Europe’s 'recovery’ is a conjuring trick

The eurozone has had a good year – on paper. But it is crippled by too much debt to survive intact, says Jeff Randall

By Jeff Randall

8:15PM BST 28 Jul 2013

Photo: EPA

This week, British people engage with their European neighbours in greater numbers than at any other time of the year. With the school holidays underway, they charge off to France, Spain, Greece and Portugal in search of better weather, cheaper drink and the je ne sais quoi of continental living.

For most, soaking up the sun and gulping down Sancerre, much will seem the same as last summer. Behind the scenes, however, financial markets in the Club Med countries are very different compared with 12 months ago, when the eurozone’s straitjacket appeared to be splitting.
Share prices in particular have enjoyed a remarkable resurgence. Stock market indices in Portugal, France and Spain are up by about 30 per cent. That’s pretty impressive for economies running on empty but is completely outshone by Greece, where the main index is now 64 per cent higher than in June 2012. If that sounds too good to be true, remember that at its current level of 294, the Athex 20 is still 85 per cent lower than its high point of 2008.

None the less, there’s a temptation to look at the direction of travel and conclude that, even for the eurozone’s weaklings, the point of maximum danger is history. This is what EU leaders and the European Central Bank would like us to believe, because it fits their broader narrative: the single currency works, is sustainable and benefits all in the long run.
At the core of this “recovery” is a bluff that has yet to be called. In August last year, the European Central Bank’s president, Mario Draghi, promised to dowhatever it takes” to defend the euro through the unlimited purchase of bonds issued by troubled EU states. It was high-quality legerdemain. Presented with the perceived safety net of a one-way bet, private investors returned to buying sovereign debt and company shares in the EU’s angst-ridden periphery.
Not since the Wizard of Oz has an illusionist created so much fuss with so little substance. Without spending a single cent, Draghi conjured up a fall in borrowing costs and a rise in stock markets.

What’s more, consumer confidence improved in the EU’s more solvent regions, albeit from a woefully low base. The killer question now is: how long can the magician keep the trick going? Or, as Toto did in the movie with Judy Garland, will the curtain be pulled back to reveal nothing more tan bluster behind a screen of smoke and noise?
The answer will not be known until after September 22, when the Germans go to the polls. Angela Merkel has played a blinder in simultaneously helping to shore up the eurozone’s balance sheet while persuading domestic supporters that Germany’s chequebook is now closed to those seeking credit extensions on easier terms. If, as seems likely, the German chancellor is re-elected, she will return to a series of horror shows that have been masked but not mastered. There are too many fundamental flaws inside the eurozone for crisis deferral to be a permanent policy.

Debt, far too much of it, is still the cancer in the system. In Portugal, it is heading for 130 per cent of national output.

Voters there are dizzy with austerity fatigue. The government in Lisbon staggers along with barely a mandate, trying desperately to keep the country’s 78 billion euro bail-out programme on track. Next door in Spain, the national mood, already grim, darkened further last week after the train disaster in Galicia.

Unemployment fell from 27 per cent to 26 per cent, but only thanks to temporary tourism jobs. Come September, many of them will vanish.

In Greece, where universal taxes remain an abstract concept, George Papaconstantinou, the country’s former finance minister (2009-11), is to be put on trial for abuse of office. He was part of a team that negotiated a 110 billion euro bailout from the EU and International Monetary Fund in 2010. That vast sum already looks far too little. Greece’s financial position is terminal. It cannot hope to save, invest and grow its way out of trouble while repaying all its creditors in full. The numbers don’t add up.

Greece needs a wholesale restructuring of national debt, including a haircut for its sovereign lenders — that means Germany, which is stuffed with Greek IOUs. Hitherto, German taxpayers have reluctantly granted loans and guarantees, but they have been told to expect all their money back. That is not going to happen.

Mrs Merkel has two options: allow Greece to collapse or admit that, if the eurozone is not to disintegrate, Germany’s next growth sector will be charitable donations. But where does Berlin draw the line? When you set up a soup kitchen, there is no way of knowing how long the queues will be.

Italy’s debt, like Portugal’s, is about 130 per cent of GDP; its credit rating was downgraded this month and the economy continues to shrink, prompting fears that several Italian banks are heading for zombie status.

