Commodities | May 12 2010
By Greg Peel
“We have made this point before and we shall make it again here this morning,” said respected US trader Dennis Gartman in his newsletter on Tuesday, “given that all economics is the study of one’s propensity to take some sort of economic action, what is the propensity on the part of the reserve management authorities at the People’s Bank of China or the Reserve Bank of India or the Central Bank of Indonesia or the monetary authorities in the Gulf to add to their EUR denominated assets? We have to think it is somewhat… and perhaps properly greatly… reduced from what it was only a short while ago. On the other hand, what is your propensity to own gold as a liquid, fungible, reservable ‘currency'? Almost certainly it is enhanced. It has to be. It cannot be any other”.
Gartman publishes his newsletter of a morning, US time, meaning his latest issue hit subscribers before last night's rally in gold of some US$30 to a new all-time high.
Gartman is making reference to the general trend of 2009 in which the euro was rapidly becoming king, albeit to the chagrin of German and other European exporters. While the developed world wallowed in debt, the developing world was wondering what to do with its trade surpluses. Previously they had simply reinvested the bulk of foreign currency takings into the reserve currency – the US dollar. But as the US government announced ever more fiscal stimulus initiatives and spending on major policy reforms, in the wake of the previous government's vast amounts pledged to save the US financial markets, developing nations decided it was time to diversify their exposures away from that one, vulnerable currency.
Various measures were undertaken, particularly in China's case. China began to buy excess commodities in order to bypass the dollar, to buy foreign commodity producers in order to bypass commodity prices, to trade commodities with foreigners such as Brazil using direct currency swaps (therefore bypassing the dollar), and to slow down investment in US Treasuries in favour of other instruments such as IMF currency-basket bonds and, in particular, the euro. After all, Europe collectively has always been a bigger trading partner to China than the US, and the euro was created to be an alternative reserve currency.
There have also been moves afoot to create other reserve currency competitors, such as a BRIC basket (real, rouble, rupee and renminbi) and a Gulf Cooperation Council basket of currencies among the US-allied Gulf oil and gas producers. But aside from slight complications like the renminbi still being pegged to the US dollar, these ideas were too immature to be of sufficient consequence. It was really only the euro which offered any other form of “safe haven”.
Other than gold, of course. But then gold does not provide a coupon, so in real terms it actually loses value in the vault. But the idea is that the price of gold rallies when fiat currency values fall, and as such it is a natural inflation hedge. China is now the world's biggest producer of gold so the PBoC was able to buy up a vast load of local product. India took the opportunity to buy half the gold on offer from the IMF, while Russia continues to talk of increasing its own gold reserves. At the same time, the biggest holders of gold outside the US – the European central banks – have now elected to hang onto their gold rather than incrementally sell it as had long been the case.
That gold action got us to US$1200/oz the first time around, but at that stage it was all considered a hedge against the inherent secular weakness of the reserve currency. And that perceived weakness was all about America's vast amounts of debt.
But what the world was somewhat oblivious to, or at least chose to ignore, was just what sort of debt levels were being carried by the eurozone countries.
It is now history what occurred after it became apparent Greece's level of budget deficit to GDP ratio far exceeded the ECB limit of 3%. Then the world realised the likes of Portugal and Spain, Italy and Ireland were not much better off. Mass bond selling followed, which begat credit downgrades, which begat more selling. And here we are now, with a European “TARP”.
What many people don't realise however, and what Dennis Gartman pointed out yesterday, is that not one of the sixteen eurozone members has a budget deficit to GDP ratio of less than 3%. The closest is Luxembourg with 4.2%, while the serial offender is not Greece but Ireland, with 14.2%. The average is 6.9% and even Germany is running a budget deficit of 5.0% of GDP. (Germany makes up for it with a current account surplus, as do a couple of others).
What this basically means is that all the while the world was considering the euro the obvious alternative to the dollar, the euro was in just as much strife. That strife is now being played out as the euro goes into free-fall.
Gartman makes note of the fact the day the Eurotarp [my label] was announced, the euro failed to rally for any more than half a day. “The response by the EUR to the huge sums of money that were and are to be thrown at the currency was and is this morning, quite horrid,” he notes. “One would have reasonably expected that the EUR would sustain at least one day’s worth of strength. One, however, would be wrong, and rather badly so”.
In reality, the euro is facing a lose-lose situation. Either it is damned if the Eurotarp fails in its quest to prevent sovereign defaults (or if more dithering means it is too late) or damned if it works, given the amount of fresh euros required to fund it. As Gartman notes:
“We are more and more convinced that the decision by the ECB to buy government debt, even though 'sterilized' as the Bank’s leadership says that those purchases shall be, will prove inflationary… or at least detrimental to the integrity of the currency itself. That process shall tend on balance to put upward, perhaps relentless, pressure upon gold as gold becomes every day to be seen as the second reservable ‘currency’, supplanting the EUR which had assumed that rule until quite recently”.
The “sterilization” of debt occurs when a central bank takes low quality paper onto its balance sheet and in turn issues its own paper to fund those purchases. In this case the ECB is now taking Greek “junk” and whatever other sovereign bonds it has to and in turn offering emergency three and six-month central bank loans (the ECB cannot issue bonds). The idea is inflation is quelled by rapidly replacing an inflationary influence with a deflationary influence. However, sterilization can't be kept up for too long because it requires a central bank to effectively “buy high and sell low”. The ECB is paying in effect high yields to Greece et al while receiving only low yields in return.
With the euro now “gone” for all intents and purposes, and the US no better off than it was on the debt front, gold becomes the only alternative as far as the gold bulls are concerned. Those who scoff at the gold bulls note simply that as soon as the US economic recovery really gets rolling, the US dollar will rally (the Fed will raise rates) and gold will then fall back into irrelevance.
There is a simple counter-counter argument as well, and that is the US economy will never recover while it is being supported by so much debt – debt that continues to grow, not diminish. On that basis, a gold rally into the heavens is still on the cards.
And it must also be noted that the US dollar has been rallying lately. From November to now, the dollar index is up 13% from 75 to 85. Gold hit US$1200/oz for the first time in November, and is again over US$1200/oz. Although this move is purely and simply a reflection of the demise of the euro.
That demise it would seem, has further to run.
