The Next Minsky Moment

 

Minsky’s model of the credit system, which he dubbed the “financial instability hypothesis” (FIH), incorporated many ideas already circulated by John Stuart Mill, Alfred Marshall, Knut Wicksell and Irving Fisher. “A fundamental characteristic of our economy,” Minsky wrote in 1974, “is that the financial system swings between robustness and fragility, and these swings are an integral part of the process that generates business cycles.” [Wikipedia]

Minsky came to mind because in the past week I saw yet more signs that financial markets are overvalued and investors excessively optimistic. Yet I still haven’t seen many references to Minsky. That’s a little surprising.

On reflection, I realized I hadn’t mentioned Minsky lately, either. That is a potentially dangerous oversight, because we forget his fundamental insights at our peril. Last week’s brief technology tumble should have been a wake-up call. So today we’ll have a little Minsky refresher and look at some recent danger signs. And I predict that we will soon see Minsky mentions popping up everywhere.

Natural Instability

Hyman Minsky, who passed away in 1996, spent most of his academic career studying financial crises. He wanted to know what caused them and what triggered them. His research all led up to his Financial Instability Hypothesis. He thought crises had a lot to do with debt. Minsky wasn’t against all debt, though. He separated it into three categories.

The safest kind of debt Minsky called “hedge financing.” For example, a business borrows to increase production capacity and uses a reasonable part of its current cash flow to repay the interest and principal. The debt is not risk-free, but failures generally have only limited consequences.

Minsky’s second and riskier category is “speculative financing.” The difference between speculative and hedge debt is that the holder of speculative debt uses current cash flow to pay interest but assumes it will be able to roll over the principal and repay it later. Sometimes that works out. Borrowers can play the game for years and finally repay speculative debt. But it’s one of those arrangements that tends to work well until it doesn’t.

It’s the third kind of debt that Minsky said was most dangerous: Ponzi financing is where borrowers lack the cash flow to cover either interest or principal. Their plan, if you can call it that, is to flip the underlying asset at a higher price, repay the debt, and book a profit.

Ponzi financing can work. Sometimes people have good timing (or just good luck) and buy a leveraged asset before it tops out. The housing bull market of 2003–07, when people with almost no credit were buying and flipping houses and making money, attracted more and more people and created a soaring market. The phenomenon fed on itself. Bull markets in houses, stocks, or anything else can go higher and persist longer than we skeptics think is possible. That is what makes them so dangerous.

Minsky’s unique contribution here is the sequencing of events. Protracted stable periods where hedge financing works encourage both borrowers and lenders to take more risk. Eventually once-prudent practices give way to Ponzi schemes. At some point, asset values stop going up. They don’t have to fall, mind you, just stop rising.

 

That’s when crisis hits.

The Economist described this process well in a 2016 Minsky profile article.

Economies dominated by hedge financing – that is, those with strong cashflows and low debt levels – are the most stable. When speculative and, especially, Ponzi financing come to the fore, financial systems are more vulnerable. If asset values start to fall, either because of monetary tightening or some external shock, the most overstretched firms will be forced to sell their positions. This further undermines asset values, causing pain for even more firms. They could avoid this trouble by restricting themselves to hedge financing. But over time, particularly when the economy is in fine fettle, the temptation to take on debt is irresistible. When growth looks assured, why not borrow more? Banks add to the dynamic, lowering their credit standards the longer booms last. If defaults are minimal, why not lend more? Minsky’s conclusion was unsettling. Economic stability breeds instability. Periods of prosperity give way to financial fragility.

Minsky’s conclusions are indeed unsettling. He called into question the belief that markets, left to operate unimpeded, will deliver stability and prosperity to all. Minsky thought the opposite. Markets are not efficient at all, and the result is an occasional financial crisis.

Complacency in the midst of a wanton debt buildup was beautifully expressed in a remark by Citigroup Chairman Chuck Prince in 2007:

The Citigroup chief executive told the Financial Times that the party would end at some point, but there was so much liquidity it would not be disrupted by the turmoil in the US subprime mortgage market.

He denied that Citigroup, one of the biggest providers of finance to private equity deals, was pulling back.

“When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing.” [source]

Minsky wasn’t around to see the 2008 crisis that fit right into his theory. Paul McCulley attached Minsky’s name to it, though, and now we refer to these crises as “Minsky moments.”

Are we closing in on one now?

Learning the Rules

As I mentioned, technology stocks suffered from a little anxiety attack in the markets last week. It didn’t not last long and really wasn’t all that serious. (Yet.) It was nothing worse than what everyone called “normal volatility” ten years ago. But the lack of concern it generated this time is not bullish, in my view. More than a few investors seem to think that “nowhere but up” is somehow normal.

Doug Kass had similar thoughts (there’s that Zeitgeist trope thing again) and reminded us all of Bob Farrell’s famous Ten Rules of Investing. You could write a book about each one of them. I’ll just list them quickly, then apply some of them to our current situation. (Emphasis mine.)

1. Markets tend to return to the mean over time.

2. Excesses in one direction will lead to an opposite excess in the other direction.

3. There are no new eras – excesses are never permanent.

4. Exponential rapidly rising or falling markets usually go further than you think, but they do not correct by going sideways.

