July 16th, 2015 Gold Chronicles topics:
*Comments on co-Keynote with Former Fed Chairman Ben Bernanke
*Comments on recent experience and invitation to Pentagon hosted financial wargames
*As predicted, there has been no Grexit
*Bank holidays is a standard way of dealing with financial crisis, people should consider preparing ahead of time
*Greece and Cyprus have been dry runs for how to deal with crisis on a much larger scale
*The China market crash is on-going, this has just begun and will continue for a time
*The extraordinary effort put forth by the Chinese government to halt the crash will not work over the long term
*The greater issue here is whether this turns into a social problem within China
*The most recent Pentagon wargame was specifically focused on China
*Other countries are now building their own systems which circumvent things like SWIFT so that they are able to function without it
*This wargame was more focused than the last, and the Pentagon is taking financial warfare very seriously
*Why a gold market corner is unlikely
*What large futures positions in gold by major institutions probably means
*Movement of unallocated gold in banks to allocated gold in private storage
*People are taking gold out of banks because they are losing confidence in the banking system and putting it into private storage
*Fourth quarter is traditionally a seasonally good time for gold
*The only reason the Fed will raise rates is if inflation remains weak, period, full stop
*The dollar price of gold continues to go down, this is probably a good entry point
*The Fed always follows the market, it doesn’t lead the market. If Yellen raises rates in a weak economy it would be a disaster
*Fed rate increases are always conditional on data, and we are not getting to any of the levels Yellen has specified in the past
*Bernanke describes the international monetary system as “incoherent”, and he is involved with the IMF and Sec. Treasury on China voting rights with the IMF
*Expectation is that China will be included in the SDR in the fall of 2015
*Bernanke says that everything the Fed had done since 2008 during his tenure had been an experiment
Listen to the original audio of the podcast here
The Gold Chronicles: 7-16-2015
Jon Ward: Hello, I’m Jon Ward on behalf of Physical Gold Fund. We’re delighted to welcome you to our latest webinar with Jim Rickards in the series we’re calling The Gold Chronicles.
Jim Rickards is a New York Times bestselling author and the Chief Global Strategist for West Shore Funds. He’s the former General Counsel of Long-Term Capital Management. He is a Consultant to the US Intelligence community and the Department of Defense and is also an Advisory Board Member of Physical Gold Fund.
Hello Jim and welcome.
Jim Rickards: Hi Jon. It’s great to be with you.
JW: Today we have an unusually full agenda. First, my apologies to our listeners as we will not be taking questions. We’ll be sure to make additional time for your questions in upcoming webinars, so please keep sharing your thoughts with us.
Greece has been the hot topic until just a few days ago, but as you predicted, there has been no Grexit. In fact, it transpires that the Greek government, for all its bluster, really had no serious contingency plans for leaving the euro. I’m left wondering, how close did we come to an actual meltdown here?
JR: It’s a great question, Jon, an important one, and you’re right. Remember that this whole Greek sovereign debt crisis started in 2010. There’s nothing new about it. It’s been going through stages of quiet periods and intense periods for the past five years.
Beginning in 2010 and continuing through this past weekend, I was one of the voices saying that Greece would not leave the euro. I think most voices were on the other side. They didn’t see how they could stay in. Even today, I saw that Austan Goolsbee, who was one of the members of the Council of Economic Advisers to President Obama, published a piece saying they’re in for now, but in the long run, they can’t possibly remain in. He listed a bunch of reasons although I thought he left out a couple.
The point is, no matter how many challenges you overcome, people just can’t get their minds around the fact that this is Hotel California. You get in; you can’t get out. There’s no treaty provision, no legal provision, for exiting. Now, that wouldn’t stop a sovereign power from simply unilaterally declaring they were breaching the treaty. That is possible, even though it would be messy. I’ve always understood this not as an economic project but as a political project. Once you see it as a political project with other goals in mind, then you can understand that the political will is there to keep it together, and indeed it has stayed together.
That’s fine as far as it goes, and I will say it’s nice to get these things right. Some people have complimented me on that. The temptation is always to take a victory lap, but the fact is, this was a lot more dangerous and came a lot closer to a Grexit than I would have thought. In other words, I got the result right, but the process was a lot more challenging.
I was up late Sunday night New York time which was early Monday morning in Brussels. The summit conference actually set a record for the longest euro summit conference with almost 24 hours of continuous meetings. There was some pretty good reporting. You could pick things up on Twitter from reporters who were outside the room, so you were getting as close to real-time information as you possible.
I always felt that Germany and Greece would both blink, that they both considered a Grexit – Greece leaving the euro – would cause more harm than whatever it was they had to do to keep Greece in. But in the end, Germany didn’t blink, at least not very much. It was Greece that had to do all the concessions, and it became apparent that Germany was prepared to see Greece leave.