Finally, there is France, capital of euro-delusion. President Hollande recently declared, “recovery is there”. With unemployment at 11 per cent and a looming pensions deficit of 20 billion euros, it needs to be. The gods, however, have not been kind.

Last week, freak hailstorms smashed through Burgundy, destroying some of its best-known vineyards and at least four million bottles of decent wine. How long before the eurozone’s financial markets suffer something similar, as disbelief returns from its 12-month suspension?

''Jeff Randall Live’’ is broadcast Monday-Thursday at 7pm on Sky News

miércoles, julio 31, 2013



Gold Backwardation Explained


July 29, 2013

In an interview on July 8th in King World News I noted how gold that day had slipped into backwardation. Since then I have read a lot of commentary on various websites about backwardation, which made clear to me that this term and, more importantly, the implications to the gold price when backwardation appears are widely misunderstood.

So I have prepared this brief note to explain backwardation, of which there are two typesmoney backwardation and commodity backwardation, and as I explain below, both apply to gold.

The following table presents the dollar’s exchange rate against the euro and British pound for different time periods ranging from spot to one year in the future. These future prices in the over-the-counter market are calledforwards”. These prices were taken from the July 26th Financial Times.

Note how the euro’s exchange rate to the dollar rises going further into the future, climbing from a spot rate of $1.3265 to a forward rate of $1.3290. In contrast, the pound’s exchange rate to the dollar falls over this same time period. Why is that?

There is only one reasoninterest rates. The euro’s interest rates over this period are less than the dollar’s interest rates, so the euro is in a state called contango against the US dollar. In contrast, the British pound’s interest rates over this same period are higher than those of the dollar, so the pound is in backwardation against the dollar.

Thus, backwardation and contango are a mathematical result that reflects the cost of money (sometimes called the “cost of carry” or the “time value of money”), as measured by the interest rates of one currency relative to another. But this observation leads to a bigger and more important question that needs to be answered. Why are euro interest rates less than those of the dollar, while pound interest rates are higher than both of these currencies?

Again, the answer is straightforward. Interest rates are a reflection of risk. The interest rate structure in the above table implies that the pound has a higher interest rate because it is more likely to be debased by government and central bank policy (i.e., lose purchasing power) than the dollar, which itself is more likely to be debased than the euro. Carrying this concept one step further, the pound is in contango (as are the dollar and euro) against the Indian rupee and South African rand for example, both of which have higher interest rates than the pound because they have a greater risk of being debased by government and central bank mismanagement.

However, the interest rates of all national currencies need to be viewed cautiously. As Chris Powell of famously declared in 2008: “There are no markets anymore, just interventions.” So rather than being a reflection of true market conditions, interest rates today result from heavy-handed central bank manipulations, thwarting real and accurate price discovery by the market.

Central banks, however, can only push so far before market forces prevail, a limitation often described as “pushing on a string”, which explains why the rupee and rand interest rates remain relatively high. If those countries’ central banks tried to lower interest rates, holders would sell the currency causing its exchange rate to drop because at lower interest rates the risk of holding those currencies would be perceived as being too great relative to other opportunities to place one’s liquid capital (i.e., their money). Thus, there are limits to what central bank intervention can accomplish, or in other words, the body of people we call the “marketstands as a guardian that carefully watches central bank tinkering and responds to it by moving their money around to better suit their risk preferences.

Importantly, market forces overpowering central bank manipulation can explain what is now happening in gold. The US government does not want gold to go into backwardation because it means that people would rather hold physical gold than dollars, which undermines the power that comes with being the world’s reserve currency. But as we can see in the following table that presents the US dollar spot gold Price and forwards against gold, market forces are prevailing to some extent over the Federal Reserve’s attempts to control interest rates.

Like the euro, pound, dollar and all the other national currencies, gold has an interest rate (usually referred to as “GOFO”) at which it is borrowed or loaned. Gold has an interest rate because it is money, which is a statement that may surprise some people. But gold did not stop being money after 5,000 years just because in 1971 governments, central bankers and some economists said so. The best this group could do was confuse, obfuscate and mislead to perpetuate their myth that gold had been demonetised. As a result, central bankers today call gold’s interest rate by a politically correct term, its “lease rate”.

Nevertheless, a new name does not change the underlying principle involved. So gold’s interest rates can be used to calculate its forwards, which in the above table are presented against the US dollar because most gold activity occurs in dollars. The interest rates I used to calculate these forwards are reported by the LBMA.