5. The public buys most at the top and the least at the bottom.

6. Fear and greed are stronger than long-term resolve.

7. Markets are strongest when they are broad and weakest when they narrow to a handful of blue-chip names. (Sound familiar? Can you say FAANGs?)

8. Bear markets have three stages: sharp down, reflexive rebound, and a drawn-out fundamental downtrend.

9. When all the experts and forecasts agree, something else is going to happen.

10. Bull markets are more fun than bear markets.

I think most of these rules are obvious to investors who experienced the 2008 mess, the dot-com crash, and (if you’re of a certain age) the 1987 Black Monday. Some of us can remember 1980 and ’82. ’82 was especially ugly. (I had just gotten my master of divinity degree, and all I knew was that the job market sucked.) Maybe we mostly forget these experiences, but hopefully we pick up a little wisdom along the way. The problem is that now a new generation of investors lacks this perspective. They had little or no stock exposure in 2008 and experienced the Great Recession as more of a job-loss or housing crisis than a stock market crisis.

Of course, the previous crises are no secret. People know about them, and on some level they know the bear will come prowling around again, eventually. But knowing history isn’t the same as living through it. Newer investors may not notice the signs of a top as readily as do investors who have seen those signs before – and who maybe got punished for ignoring them at the time.

Doug Kass notices. Here’s a bit from an e-mail conversation we had last week.

During the dot.com boom in 1997 to early 2000 there was the promise (and dream) of a new paradigm and concentration of performance in a select universe of stocks. The Nasdaq subsequently dropped by about 85% over the next few years.

I got to thinking how many conditions that existed back then exist today – most importantly, like in 1999, when there emerged the untimely notion of “The Long Boom” in Wired magazine. It was a new paradigm of a likely extended period of uninterrupted economic prosperity and became an accepted investment feature and concept in support of higher stock prices!

[JM note: Here’s the Wired article Doug mentions: “The Long Boom: A History of the Future, 1980-2020.”]

And in 2007 new-fangled financial weapons of mass destruction – such as subprime mortgages that were sliced and diced during a worldwide stretch for yield – were seen as safe by all but a few.

And, just like during those previous periods of speculative excesses, many of the same strategists, commentators, and money managers who failed to warn us then are now ignoring/dismissing (their favorite phrase is that the “macroeconomic backdrop is benign”) the large systemic risks that arguably have contributed to an overvalued and over-loved U.S. stock market.

Doug points especially to Farrell’s Rule 7, on market breadth. A rally led by a few intensely popular, must-own stocks is much less sustainable than one that lifts all boats. We see it right now in the swelling interest in FAANG (Facebook, Apple, Amazon, Netflix, Google). Tesla comes to mind, too. Their influence on the cap-weighted indexes is undeniably distorting the market. These situations rarely end well.

Chinese Minsky

What is behind these distortions? Ultimately, it’s about capital flows. Asset prices rise when demand outstrips supply, which is what happens when stocks or real estate or whatever are perceived as more rewarding than cash. Those with the most unwanted cash compete with each other to buy the alternatives.

The Fed and other developed-country central banks created a lot of liquidity in recent years, so that’s undoubtedly a factor. An even greater one may be China, though.

Consider China’s explosive growth. Its proximate cause is US demand and, to a lesser extent, European demand for Chinese exports. We sent them our dollars and euros; they sent us widgets and doodads. US dollars inside China are undesirable to wealthy Chinese and the Chinese government, so they send the dollars right back to us in exchange for other assets: homes, commercial real estate, stocks, Treasury bonds, entire companies.

Meanwhile, within China, the government aggressively encourages lending for projects a free economy would never produce. Let me make a critical point here: While the central bank of China is not doing much in the way of quantitative easing, the government’s use of bank lending gone wild is essentially the same thing. The banks have created multiple trillions of yuan every year for many years. If you add Chinese bank lending statistics to the quantitative easing statistics of the world’s major central banks, the number is staggering. I think it’s entirely appropriate to perform that calculation.

Beijing thinks this massive bank lending is useful in keeping the population happy, employed, and satisfied with their government. It has worked pretty well, too. It can’t work indefinitely, but the government seems bent on trying. Consider this June 14 Wall Street Journal report.

While Beijing is carrying out a high-profile campaign to reduce leverage in its financial markets with one hand, with the other it is encouraging more potentially reckless borrowing. This week, the regulator put pressure on the country’s big banks to lend more to small companies and farmers, while the government announced tax breaks for financial institutions that lend to rural households. That follows recent guidance that banks should set up “inclusive finance” units.

If the goal of lending to poorer customers sounds noble, the concern is that the execution will only worsen Chinese banks’ existing problems, namely high levels of bad loans and swaths of mispriced credit. Bank lending to small companies is already growing pretty fast, with non-trivial sums involved: It jumped 17% in the year through March to 27.8 trillion yuan ($4.084 trillion). That compares favorably with the 7% rise in loans to large- and medium-size companies over the same period.