I’ve been in a lot of tough negotiations, and the only way you get a good result in any negotiation is if you’re prepared to walk away. If you make it clear at the table that you’ll pay any price or do anything, whatever it takes, to get a deal done, then the other side will take advantage of you one way or another. To get a good deal, you have to be prepared to let the deal go down.
That was always dangerous as far as the euro was concerned. I took the strong view that there would be no Grexit, but I also said that if I was wrong and there was a Grexit, it wasn’t going to be contained. It wasn’t going to be the non-event a lot of people were expecting, and that it would be catastrophic in its consequences.
That became very apparent Sunday morning when markets seemed to be a little bit complacent. When it became obvious that Germany was prepared to see Greece go, then you start to think through what that meant. The only way I could understand it was that Germany understood the consequences but felt it would be really bad for the rest of the world. In other words, it might be the United States and certainly the Greeks themselves who would have to bear the brunt of it, rather than Germany.
There might be some truth to that, but the good news is that Greece did not leave. There was no Grexit, and the eurozone has held together. I expect that will continue to be the case and that they will add new members.
I went through this in some detail in Chapter 5 of my book The Death of Money. Anyone who read the book last year would have seen this result coming because I outlined it in detail. I expect that will continue to be the case, but it was a far more dangerous situation.
I will say that late Sunday night New York time was the most critical, most dangerous moment in global capital markets since the Lehman Brothers weekend in mid-September 2008. It didn’t result in a collapse; the world didn’t actually fall apart, but it came dangerously close. I guess I would say that I’m glad we got the call right, but it did look a lot more dangerous than I thought, and that’s something that should bear watching in the future because the danger has not really gone away.
JW: There’s one footnote to the Greek story that you picked up in your newsletter, Strategic Intelligence. You report that in response to the crisis, Greece banned the sale of gold to its citizens. This may be a point of interest to our listeners here. Do you have any comment on that?
JR: I did notice that, and it’s very typical of what governments do in a crisis situation. We all know that the banks were closed and the ATMs were reprogrammed to allow 60 euros a day. We all saw the queues of Greek citizens lined up to get 60 euros – roughly $100 or so – out of the banks.
When I saw those pictures a week ago Sunday, I certainly felt a lot of sympathy towards the people in that situation, but I thought to myself, “Gee, what were you waiting for? You could see this coming a mile away. Why weren’t you at the ATM a month ago, two months ago, six months ago or a year ago getting some cash and putting it in a safe place of contingency for exactly this kind of thing?” This has happened in Cyprus, it’s happened in Greece, and it will happen again. I can see this happening even in the United States in the next financial crisis, one that I expect will be worse than 2008.
That brings us to gold. You get your money if you can – that’s easier said than done – but what do you do with it? Authorities did not want people buying gold. You could say, “I’m going to get my euros out of the bank. I’m a Greek citizen; I don’t trust the Greek banks, so I’m going to get my euros out of the bank.” But what would happen if Greece was kicked out of the euro and the euro itself collapsed? Now you’d have two layers of risk: one, your own banking system, and two, maybe your euros aren’t going to do any good because those two things are correlated.
It’s a lot like when you work at a company and they offer you a generous stock purchase plan. You buy the stock thinking that’s a good investment much like the employees at Enron. Then you wake up one day and find that the company has failed. Well, you get a double-wipe out — you lose your job and your net worth at the same time. By buying your own company’s stock, you’ve doubled down on the company, and if it fails, you lose both your job and your investments. There’s a conditional or hidden correlation there.
The same thing could have been true for Greek citizens. They were lucky to get euros out of the bank – the ones who could – but just because they had their euros doesn’t mean they were home free, because if Greece quit, then the euro itself could have failed. They were doubling down in a way.
What’s the way out of that? One way out is in buying gold, to be protected against both – the Greek banking system and the euro failing – because gold is not correlated to either one of those things. In fact, I think gold could be expected to go up in that kind of catastrophic outcome.
The authorities don’t like that. They probably weren’t happy with the 60 euros a day or anyone who was hoarding cash, but they at least felt, “If we stabilize the system and do the deal with Germany, then those people will show up and put the money back in the bank.”
By the way, that’s exactly what happened in the United States in 1933. As this Greek bank holiday was going on – it was day 5, day 6, day 7 – I was reminding people that, so far at least, the Greek bank holiday had not lasted longer than the U.S. bank holiday. In March 1933, the U.S. closed all banks. Of course, there were no ATMs then, so you couldn’t even go the ATM and get $100. President Roosevelt just closed every bank in the United States by executive order. When they closed, they did not say when they would reopen. It so happened that they reopened about nine days later, but they didn’t say that at the time. They just said the banks were closed until further notice and would let people know when they would reopen.
