GOLD AND THE G7 DEBT CRISIS / MACLEOD FINANCE

Gold and the G7 debt crisis

It’s no coincidence that all G7 nations face a debt crisis and that gold is going higher again, with silver playing catch up. It’s the beginning of the end for the major fiat currencies.

ALASDAIR MACLEOD

Last Friday, there was great excitement in the goldbug community, because all of a sudden it looked like gold’s four-month consolidation phase is over and it’s about to rise to who knows where. 

Buying was notable on Comex with open interest in the gold contract increasing sharply by 21,788 contracts representing about 68 paper gold tonnes on Friday’s preliminary figures.

By way of contrast, silver’s open interest fell to the lowest level for three months as a vicious bear squeeze drove the price higher to just under $40 before closing up 1.8% — the highest level in 24 years. 

Egon von Greyertz of his eponymous gold and silver storage firm confirmed in a King World News interview that finding physical silver for his clients is difficult, confirming its scarce liquidity. 

And as he put it, investment demand for it has hardly started.

After decades of suppression, without doubt silver is undergoing a massive rerating even against gold. 

And coincidently with gold’s breakout, after a brief consolidation silver is breaking higher as well:

These advanced warnings of systemic danger are flagging a developing crisis in fiat currencies. 

In each of the main currency jurisdictions, economic commentators are warning of an impending national crisis without appearing to realise that the other G7s are in the same boat. 

When it blows, taking the looney down with them the four major G7 currencies will face a collapse in the faith upon which their value relies for similar reasons. 

The 54-year fiat currency era faces an existential crisis.

This raises the question: when will the crisis be triggered, what form will it take, and how rapidly will it occur?

Essentially, we are looking at escalating credit risk. 

The most sensitive risk indicator 

in any currency is changes in its long maturity government bond yield. The chart below shows yields in 30-year maturities of the four major currencies, all of which are at or close to long-term highs:

While bond market commentary focuses on the US long bond which has yet to break into new 18-year high ground, the other three are clearly signalling government debt distress. 

It is not a stretch of imagination to expect the US to soon follow.

These representative bonds are issues of highly indebted governments, but high debt levels on their own do not explain why yields should be high and rising. 

The risk factor is in a government’s ability to cover the interest element through growth in its tax receipts. 

Otherwise, it cannot afford to maintain the debt, and it enters into a debt trap where yields continue rising for lack of buyers and/or the currency collapses.

To assess a government’s ability to maintain its debt, GDP should be adjusted by subtracting or adding any budget deficit or surplus respectively. 

Today, it is always a deficit, and the table below illustrates the approximate position for the four major currencies.

These figures are indicative because of timing differences, but they reveal the general picture. 

So far analysts have ignored the fact that adjusted for excess government spending, which is injected almost entirely into national GDP, major economies have either stagnated or been in recession in recent years. 

Presumably, this is because deficit spending has been conventionally viewed as economically simulative by Keynesians, who have failed to differentiate it from genuine private sector activity.

A contracting GDP is also a contracting tax base, calling into question a government’s ability to maintain its debt and to roll over bond interest into future debt. 

As already noted, it has not yet caused alarm beyond elevating 30-year debt maturity yields. 

This now appears to be changing, signalled by the gold price. 

Deteriorating economic outlooks in the G7 nations are now likely to make bond yields rise more generally, hitting new long-term highs.

The cost of funding government debt is increasing because investors are now looking for risk compensation — the classic debt trap. 

Debt traps being sprung on government finances will drive bond yields ever higher, making a deteriorating situation even worse. 

And as bond yields rise, government finances enter a doom loop. 

Private sector insolvencies rise sharply. 

The viability of banks with high balance sheet leverage is called into question, and financial collateral begins to be liquidated.

Mortgage finance becomes more expensive, hitting household wealth. 

And it is not just the underlying economy. 

In an attempt to reduce credit risk, banks will withdraw lending from financial speculation, which according to FINRA’s statistics is at an all-time high:

The rise in margin finance since mid-2022 has coincided with a near-doubling of the S&P 500 Index. 

The contraction of margin debt as banks reduce their exposure will have a dramatic impact on equities, likely to crash the entire market. 

Furthermore, the value relationship between the long bond and equities is more stretched now than it has probably ever been. 

The next chart makes this point graphically:

Value theory tells us that low bond yields are good for equities, while high bond yields are bad. 

The chart above captures and confirms this relationship by rebasing both the S&P index and the long bond’s inverted yield to 1985. 

For most of the time, this negative correlation is close and confirmed.

The greatest exceptions were in 2020 during and shortly following covid lockdowns, when economic activity was suspended and bond yields were suppressed toward the zero bound by the Fed’s policies. 

The severe undervaluation of the long bond without a commensurate bullish equity response needs no explanation.

The second exception is today, with equities hitting new highs while the long bond yield is at the highest levels for 18 years. 

This disparity is at a record: either the long bond’s yield must fall sharply, or the S&P must collapse to correct it. 

In fact, this gap is more than twice as extreme than during the dotcom bubble and is probably at the highest level ever.

It is not unusual for equities to rise in the early stages of a bond bear market. 

It is the second phase of the bond bear which kills equities. 

And if, as now seems inevitable, long bond yields rise from here a severe bear market in equities is bound be triggered.

The shape of the next financial crisis is now becoming apparent. 

Rising bond yields, driven by increasing risk in the light of G7 government debt crises in the four major currencies will have the following consequences:

· A collapse in equities, the suddenness of which will be exacerbated by sudden awareness of the knock-on consequences.

· Liquidation of malinvestments in the private sector, leading to insolvencies, unemployment, and potential banking distress.

· Panicked collateral liquidation of equity stocks by banks as loans become uncovered.

· Economic slumps in all the G7, leading to lower tax revenues and higher welfare costs leading to soaring budget deficits, which in turn tightens the bond trap screws.

· A doom loop of rising bond yields, interest rates, deficits, collapsing financial collateral values, deepening economic slumps, corporate failures, and banking crises. Rinse and repeat, again and again.

· Financial and systemic contagion between G7 nations will ensure that none of them escape the collapse, and individual national remedies will be overwhelmed.

In a nutshell, the entire system of credit embodied in fiat currencies faces the prospect of a rapid collapse. 

Undoubtedly, governments, their finance ministries, and their central banks will move heaven and earth to prevent widespread bankruptcies and their systemic consequences by expanding ultra-short term government finance, undermining the value of their fiat currencies.

The only escape route for individuals from this now certain credit crisis is to get out all G7 fiat currencies in favour of money without counterparty risk, which in everybody’s common law is metallic — principally gold.

How high will gold go?

This is the wrong question. 

Instead, we should ask low will currencies go. 

In the absence of a combined political will across G7 nations to embrace higher interest rates and slash public sector spending, their downside is infinite. 

It can only be hoped that Russia and China, who are not in the G7 club and possess sufficient gold reserves secure their currencies by introducing gold standards, will force a behavioural change on G7 governments before their currencies collapse entirely.

Meanwhile, it would be a triumph of hope over experience to expect anything else.

On existing estimates, global portfolio investment exceeds $300 trillion, while the estimated value of 200,000 tonnes of above-ground gold stocks is $22 trillion. 

Most gold is in firm hands not available to investors, being in jewellery, central bank holdings and firmly hoarded. 

Available liquidity is remarkably low, and most mine output is spoken for.

With the entire investment industry yet to buy gold, the enormous scale of investment demand from panicking investors will face highly restricted supply. 

And as Egon von Greyerz warned in that KWN interview, it is a situation already emerging in silver.