Observers like me have been saying for years that China’s banking system is overleveraged and will eventually collapse. We’ve been wrong so far. Beijing’s central planners may be Communists, but they use the capitalist toolbox to their advantage.

 China will eventually face a reckoning. When it does, the impact will spread far outside China. What do you think will happen when Chinese money stops buying Vancouver real estate and US stocks? The outcome won’t be bullish.

The Swiss National Bank Is Doing What?

Pity the poor Swiss government. They have run their country well and don’t have a great deal of debt. They are a small country of just 8 million people, but they make an outsized impact on economics and finance and money.

Because Switzerland is considered a safe haven and a well-run country, many people would like to hold large amounts of their assets in the Swiss franc. Which makes the Swiss franc intolerably strong for Swiss businesses and citizens. So the Swiss National Bank (SNB) has to print a great deal of money and use nonconventional means to hold down the value of their currency. Their overnight repo rate is -0.75%. That’s right, they charge you a little less than 1% a year just for the pleasure of letting your cash sit in a Swiss bank deposit.

And the SNB is buying massive quantities of dollars and euros, paid for by printing hundreds of billions in Swiss francs. The SNB owns about $80 billion in US stocks today (June, 2017) and a guesstimated $20 billion or so in European stocks (which guess comes from my friend Grant Williams, so I will go with it).

They have bought roughly $17 billion worth of US stocks so far this year. They have no formula; they are just trying to manage their currency. Think about this for a moment: They have about $1000 in US stocks on their books for every man, woman, and child in Switzerland, not to mention who knows how much in other assorted assets, all in the effort to keep a lid on what is still one of the most expensive currencies in the world. I gasp at prices every time I go to Switzerland. (I will be in Lugano for the first time this fall.)

Switzerland is now the eighth-largest public holder of US stocks. It has got to be one of the largest holders of Apple (see below). What happens when there is a bear market? Who bears the losses? Print just more money to make up the difference on the balance sheet? Do we even care what the Swiss National Bank balance sheet looks like? More importantly, do they really care? We all remember European Central Bank President Mario Draghi’s famous remark, that he would do “whatever it takes” to defend the euro. We could hear the Swiss singing from the same hymnbook, by and by.

The point is that central banks and governments all the world are flooding the market with liquidity, which is showing up in the private asset markets, in stock and housing and real estate and bond prices, creating an unquenchable desire for what appear to be cheap but are actually overvalued assets – which is what creates a Minsky moment.

Now, remember what Minsky said. When an economy reaches the Ponzi-financing stage, it becomes extremely sensitive to asset prices. Any downturn or even an extended flat period can trigger a crisis.

While we have many domestic issues that could act as that trigger, I see a high likelihood that the next Minsky moment will propagate from China or Europe. All the necessary excesses and transmission channels are in place. The hard part, of course, is the timing. The Happy Daze can linger far longer than any of us anticipate. Then again, some seemingly insignificant event in Europe or China – an Austrian Archduke’s being assassinated, or what have you – can cause the world to unravel.

It’s a funny world. We have our rashes of zombie moves and 20 people in all corners of the planet inventing the same thing at the same time. And we have our central banks and governments exhibiting unmistakable herd behavior and continuing to do the same foolish things over and over. They never really intend to have the crisis that ensues.

Remember Farrell’s Rule 3: There are no new eras. The world changes, but danger remains. Gravity always wins eventually. It will win this time, too. And when it does, we will begin undergo the Great Reset.

It’s time to hit the send button. This week will be a full-on sprint to try to get everything done before we leave for the Virgin Islands on Saturday. You have a great week.

Your pondering the Great Reset analyst,

John Mauldin

Here Comes Quantitative Tightening

By: Peter Schiff


All of a sudden the Fed got a little tougher. Perhaps the success of the hit movie Wonder Woman has inspired Fed Chairwoman Janet Yellen to discard her prior timidity to show us how much monetary muscle she can flex when the time comes for action.

Although the Fed's decision this week to raise interest rates by 25 basis points was widely expected, the surprise came in how the medicine was administered. Most observers had expected a “dovish” hike in which a slight tightening would be accompanied by an abundance of caution, exhaustive analysis of downside risks, and assurances that the Fed would think twice before proceeding any farther. But that’s not what happened. Instead Yellen adopted what should be viewed as the most hawkish policy stance of her chairmanship.

The dovish expectations resulted from increasing acknowledgement that the economy remains stubbornly weak. Just like most of the years in this decade, 2017 kicked off with giddy hopes of three percent growth. But as has been the case consistently, those hopes were quickly dashed. First quarter GDP came in at just 1.2%. What's worse, second quarter estimates have been continuously reduced, offering no indication that a snap back is imminent. The very day of the Fed meeting, fresh retail sales and business inventory data surprised on the weak side, becoming just the latest in a series of bad data points (including figures on auto sales and manufacturing). By definition these reports should further depress GDP growth (much as widening trade deficits already have).

But despite all this Yellen came out swinging. And unlike prior policy statements that came after periods of economic disappointment, she didn’t even bother to argue that the current softness was transitory, or the result of “residual seasonality.” Instead she chose not to acknowledge any weakness at all, and kept to the tightening path that the Fed had mapped out last year. But she even went further than that.