We can see that gold is in backwardation 30 days and 90 days forward, but in contango one year in the future. Also, the backwardation is deeper 30 days forward than for the 90-day period, but it is backwardation nonetheless. This means that gold’s interest rates for 30 and 90 days are higher than those of the dollar for these durations, which leads to one remaining question that needs to be answered.

Given that interest rates reflect the risk of debasement, and that physical gold cannot be debased as national currencies are debased by ‘printing too many of them, how can gold’s interest rate be higher than those of the dollar?

The answer is that it cannot, or at least not in a market unfettered by government intervention. Gold backwardation is an abnormal condition, but theory and practice are different things. It is extremely rare for gold to be in backwardation, but it does happen when governments intervene in the market process.

Gold is different from crude oil, soybeans and all other commodities, any and all of which can be – and frequently are – in backwardation. Gold has an interest rate. Lumber, sugar, corn and all other commodities do not. Their ‘cost of carry to determine their future price is based mainly on warehousing fees that need to be paid for their storage.

More to the point, gold is money because it is accumulated. Essentially all the gold mined throughout history exists in its aboveground stock, whereas commodities get consumed and disappear. They are not money, as I explain in The Aboveground Gold Stock: Its Importance and Its Size.

So while commodity backwardation is not a unique event, gold backwardation is rare. Even though gold backwardation cannot happen in theory, it does occur when government intervention loses its desired effect, meaning that market forces are overpowering government attempts at manipulation.

Until now gold backwardation has only happened two times since this bull market in gold began back in 1999, and each prior occurrence lasted only a few days. In both instances market forces briefly overpowered government interventions aimed at manipulating interest rates. So gold backwardation does occasionally occur in spite of government intervention because central banks cannotprintphysical gold to alleviate demand pressures.

Amazingly, gold has remained in backwardation against the dollar since my KWN interview. The duration of this backwardation is unprecedented in the 4+ decades that I have been following the gold market. Clearly, something noteworthy is happening, which I believe in turn is signalling that something significant may yet happen. An indication of what that event may be can be discerned from the definition of backwardation on the LBMA website:

Backwardation - A market situation where prices for future delivery are lower than the spot price, caused by shortage or tightness of supply.

Clearly, the LBMA is defining commodity backwardation, and not the backwardation that occurs between different monies as a result of interest rate differentials. But their definition can be applied to physical gold, which is both money and like commodities, a tangible asset. A “shortage or tightness of supply means that unless demand slackens or supply increases, the price must rise. Given the strong demand for physical gold at the moment, a decline in demand at current price levels seems unlikely.

In contrast to national currencies, the supply of which can be increased to any quantity by mere bookkeeping entries, physical gold comes from two sourcesnew mine production or the existing aboveground stock. But mine production is relatively fixed. As I explain in The Aboveground Gold Stock: Its Importance and Its Size, the aboveground stock of gold grows consistently year after year by 1.8% per annum, which is not rapid enough to satisfy current demand.

Consequently, the presentshortage or tightness of supply” of gold can only be relieved from its existing aboveground stock. The only way for that to happen is for the gold price to rise high enough to entice people to exchange their physical metal for dollars, which is what happened the last two times gold was backwardated.

In summary, when gold backwardated in 1999 and in 2008, it marked important lows and key turning points in the gold price, which thereafter began multi-year uptrends. I expect the same outcome to be repeated now given that gold is once again in backwardation.


July 28, 2013, 11:06 p.m. ET

Federal Reserve 'Doves' Beat 'Hawks' in Economic Prognosticating

Slow Growth, Low Inflation Give Yellen, Dudley Upper Hand on Forecasts


As the U.S. emerged from recession in the summer of 2009, Janet Yellen, then president of the Federal Reserve Bank of San Francisco, took a grim view of the economy's prospects. 

"I expect the pace of the recovery will be frustratingly slow," she said in a San Francisco speech. A month later, addressing fears that money flooding into the economy from the Federal Reserve would stoke inflation, Ms. Yellen said not to worry in a speech to Idaho bankers: High unemployment and the weak economy would tamp wages and prices. 

