Musings Report #20 05-13-12 Deflation, Deleveraging, Recession and Gold
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Deflation, Deleveraging, Recession and Gold
A number of readers have asked me for my views on gold, specifically, is its downtrend nearing an end or is it just beginning a much longer, deeper decline? I think the question about gold is an interesting one even if you're not an investor in gold because it's also a question about deflation, deleveraging and recession.
The financial "gold bug" media tends to ascribe any decline in gold to market manipulation by The Powers That Be (TPTB), who must suppress gold's price lest the masses awaken to the ultimately doomed project of relying on freely printed money as a store of value.
Since all financial markets are being manipulated for "perception management" purposes (to promote the idea that "we're doing a heckuva job here at the Fed, ECB," etc.), we can certainly assume authorities are engaged in the gold market.
But cloaked official intervention cannot control the entire market once volume picks up, so gold's decline may be signalling that "smart money" is anticipating deflation, i.e. a general increase in the value of cash and a general decline in the value of financial and commodity assets.
In deflation, U.S. dollars would increase in buying power (i.e. buy more than they did last year) while gold and other commodities would decline in price. Once deflation reversed into inflation, the "smart money" would buy gold at prices considerably lower than current prices.
Gold is not the only indicator of deflation--the other commodities and the CRB (Commodity Research Bureau) Index are also measures of demand/supply and thus of inflation/deflation. If demand for copper and other commodities declines, that means the global economy is contracting or slowing.
Officially, the U.S. economy and many others are still growing, but if demand for actual physical commodities is declining, that suggests growth is not as robust as officially advertised.
J.P. Morgan's recent $2 billion loss in trading credit derivatives highlights not just financial risks but the potential for massive deleveraging of financial instruments.
What does this mean? Derivatives are ultimately claims against some actual asset--real estate, oil, etc.--or a financial asset that is ultimately based on some collateral (cash, securities, bonds, etc.) There are some $600 trillion in derivatives floating around, and ultimately these are claims on the world's $160 trillion in total assets. This is like four different people holding a claim to a gold coin: there are four claims but only one coin. Eventually three of those claims are going to be declared worthless.
The official explanation of derivatives is that they are hedges against risk and not really claims against real things, but a hedge only works if it eventually lays claim to a real asset. Since all these derivatives are based on credit, collateral or tangible assets, any reduction in the value of the underlying credit, collateral or tangible assets puts the value of the derivative at risk. Reducing that risk by selling or closing the position is called deleveraging, much like paying down a mortgage is deleveraging the debt that was leveraged on a house.
If the house was purchased with 10% down, then that cash was leveraged 9 to 1 in a 90% mortgage. If the owner pays the mortgage down by about 10%, then the leverage declines to 4 to 1 (20% cash and 80% mortgage). That's deleveraging.
Since so much of the global economy's spectacular growth over the past 30 years was based on increasing leverage, then deleveraging will necessarily lead to less borrowing, less consumption and less growth. Deleveraging leads to recession.
Another aspect of deleveraging might be causing gold to be sold. If the collateral underlying a loan or derivative declines in value, the owner has to deleverage/increase collateral with cash. To raise cash, he needs to sell something. Quite often people sell what has best held its value, and gold certainly qualifies.
Conclusion: Gold's decline may be signalling deflation, deleveraging and recession.
Perhaps the deleveraging that should have happened in 2008 was simply pushed forward four years, and the game clock on extend-and-pretend is finally running out of time.
What happens should deflation take hold? The need for dollars/cash will rise, pushing the value of the dollar higher. Longer term, the Ka-Boom Theory holds that such a deflationary shock will cause central banks to print trillions and that vast money-creation will spark runaway inflation.
On a very short-term basis, stocks tend to rise in options expiration week, so I anticipate a nice little bounce in global stocks this week.
From Left Field
More Wealthy Chinese Said to Prepare Exits from China (via Maoxian, who added: NOT NEWS ... EVERYONE I KNOW WHO HAS EVEN FAIRLY MODEST MONEY HAS ACQUIRED A (foreign) PASSPORT (INCLUDING TONGA) What does this say about how Chinese people perceive stability in China? Nothing good....
How Working the Muscles May Boost Brainpower: Muscles appear to affect the mind, according to a study of drugs that simulate the effects of exercise in mice. Mice that had "exercised" did better on tests of memory and learning and had far more new neurons in brain areas central to learning and memory than mice that had remained quiet in their cages. (via Joel M.) Note how drug companies are trying to mimic the good effects of exercise with a pill but it doesn't work that way: muscles also affect mood, cardio fitness, weight loss and strength--none of which can be replaced by a pill.
Subsidies Aid Rebirth in U.S. Manufacturing: There is a quiet realization that American factories need subsidies to survive globally — especially to compete with Asian and European companies that routinely receive government assistance. (via Joel M.)
"It is not the strongest of the species that survives, nor the most intelligent, but the ones most adaptable to change." Charles Darwin
Thanks for reading--
charles