For the first time, the Fed set into motion firm plans to reduce the size of its $4.5 trillion dollar “balance sheet.” Such a process has been talked about for years, but many were convinced, myself included, that it would always just be talk. The balance sheet consists of Treasury and mortgage-backed bonds that the Fed amassed during the experiment with quantitative easing between 2009 and 2014. During that time, the Fed injected liquidity into the financial markets by creating money to purchase more than $80 billion per month (at times) of such securities. These efforts pushed down long term interest rates, drove up bond and real estate prices, and set the stage for a massive stock market rally that had little to do with underlying economic fundamentals. Despite several informal hints over the years that these stockpiles were being reduced through bond maturation, the war chest has not decreased in size by one iota. However, the Fed has admitted that these ponderous holdings will limit its ability to stimulate in the event of future recessions. As a result, it wants to shrink the balance sheet down to a more manageable size now, precisely so it can expand it again during the next recession.

To do this, the Fed must essentially perform quantitative easing in reverse. It must sell, or force the Treasury to sell, treasuries and mortgage-backed securities into the current market. This process will reduce the Fed's balance sheet while drawing free cash out of the economy, thereby unwinding prior stimulus. The Fed even told us how large the reductions will be…and it’s a lot. Much in the way that the Fed “tapered” out of its QE program back in 2014, gradually reducing the $85 billion of monthly purchases by about $10 billion per month, the Fed anticipates a similar approach to what is, in effect, a “quantitative tightening” campaign, or QT for short. It will start by allowing it’s balance sheet to shrink by $10 billion per month (total) of mortgage and government bonds, and will gradually increase the reductions to $50 billion per month, or $600 billion per year. Those are very big numbers that will provide very real headwinds to the economy and the financial markets.

But it’s important to realize that the Fed envisions doing this at a time when Federal deficits are likely to be rising steeply. In the next few years, the Congressional Budget Office estimates that Federal budget gaps will be in at the $700 - $800 billion dollar range annually (hitting $1 trillion by 2021 or 2022). These assumptions of course do not factor in any potential any tax cuts, spending increases, or recessions (I think we are likely to get all three). So this means that in a few years, the Treasury will have to sell $600 billion of additional bonds into the market annually to repay the Fed while at the same time selling $800 billion or more to finance its current deficits. That may create some traffic problems. Should we assume that there are enough buyers to step up to the plate, especially if yields stay as low as they are? It’s not likely.

With so much supply hitting the market at once, bond prices will have to fall (and yields rise) in order to attract buyers. This will amplify the tightening effect that these sales are meant to generate. Higher yields will also add a tremendous burden to the U.S. Treasury. With outstanding Federal debt already at $20 trillion, every percentage point rise in rates translates into approximately $200 billion more per year in debt service costs, which also must be borrowed. After the Fed announcement, Mick Mulvaney, the Director of the Office of Management and Budget admitted that quantitative tightening from the Fed had not factored into the Administration’s long-term budget projections.

Assuming some form of infrastructure bill and/or tax cut finally passes in 2018 causing annual budget deficits to once again rise to 1 trillion sooner rather than later, how will the government finance its own rising budget deficits and repay the Fed simultaneously? Remember the last time we had trillion dollar deficits the Fed was providing $80 billion of QE support per month. That meant the Treasury was actually doing no net borrowing, as the Fed was monetizing all the bonds it was selling. But with $50 billion per month in QT, the net borrowing could likely be in the $1.6 trillion range annually. There is no precedent for the Federal Government every legitimately borrowing this much money. An even greater problem would develop if other large holders of Treasuries, such as foreign central banks, decide they want to front run the Fed, and start unloading some of their stash as well before prices fall further. A Fed actually committed to QT could turn a bond bear market into an outright crash very quickly.

Of course the federal government is not the only borrower that will feel the sting of higher rates. Thanks to the Fed having kept them so low for so long, state governments and households are also loaded up with debt. What will happen to the auto and housing markets when higher borrowing costs make purchases more expensive to finance? What about the impact of higher interest payments on student loans?

If Yellen’s confidence is based on her belief that the markets will tolerate QT, she may have gotten her signals crossed. Although U.S. markets continue to test all-time highs, in recent days the ascent has slowed and the technology stocks that have been some of the Street’s best performers since at least 2013 have instead led other sectors to the downside. If markets are in fact nearing a top, you would expect traders to shift out of the high flyers into the more defensive sectors. If the Fed thinks that unexpected QT can occur without a meaningful drop in asset prices, it may be badly mistaken. Since the Fed itself often credits its QE program for lifting both asset prices and the economy, wouldn’t QT have the opposite effect on both?

Also, if the markets react to the beginning of QT the way they did to the first rate hike of this cycle the Fed has another problem on its hands. Remember the 8% rout that occurred in the first two weeks of January 2016. At that point markets were reacting to the Fed’s first rate hike in nearly a decade (which had occurred in mid-December of 2015). When weakening economic data surprised the markets in January, traders had to digest the possibility of rising rates coming at the wrong time. The slide continued for two weeks until the Fed shifted to solidly dovish policies by mid-January. Imagine what could happen this time around if the economy continues softening in the face of QT? If that ship actually sales it will be a short journey, with her sister ship, the QE4, following closely behind.