The reason they closed them was because there was a run on the banks. People had completely lost confidence in the banking system and were running down to get all their money out of the banks. They were putting it in coffee cans and shoeboxes, burying it in the back yard, hiding it under their beds and mattresses or whatever.
As they were taking money out of the banks, a funny thing happened. There were “bank holidays,” so you couldn’t get your money out any longer. During the next nine days, the government went through the exercise or the appearance of examining all the banks. I don’t think they examined very many, but they were at least able to go through the motions – à la Tim Geithner’s stress test – and then announced that the banks that were opening at least were sound. At that point people lined up to put their money back. The banks were closed because of a run on the bank and everybody taking their money out, but then, after they reopened because confidence had been restored, people put their money back.
I’m sure the Greek authorities were hoping for the same thing, meaning people would take the money out, but once things stabilized, they’d come back down to the bank and put money back in. But there’s a problem. If you buy gold, that’s it. If you own gold, you’re not going to walk up to the teller and hand them your gold, so the authorities wanted to ban the sale of gold. Gold is a one-way street. You can always sell it, but you’re much more likely to hang onto it as a form of insurance, which in fact is a good reason to own it.
Authorities – central bankers, bank regulators, and mainstream economists – hate gold, because once people buy gold, they tend not to sell it. They tend to hold onto it to keep as protection against various catastrophic outcomes. I believe we’ll see that again.
I look at Greece and Cyprus as dry runs for the same thing on a much larger scale. Whether it’s in the U.K. or United States or Canada – it could be a lot of countries around the world – these things are being tried out on a small scale. Bail-ins, reprogramming of ATMs, and the ban on gold sales will be used on a much larger scale in the next financial panic.
Going back to the people lined up at ATMs, I say, “What were you waiting for? You should get your cash now if you want cash. Get your gold now if you want gold. Don’t wait for the lockdown.”
JW: Let’s turn from Greece to China, where there’s been some measure of recovery from the stock market collapse. We were all following it with great interest, but how serious was this collapse? It looked huge on the charts, but after all, the fall in values was only to levels seen as recently as March of this year. Is the bigger story perhaps the zealous interventions of the Chinese authorities?
JR: I think both stories are big. Let’s take them separately. First of all, I would not refer to this crash in the past tense. It’s actually just starting. I was on television last fall looking at the Shanghai Composite Stock Index and said, “This is a bubble that’s going to crash.” To me, it was very apparent. Bubbles are not that difficult to spot.
When it did crash, I called attention to that and said, “Hey, I was out there a while ago saying this was a bubble that was going to crash.” Somebody immediately came back and pointed out that the level at which I made that forecast was actually below where it was after the so-called crash. In other words, if you had ignored me and bought stocks, you would still have made money.
I’m not in the business of picking tops and bottoms or picking exact turning points. I am in the business of analyzing system dynamics and trying to understand where those dynamics are going so that we can stay ahead of the curve and not be surprised by these things, whether it’s Greece or the Chinese stock market and so forth.
Yes, it is correct that it was off the top and crashed pretty hard – about 30% – but even at the 30% level, it ran up so much that even after going down 30%, it was still above the level where it was at the beginning of the year. But it’s not over. When bubbles break, they don’t go straight down to the bottom. They go down, bounce up, down again, and then they bounce up a little bit. We hear people saying, “Buy the dips.” They buy the dips, it goes up, it goes down again, and some people say, “There’s another dip. Buy the dip,” etc. It’s a process of denial, a process of stages, an irregular process. It doesn’t go straight down.
I suggest that analysts or investors take two stock charts that actually look very alike, the Dow Jones Industrial Index from 1927 to 1933 or the NASDAQ stock market from 1996 to 2001. Either one of them will do fine. Then just normalize it and overlay it on top of the Shanghai Composite. What you’ll see is that the run up looks quite similar. It gets strong, it gets momentum, and then it goes hyperbolic. Then it goes straight up, it gaps up, and then it breaks. You’ll see is that Shanghai is nowhere near a bottom.
Everybody remembers October 21, 1929, when the U.S. stock market went down almost 25% over a two-day period. That was just the beginning. The market didn’t hit bottom until 1933. It took four years to grind its way down and was down 90% by the time it was done, not 20% or 30%.
It was the same thing with NASDAQ when it broke in January 2000. It found its way back not to the old high, but it went up a little bit and ground down a little bit. Then it broke sharply and ended up down 80%. So if you look at those stock charts and look at what’s going on in Shanghai, I would say that this crash has just begun.