Others at the Fed spoke forcefully in the other direction. Unless the central bank reversed the easy money course, Philadelphia Fed President Charles Plosser warned in December 2009, "the inflation rate is likely to rise to levels that most would consider unacceptable."
Ms. Yellen was proved right.
Predicting the direction of the U.S. economy with precision is impossible. But the Fed must forecast growth, inflation and unemployment to guide its decisions on interest rates.

Central bank miscalculations—when the Fed pushed interest rates too low or too high—have historically turned problems into catastrophes, fueling the Great Depression, for example, and the wealth-eroding inflation of the 1970s. 

The Wall Street Journal examined more than 700 predictions made between 2009 and 2012 in speeches and congressional testimony by 14 Fed policy makers—and scored the predictions on growth, jobs and inflation.

Ranking the Fed Forecasters

Review the WSJ analysis and the actual forecasts of Fed officials.

The most accurate forecasts overall came from Ms. Yellen, now the Fed's vice chair. She was joined in the high scores by other Fed "doves," policy makers who wanted aggressively easy money policies to confront a weak U.S. economy and low inflation. Collectively, they supported Fed Chairmen Ben Bernanke's strategy to pump money into the U.S. economy.

The least accurate forecasts came from central bank "hawks," those who feared Fed policies would trigger rising inflation.

Examining such predictions is more than a parlor game. Fed forecasts are important now because the central bank is near a turning point that will have a substantial impact on the U.S. economy.

Fed officials are considering whether to scale back an $85-billion-a-month bond-buying program this year, a move that could pull stock prices down and send interest rates higher. 

If the Fed believes growth and hiring will pick up—and inflation will rise to a more normal 2%—the central bank will start to pull back on the purchases.
But if forecasts are wrongif the Fed overestimates the economy's strength and pulls back too soon, for example—then economic growth could falter, stalling an incipient housing recovery and fueling the jobless rate. 

"We should be keeping track of these forecasts and having some accountability," said Mark Gertler, a New York University economist who reviewed the Journal analysis.
Of course, forecasting ability doesn't always translate into wise central bank leadership. Arthur Burns, who led the Fed during the high inflation of the 1970s, was known for his forecasting prowess.

But New York Fed President William Dudley said forecasting errors have had serious consequences. "We were consistently too optimistic about growth over the 2009-2012 period," he said in a May speech. "As a result, with the benefit of hindsight, we did not provide enough stimulus."

Richard Fisher, the Dallas Fed president and another high scorer, took a different view. He has said slow growth was evidence the Fed's easy money medicine wasn't working and the economy needed less of it.

Who Has the Clearest Crystal Ball?

The Fed issues a quarterly forecast based on the views of its 12 regional Fed bank presidents and seven Fed governors. Over the past four years, these forecasts included errors, mostly from overestimating the economy's strength. None of the Fed forecast reports indicate who said what.

To evaluate the performance of individual Fed officials, the Journal looked at texts of speeches and congressional testimony. Forward-looking comments about the economy were rated for accuracy.

The Journal gave a mark ranging from -1.0far off the mark—to 1.0nearly perfectly correct—for each comment and averaged the total. A final score of zero showed someone was wrong as often as correct.

The analysis was shared with the Fed policy makers. Five of the 19 policy makers weren't ranked because they hadn't been at the Fed long enough or hadn't spoken publicly enough about the economy.
Ms. Yellen and Mr. Dudleyboth in Mr. Bernanke's inner circle—ranked first and second in the Journal analysis. Both predicted slow growth and low inflation over the past four years. Ms. Yellen had the highest overall score in the Journal's ranking, 0.52. Mr. Dudley scored 0.45.

The lowest scores were tallied by Mr. Plosser, -0.01; St. Louis Fed President James Bullard, 0.00; Richmond Fed President Jeffrey Lacker, 0.05, and Minneapolis Fed President Narayana Kocherlakota, 0.07.

Investors who closely follow every comment by Fed officials don't appear to distinguish policy makers by the accuracy of their economic forecasts.

Macroeconomic Advisers LLC, a research firm, determined Mr. Plosser, Mr. Bullard and Mr. Lacker consistently moved markets more than Ms. Yellen. Messrs. Plosser, Lacker and Bullard and Ms. Yellen declined to comment for this article.

Forecasts by Fed officials depend on their view of how the economy works. Ms. Yellen, for instance, places great weight on the role of economic slackhigh unemployment or idle factories—in driving inflation. Lots of slack, she has argued, holds down inflation. On the other hand, prices are more likely to rise when there are few available workers and factories are operating near capacity in this view.