Politics provides one explanation for the Fed’s newfound forcefulness in the face of these risks. Since his election in November, President Trump has continually cited stock market gains as proof that his policies, or intended policies, are working to improve the economy. (Never mind that during the campaign he consistently called the stock market a bubble and downplayed its economic significance.) But even Trump may not be able to get away with saying the gains are his doing but the declines are not. As a result, President Trump owns this market, and it could easily turn around and bite him as badly as his ill-advised tweets. A five percent decline in the Dow would be enough to seriously undercut his claims of economic success. A ten percent correction could completely change the narrative.

Perhaps the Fed sees an opportunity? Although they may have wanted to spare the Obama administration from the economic turmoil that would have accompanied a hawkish policy, they likely feel no such charity towards Trump. In that sense, Janet Yellen may be a bigger danger to Trump than Robert Mueller could ever be. Wonder Woman indeed.

Cost of ‘Black Swan’ bet on falling markets hits pre-crisis low

Hedge funds could make 25 times their money if S&P 500 falls 7 per cent in a month

by: Miles Johnson in London

 

The cost for hedge funds of taking out “Black Swan” insurance against a sharp fall for US equities has fallen to the lowest level since before the financial crisis as stock markets continue to touch all-time highs.

Months of low market volatility has forced down the price of options allowing hedge funds to place bets that would make them 25 times on their money if the S&P 500 index fell by 7 per cent over the next month.

“The price of constructing hedges against a fall in equity markets are at their lowest levels ever, while equity markets are trading at all-time highs,” said Deepak Gulati, chief investment officer of Argentiere Capital and former head of equity proprietary trading at JPMorgan Chase.

“Historically low levels of volatility in options markets are providing the opportunity to construct long volatility positions with completely asymmetric pay-offs.”

At a time when equity markets continue to grind higher and most investors are betting that volatility will remain low, the potential for big payouts worth many multiples of their cost is tempting a small number of hedge funds to take the other side of that trade.

Options using the so-called one month 97-93 per cent put spread on the S&P 500, which requires the index to fall by between 3 and 7 per cent in a month to be profitable, currently allows a maximum profit of $4 for contracts that cost $0.16, or a 25 times return, according to Bloomberg data.



Expectations of market volatility, which make up an important input into how much options bets cost, have been plumbing new lows this year. Earlier this month, the Vix index, which tracks the implied volatility of the S&P 500 over the next 30 days, closed at the lowest level since 1993.

Last month the Financial Times reported that Ruffer, a $20bn London investment company, had been buying up large amounts of contracts linked to the Vix index priced at half a dollar as part of a hedging strategy for its portfolio, earning it the moniker “50 Cent” among bemused traders.

At the same time, low expected volatility also allows traders to make cheap bets using options on the US stock market also rising in value.

The so-called 3 month 105-110 per cent call spread on the S&P 500, which needs the index to rise by 5 to 10 per cent over three months to be profitable, would generate a profit of up to 38.5 times. This compares to an average pay-off ratio for an identical call spread of 5.6 times over the past decade.

 Next Generation Risks, Part 1: “Super EMP” Attack 

The Fed Is Hawkish - Should Gold Investors Be Bearish Too?

by: Hebba Investments

- Despite the sizable drop in gold during the COT week, we saw relatively muted speculators activity.

- In silver speculative longs maintained their positions while shorts increased on the week.

- During the Fed's press conference, Janet Yellen was surprisingly hawkish which caused gold to drop.

- Even though a hawkish Fed is normally not good for gold, we think the probabilities are rising that the Fed is making a policy mistake.

- Any Fed policy mistake would be bad for markets and good for gold.

 

The latest Commitment of Traders ((NYSE:COT)) report predictably showed a week of speculators selling gold positions and initiating speculative shorts. Though despite the large gold drop on the COT week (2.4%), the speculative change on the week was relatively minor - we would have expected more long positions being sold or short positions initiated.

The big event for the week was obviously the Fed statement and conference on Wednesday, but unfortunately those COT positions will not be published until next week - you can complain to the CFTC about still publishing dated reports and not giving us a little more current data.

Having said that, the change in gold since Tuesday's COT positional close and the Friday close is only around 1%, so we don't think positions are too different from what we see today.

We will get more into some of these details but before that let us give investors a quick overview into the COT report for those who are not familiar with it.

About the COT Report

The COT report is issued by the CFTC every Friday, to provide market participants a breakdown of each Tuesday's open interest for markets in which 20 or more traders hold positions equal to or above the reporting levels established by the CFTC. In plain English, this is a report that shows what positions major traders are taking in a number of financial and commodity markets.

Though there is never one report or tool that can give you certainty about where prices are headed in the future, the COT report does allow small investors a way to see what larger traders are doing and to possibly position their positions accordingly. For example, if there is a large managed money short interest in gold, that is often an indicator that a rally may be coming because the market is overly pessimistic and saturated with shorts - so you may want to take a long position.

