sovereigns to junk dealers have rushed to the market to soak up the trillions of dollars searching for yield.
That circuitous path has kept money flowing into bonds in search of falling yields as issuers take advantage of low rates artificially manipulated by the Fed's actions.

All dollar-denominated bonds issued in the United States (and many issues globally) are priced off the U.S. Treasury yield curve.

That's the scale of interest rates that starts with the federal funds rate (even though the Fed doesn't issue fed funds) and displays the interest rates payable on Treasury bills, notes and bonds, up to and including the most actively watched, traded and talked about 10-year T-bond, all the way to the 30-year T-bond.
Treasury issues are considered "risk-free" because they are backed by the full faith and
credit of the U.S. to pay all interest and principal on its debts.

All other bonds yield more (pay more interest) than equivalent-maturity Treasury issues to reflect the difference in "quality" between a Treasury issue and a municipal, corporate, or other bond issue.

The difference between what a Treasury's yield is for a particular maturity bill, note or bond and what the yield is on another issue is called the "spread."

The spread refers to the additional yield (the difference in the interest rate) issuers have to pay to attract investors who otherwise might opt for the safety of Treasuries.

As interest rates have been kept artificially low, investors looking for additional yield above exceptionally low-yielding Treasuries have been increasingly willing to accept smaller and smaller "spreads" when they buy bonds that aren't risk-free.

Issuers recognize investor demand for yield and know investors will still buy their bonds even as they offer less and less interest, because whatever yield advantage investors can get, they will gladly take.


As a result, the spread over Treasuries has come down for all issuers from top-rated investment grade issuers to leverage bond and junk issuers.

In other words, investors are not being adequately compensated for the increasing risk they are taking with issuers, who range from investment-grade corporations to special-purpose vehicles issuing junk bonds for leveraged and speculative endeavors.

The Fed's recent announcement that they will buy $40 billion per month of top-rated agency paper (mostly mortgage-backed-securities), only takes even more U.S. government-backed paper out of the market, leaving investors clamoring even more for whatever investment-grade ("IG") bonds they can get. That's a further boon to bond issuers.

In fact, in just the third quarter of 2012 (the latest quarter for which data is available) IG issuance, excluding sovereign, supranational, split-rated and preferred-stock issues, exceeded $215 billion -- a near record.


But that's IG. What's more telling, and evidence of how much investors are reaching for yield further out on the risk spectrum, is what third-quarter issuance was in the leverage and high-yield (junk) markets.

Leverage loans are loans and bond issues backing loans to corporations, companies and other issuers that already have high leverage on the debt side of their capital structure. High yield, also known as junk bonds, are debt issues offered by the most speculative issuers seeking debt financing.

Leverage bond issuance totaled $114 billion in Q3, a record, which included a constituent record $20 billion issued in August, historically the year's slowest month.

At the current pace, with $317 billion already issued year to date, leverage loans are on track to reach $423 billion, or exceed $508 billion if September's $63.5 billion pace continues.


And while the leverage loan market has been flush, the high-yield market has been doing its own hot issuance thing.

Bond-clearing yields fell in the third quarter to all-time lows, even though spreads are still above record lows. High-yield issuance in the third quarter was $91.9 billion, the second highest on record. The highest quarter ever was this year's first quarter at $99.9 billion. Full-year 2012 junk issuance is closing in on the record $287 billion issued in 2010, and likely to exceed it.


Combined leverage and HY issuance in all of 2012 is expected to exceed $748 billion, topping the former record of $679 billion reached in 2007.


We Know What Happened Next....


With rates so low and investor appetites still high, we're seeing more and more "covenant-lite" deals, the ones that afford more protections to issuers than to investors.

Investors need to look through the froth in the bond market and realize that a lot of bonds are issued with call features and are in such demand that they are trading at premiums to par value, or what will be returned at maturity.

It's imperative that investors realize that coupons, or the interest rate that a bond comes to market with, is different than what you will get on a yield-to-maturity basis if you pay a premium, or especially if you pay a premium and the bond is called long before you expect to have held it.

With prices so high and yields so low, all relative to the risk of holding bonds in a bubble-like market, investors need to have an exceptionally strong stomach to wade into the bond market now or in 2013.



Investors also need to beware of false rallies.

The risk-off trade, where equity investors flee to the safety of Treasuries, could make Treasury prices rise and bonds look like a safe haven. They could be, for a while.

Then there's the outside threat of inflation that would cause rates to rise and bond prices to plummet. Or the move to the risk-on trade, which would signal that equity investments are preferred to the low-yielding safety of bonds, which could decimate bond prices.

Or there's the chance that the economy double-dips in 2013, putting pressure on leverage loan and high-yield issuers to make interest payments at the same time that investors flee their bonds and raise capital structure costs for them.

I'll be watching the derivatives markets, namely the credit default swap indexes like CDX-IG-19 to see if default insurance costs start rising, by how much, how fast, and on which indexes.

I'll leave a light on for you, and shout out loud here and in my services if the bond vigilantes start gathering at the end of town.