"With slack likely to persist for years, it seems likely that core inflation will move even lower," Ms. Yellen said in September 2009. Her views warrant scrutiny because she is a candidate to succeed Mr. Bernanke when his term ends in January.

Mr. Dudley did especially well forecasting growth. Some Fed officials believed the current recovery would behave like past recoveries and the economy would, for a while, grow faster than its long-term trend of 3.2%.

But in May 2010, Mr. Dudley returned to his alma mater, New College of Florida, with a grim counter argument during a commencement address.

"The recovery is not likely to be as robust as we would like for several reasons," he said, pointing to the fragile banking system and the debt weighing down many households. He declined to comment for this article.

Other Fed officials, including Mr. Bernanke consistently predicted that faster growth was just around the corner.

"Although the pace of recovery has slowed in recent months and is likely to continue to be fairly modest in the near term, the preconditions for a pickup in growth next year remain in place," Mr. Bernanke said in October 2010, just before launching a bond-buying program. Growth slowed the following year.

Mr. Bernanke finished in the middle of the pack in the Journal's analysis, in part because he often relayed the consensus of Fed officials. He declined to comment for this article.

Luck also played a role in forecasts. In 2011, for instance, the economy looked like it was moving to faster growth when a tsunami struck Japan, disrupting the global economy.

The Fed's hawks had some of the worst forecasters. Mr. Plosser overestimated growth, while Mr. Bullard, Mr. Lacker and Mr. Kocherlakota warned of looming inflation. Their forecasts were wrong almost as often as they were correct.

While Ms. Yellen focused on the impact of slack on inflation, some hawks focused on money. The late Milton Friedman, the Nobel Prize-winning University of Chicago economist, said inflation was always and everywhere a byproduct of monetary policy: Prices only shoot higher when a central bank pumps too much money into the economy.

Hawks worried the Fed's decision to pump trillions of dollars into the U.S. financial system after the crisis would result in fast-rising prices. They sometimes couched their worries as risks, rather than predictions. In 2009, for instance, Mr. Bullard warned that the Fed's bond-buying programs had created a "medium-term inflation risk."

"The hawks have been issuing warnings, but there has been no sign of the things they've been warning against," said Martin Eichenbaum, an economist at Northwestern University and a Fed dove.

Mr. Kocherlakota of the Minneapolis Fed changed his hawkish views in 2012. "Inflation is not coming in as hot as I expected," he said in an interview last year. "You have to learn from the data."
He declined to comment for this article.

Mr. Bullard changed his focus at times. In 2010, and again more recently, he signaled concern about inflation getting too low. A St. Louis Fed spokeswoman said the Journal analysis failed to account for the role Mr. Bullard's warnings played in formulating policies that helped to prevent inflation from getting too high or too low.

Some of the Fed's best forecasts came from noneconomists, including Fed governor Elizabeth Duke and Atlanta Fed President Dennis Lockhartformer bankers—and Mr. Fisher, a former investment manager. Some of the Fed's most brilliant Ph.D.s, including Mr. Kocherlakota, generated the most subpar scores.

Economists generally rely on economic models based on past behavior. These models are used heavily by the staff at the Federal Reserve Board in Washington and at regional Fed banks. But the recession and the current recovery were unlike most past cycles.

"The models have been wrong," Mr. Bullard, one of the Fed's many Ph.D. economists, said in an interview with the Journal in November.

James Hamilton, an economist at the University of California at San Diego who also reviewed the Journal's analysis, warned against betting that the doves' recent winning streak would continue. 

"This was a period of subpar GDP growth and low inflation," he said. "Whether these same individuals would also prove to be better forecasters during a period of strong GDP growth and rising inflation is difficult to determine on the basis of the last four years."

One reason the hawks have been wrong about inflation is that the money the Fed has pumped into the financial system has tended to sit at banks without being lent to customers.

Economists say it is possible inflation can still catch fire if Banks lend more aggressively and money starts circulating more widely.

If that happens, Mr. Eichenbaum said, the hawks would be proven right and "everybody else is going to look real bad."
—Michael R. Crittenden contributed to this article. 

Copyright 2012 Dow Jones & Company, Inc. All Rights Reserved