The big disadvantage to the COT report is that it is issued on Friday but only contains Tuesday's data - so there is a three-day lag between the report and the actual positioning of traders. This is an eternity by short-term investing standards, and by the time the new report is issued it has already missed a large amount of trading activity.

There are many ways to read the COT report, and there are many analysts that focus specifically on this report (we are not one of them) so we won't claim to be the exports on it.

What we focus on in this report is the "Managed Money" positions and total open interest as it gives us an idea of how much interest there is in the gold market and how the short-term players are positioned.

This Week's Gold COT Report


*Gold price data reflects the COT week (Tues-Tues) not a standard week (Mon-Fri)


After three consecutive weeks, speculative longs cut back on their long positions by 15,842 contracts, which was actually lower than we would have expected considering the 2.4% drop in the gold price.

Additionally, we saw speculative shorts increasing their own positions by 3,779 contracts - which was also fairly slim for the large drop we saw this week in gold. This is telling us that speculators are still fairly bullish on gold and are reluctant to take the short side of the gold trade.

Moving on, the net position of all gold traders can be seen below:


Source: GoldChartsRUS


The red-line represents the net speculative gold positions of money managers (the biggest category of speculative trader), and as investors can see, we saw the net position of speculative traders decreased by around 20,000 contracts to 155,000 net speculative long contracts. We still remain at net speculative long positions that are on the high side of historical averages.

As for silver, the action week's action looked like the following:


Source: GoldChartsRUS


The red line which represents the net speculative positions of money managers, showed a decrease in the net-long silver speculator position as their total net position rose by around 6,000 contracts to a net speculative long position of 44,000 contracts. Most of this was due to an increase of shorts (around 5,000 contracts) with very little net action on the long side.

The Fed Meeting

The big event last week was the Fed meeting, which interestingly enough led to a large drop in gold after it had soared earlier in the day after disappointing retail sales and inflation data. The reason for the drop was attributed to a hawkish Fed that seemed more concerned about inflation than boosting the economy by letting inflation run a little "hot".

It was a bit surprising that the Fed was so focused on inflation rather than the weak economy - and certainly the fact they were considering cutting back on their balance sheet is concerning.

How does the Fed expect to keep rates under control if even they start selling bonds?

But we think Ben Hunt of Salient Partners summarized the shift best (emphasis ours):

What has happened (and apologies for the ten dollar words) is that the Fed's reaction function has flipped 180 degrees since the Trump election. Today the Fed is looking for excuses to tighten monetary policy, not excuses to weaken. So long as the unemployment rate is on the cusp of "instability", that's the only thing that really matters to the Fed (for reasons discussed below). Every other data point, including a market sell-off or a flat yield curve or a bad CPI number - data points that used to be front and center in Fed thinking - is now in the backseat. 

I'm not the only one saying this about the Fed's reaction function. Far more influential Missionaries than me, people like Jeff Gundlach and Mohamed El-Erian, are saying the same thing. If you think that this Fed still has your back, Mr. Investor, the way they had your back in 2009 and 2010 and 2011 and 2012 and 2013 and 2014 and 2015 and 2016 … well, I think you are mistaken. I think Janet Yellen broke up with you this week.

The Fed is looking to tighten and, all else being equal, that is not a positive for gold prices when inflation isn't off to the races. Does that mean all is lost for gold investors and it is time to sell?

There is one BUT…

If the Fed is tightening into a weak economy that is over-leveraged with debt, then the Fed is making a big mistake. This policy error would have huge consequences as what would happen would be that higher interest rates would choke a weak real economy that only looks strong based on the stock market's rise - which would quickly reverse. That in turn would lead to defaults and bankruptcies that would snowball through the economy, like in 2007 EXCEPT that we have way more debt now.

In fact, we believe that gold SHOULD have fallen much more on the Fed statement then it did as it was only down around 1% on the week. We think there is some sizable "Fed policy error" buying in gold that is maintaining its $1250+ Price.

Our Take and What This Means for Investors

Despite our view that the Fed is making a policy mistake by raising rates and maintaining a hawkish view on inflation, we remain short-term Neutral-Bearish on gold and silver as we believe that hawkish stance is what investors will focus on.




We eventually think that will change as investors start seeing the Fed's position as a big policy mistake, but we think that gold bulls should give it a week or so for the Fed's position to be digested by markets. Thus for us it seems prudent to wait on purchasing additional gold and silver positions (SPDR Gold Trust ETF (NYSEARCA:GLD), iShares Silver Trust (NYSEARCA:SLV), Sprott Physical Silver Trust (NYSEARCA:PSLV), and ETFS Physical Swiss Gold Trust ETF, etc).

Is the Paris Accord Unfair to America?

Peter Singer

North Korea: Structured for Survival

Summary Since the 1990s, when the Soviet Union collapsed and the founder of the Democratic People’s Republic of Korea, Kim Il Sung, died, experts have warned that the North Korean regime was on the brink of collapse. And since the 1990s, the experts have been wrong. North Korea has been remarkably resilient in the face of war, international sanctions, famine and natural disaster. Twice has a system that supposedly functioned only by the will of its supreme leader transferred power to a chosen successor, and in doing so it has created a dynasty that is, for better or worse, unlike any other. Now, under its third leader, Kim Jong Un, the grandson of the founder, it is commanding the world’s attention like never before. In the following report, we set forth to answer a simple question: What explains the longevity of the government in Pyongyang? Introduction North Korea as we know it was created by an agreement between the United States and the Soviet Union in 1945. Before then, the peninsula had been occupied by foreign powers off and on for years, but it had never been divided like it is today. Visions of Korea The Soviets installed Kim Il Sung in 1948, shortly after the partition, and conditions were ripe for his ascension. North Korea had been occupied by the Japanese for nearly four decades, and the country was eager for a Korean leader. He lived, perhaps ironically, most of his early life outside Korea – his parents escaped the Japanese occupation, so he grew up in Manchuria in northern China. When he grew up, he became a guerrilla, fighting the very people his parents had fled. Once it was founded, North Korea couldn’t escape Soviet influence; Moscow propped it up, and in any case the countries share a border. In fact, Kim Il Sung was educated in the Soviet Union and served as a major in the Soviet military during World War II. He left the Soviet Union only after the war ended. And though the party Kim would lead was, in part, a consequence of Soviet influence, it was not simply an extension of it. It’s best thought of as an instrument of “oriental despotism,” an oft-forgotten political philosophy popularized by Karl Marx that describes an extremely centralized regime with absolute power of its central bureaucracy. The government in this system is the sole business proprietor and organizer of economic activity. It uses coercion and military force to govern. The people who live under it have no personal liberties. Oriental despotism concedes that, for a variety of reasons, including geography, despots of the “East” simply function differently from those of the West – predisposing them to anti-colonialism, nationalism and fierce self-sufficiency.   Indeed, Kim Il Sung was, at his heart, a Korean nationalist. It didn’t take him long to subvert Soviet interests to his own. He was, after all, responsible for the invasion of the South in a failed bid to reunify the peninsula. Kim never fully endorsed the measures Nikita Khrushchev introduced to break the cult of personality that surrounded Stalin – it was a tool that had served Kim well – and never really took part in China’s Cultural Revolution. Put differently, his regime was never prototypically communist – power rested in the Kim family and a handful of elite party members, not the party writ large. Kim’s philosophy is perhaps best captured by a policy known as Juche, which was the foundation of the North Korean regime. Usually translated as “self-reliance,” Juche emphasizes the role of the individual as the master of his or her destiny, the driving force behind, in Kim’s words, the “revolution and construction.” It rests on three pillars: independence in politics, self-sufficiency in economics and self-reliance in defense. In some ways, it was just what Koreans needed to hear after decades of occupation: “Reject foreign powers, and create the country you want.” After Kim died, his son and successor, Kim Jong Il, reinforced one particular aspect of the Juche policy: the military. In what came to be known as the Songun policy, Kim prioritized the development of the North Korean military and gave its leaders more power in the government. The policy harkens back to the anti-imperialist sentiment that existed even before North Korea became a country, and so it was relatively easy to enact what the policy called for: arming the nation, training all soldiers to fulfill responsibilities above their rank, fortifying the country and modernizing the armed forces. The transition from Juche to Songun was fairly smooth – it was less of a radical departure than it was a natural evolution of one policy to the next. Songun merely elevated the military, with Kim as its leader, to a higher role in government. And though the policy may have empowered the military over the other aspects of Juche – political independence and self-sufficient economics – it didn’t forsake them. Kim Il Sung’s vision for the Korean Peninsula was still intact; it just featured the military more prominently than it once did. This vision of Korea evolved further when Kim Jong Il’s son and successor, Kim Jong Un, introduced Byungjin in 2013. An early attempt for the newest Kim to make his mark, Byungjin called for the parallel pursuit of economic development and nuclear weapons. (Observers of North Korea initially thought Byungjin would open the North Korean economy to the rest of the world. It did no such thing.) Pyongyang had, of course, been pursuing a nuclear weapon for some time, conducting tests as early as 2006. Much like Songun had done to Juche, Byungjin formalized and prioritized aspects of North Korean policy that were already there: self-sufficiency in economics and self-reliance in defense.   (click to enlarge)   One Purpose With so much power placed in the supreme leader, it’s little wonder that the North Korean government is structured for one purpose above all others: survival. State organizations exist only to support the supreme leader and a select group of officials (read: the regime) and serve one of two specific purposes. The first is to create policy and regulations that align with Kim’s philosophy and advance his agenda. The second is to enforce government policies and ensure compliance by military members, government members and civilians. Law The legislature, the Supreme People’s Assembly, is the highest organization in North Korea, at least according to the constitution. It has 687 members and a presidium that can perform the same functions as the assembly when it has recessed. The assembly has the power to change the constitution, set basic policies for domestic and foreign policy, pass laws, ratify budgets and treaties and, ostensibly, elect and recall officials. In theory, the chairman of the State Affairs Commission (whoever is the supreme leader, in this case Kim Jong Un), the State Affairs Commission, the Presidium of the Supreme People’s Assembly, the Cabinet and the Committees of the Supreme People’s Assembly can submit legislation to the assembly for consideration. But in practice, the assembly’s actions are largely dictated by the supreme leader. The State Affairs Commission is the source and arbiter of all policy. It is primarily responsible for defense and economic development – unsurprisingly, the two components of Kim Jong Un’s Byungjin policy. As chairman, Kim not only is responsible for the commission’s general operations but also is the head of the armed forces. This role confers on him the power to call a state of emergency, declare war, mobilize the military inside the country and, in times of war, direct the National Defense Commission. (The State Affairs Commission replaced the National Defense Commission in 2016, but it can be revived in wartime.) Kim Jong Il (R) and Kim Il Sung (L) inspecting a soccer ground in Pyongyang in 1992. AFP/Getty Images   There are other areas in which executive political powers bleed into military powers. North Korea even has structures in place to harmonize political affairs and martial affairs. One such structure is the Korean People’s Army General Political Department, which is controlled by the party. It liaises between the party and the military to ensure that the supreme leader retains control of the armed forces, and it monitors military behavior, discipline, promotions, indoctrination, education and general administration. It also surveils the public. It coordinates its actions with the Central Military Commission, the institution that puts the party’s military and defense policies into action. It works closely with the State Affairs Commission. The CMC has the authority to commission research projects, weapons development and manufacturing, outside acquisition and defense spending. It also determines how resources from military-controlled production units will be allocated. Under Kim Jong Un, the CMC has been reduced from 15-20 members to 12 members, many of whom are senior officials either in the Ministry of State Security or the Ministry of People’s Security rather than the military itself. Some reports suggest that some members also occupy seats on the Political Bureau, giving them even more influence over military and state affairs. Other notable entities include the Ministry of People’s Armed Forces and the Korean People’s Army General Staff Department. The ministry oversees the logistical, political and personnel aspects of the military. It also coordinates relations with foreign militaries, regulates military-owned businesses ventures and helps to indoctrinate servicemen. The General Staff Department, on the other hand, is the traditional institution of military management. It coordinates the different branches of the military, formulates strategy and issues orders to the branches. It also manages specialty bureaus such as electronic warfare, weapons supply, equipment, training and transportation. Order Policy and procedure, of course, are meant to be enforced, and North Korea has a variety of ways it can enforce them. The Ministry of State Security is North Korea’s primary counterintelligence service and reports directly to Kim. It operates prison camps, investigates cases of domestic espionage, repatriates defectors and conducts overseas counterespionage activities. (This differs from the Ministry of People’s Security, which is responsible for public order and civilian control.) The Military Security Command, on the other hand, is the eyes and ears of the military. It monitors the activities of military commanders and political loyalists – a mandate that gives it far-reaching powers to investigate and arrest in a variety of jurisdictions. There are also government agencies meant specifically to protect the supreme leader and the government. The Pyongyang Defense Command, for example, is a corps-level mobile unit that protects the capital city and secures select buildings in the event of a coup. The command has tank divisions, an artillery brigade and heavy weapons brigade. It is linked closely to the Supreme Guard Command, the Kim family’s personal security service, and the III Corps, an army unit that defends the areas immediately outside Pyongyang. (The Supreme Guard Command also monitors the electronic communications of the country’s leaders.) A New Complexion The structure of the regime is built around a single leader with absolute authority. But even absolute leaders need supporters. He is therefore compelled to purge, appoint and reorganize upon assuming control. Subsequent purges and appointments are used to maintain control. (Since the party and the military are the only vehicles of power in North Korea, there are always people willing to fill vacant posts.) The process takes about three to five years, and once he consolidates power he formalizes his policy priorities and tailors the system by making changes in the constitution. This goes a long way to explain the Kims’ staying power. Specific roles, titles and offices have changed, but the general apparatus has remained the same. There is strong party leadership, a strong military and total control over civilian life. What differences exist under each Kim reflect only subtle changes in political philosophy. Kim Jong Un’s tenure is a case in point. After assuming power, he spent the first two years or so dismissing and executing potential rivals. In May 2016, during the 7th Congress of the ruling Workers’ Party, Kim reinstated the Workers’ Party chairmanship and several vice chairmanships. (He was, naturally, elected its chairman.) He also reduced the number of military personnel on the Political Bureau. Then in June 2016, during the 13th Supreme People’s Assembly, he modified the constitution, formally replacing the National Defense Commission with the State Affairs Commission. (Kim was, naturally, chosen to head it.) The new commission assumed the responsibilities of the previous one and added things like the economy and foreign policy to its portfolio. Kim Jong Un appears to have given his government a new complexion that de-emphasized the military and brought the economy back to the fore. That’s partly true, but the larger point is that he installed people who would be loyal to him, just as his father had, albeit in slightly different ways. Conclusion And so the current incarnation of the regime survives because it’s loyal enough to the founding principles of the country but just innovative enough to adapt to the times. The power of its leader, who reigns absolute, is fueled by nationalism and sustained by a structure that has every reason to keep him in place. That, and a zero-tolerance policy toward dissent, explains why the regime has stood stalwart these many years.