Coming to your second point, the Chinese government has used extraordinary measures that are fairly well-known. They did a whole host of things to basically stop the fall. They banned short selling which seems to be the first thing everybody does. Then they told institutions they were not allowed to sell at all. Then they limited margin accounts. They also came up with a $19 billion investment fund. So they got all the brokers to buy stocks, they told the institutions they were not allowed to sell stocks, they eliminated short selling, and they did a number of other things. Who knows what they did that we don’t know about?
It was an extraordinary effort, but it hasn’t really worked. It stopped that crash dynamic and put a floor under it, but it hasn’t caused it to rally very much. I wouldn’t expect it to. This process is just beginning, so yes, it is very serious.
By the way, this doesn’t mean that the Chinese economy is falling apart. Growth has slowed down a lot, and that’s a big deal for the world because they are about 10% of global GDP, but the economy hasn’t ground to a halt. This is a stock market crash and a capital markets problem. A lot of individual investors are getting wiped out, and it could be a social problem for the Communist Party and the authority of the Communist Party.
I expect it to go down a lot more, but I would watch very closely. It’s far from over. It has that dynamic to it where it could to go down another 50% from here, go up and down a little bit, and fluctuate. This is really just beginning, and it’s a serious problem for people who threw money into it.
Meanwhile, the elites – the princelings, senior Communist party members, CEOs, owners of state-owned enterprises, and other mega-wealthy in China – are getting their money out as fast as they can. They have been for years as I covered in Chapter 4 of The Death of Money.
I travel around the world quite a bit. Go to Vancouver, British Columbia or Melbourne, Australia or Istanbul, Turkey or London or Paris – I was just in London and Paris last week – and you hear the exact same story. High-end condos are going through the roof. They’re being bought up by mostly Chinese money among others – maybe some Russian oligarchs and South American drug lords as well.
You have to be connected to get your money out of China. You may be upper middle class – perhaps you own five McDonald’s restaurants in Wuhan or a chain of 7-Elevens in Chongqing or a car dealership in Shanghai — you’re not poor but you’re not mega-wealthy. You may have a few million dollars saved up, but you still cannot get your money out of China very easily. If you are mega-wealthy worth $100 million or $500 million or $1 billion as many of these Chinese princelings are, there are a lot of ways to get money out of the country either through corruption, the ability to have offshore companies, transfer pricing, rigging fake losses in a casino, etc.
What does it tell you if the smartest, richest, most connected people in China are getting their money out? How much confidence do they have in their own economy? The stock market is a problem, but it’s not the only problem. There is a lot of rot in that society. You could be looking at social unrest down the road.
As I said, I think their stock market has a long way go down, so I wouldn’t invest a nickel in China. There are other reasons for that. For example, if you’re a large business, they steal your intellectual property. China is a fascinating story. It’s an old culture, a strong economy, and an important player in the international monetary system. I watch it from the global macro international monetary perspective, but it has so many problems and so much opaqueness that I wouldn’t recommend anyone investing in it.
JW: Is the implication then that this collapse is a very special case? Or is there anything to draw from it in a larger sense about stock market investment and what can happen from an investor’s point of view?
JR: It’s a special case in the sense that China’s stock market is collapsing. This is not happening elsewhere in the world. The European stock industries are doing okay, and Europe’s growth seems to be a little bit better.
The U.S. looks like it peaked last November – not literally peaked, but it’s reached a few new highs since then although not very much higher than it was last fall. The U.S. stock market is going sideways in what I call ‘non-directional volatility.’ There are days when it’s up 200 points, down 150 points, up 90, and down 80. Looking at a chart of the S&P and the Dow Jones, they’re wiggling sideways with a lot of volatility. Job creation seems to have slowed down as have a lot of things, so it looks like the U.S. is not quite in a recession, but we’re close to one. Growth really hit a wall as to the stock market late last year.
I don’t see the bubble crash dynamic in other major stock markets that I do in China. China seems to be unique in that case. I look at the interconnectedness, what I call density function or the potential for either what’s called contagion or what the IMF calls spillover effects. What are the odds that a crisis in one country spills over and causes a crisis in another country? That’s always a potential problem and something I look at very closely.
The Greece thing seems to have been contained to Europe so far and not too much damage was done to capital markets. Obviously, this is extremely painful for the people of Greece as they have to sacrifice: their pensions are being cut, their unit labor costs are going down, wages are going down, and unemployment is going up. There are a lot of problems inside Greece, although that could bottom and turn around pretty quickly once banks reopen, they get access to capital, and maybe some Chinese capital comes in. You might look for a turnaround in Greece, but there was no real contagion, although I think there would have been if Greece had left the euro.
The China thing does seem to be unique to China. Looking back a week ago Wednesday when we had that awful sequence of events, it looked like Greece was collapsing, China was collapsing, and the New York Stock Exchange was closed for some software problems all at the same time. Two of those things are behind us – the Greece thing and New York Stock Exchange closing – and regarding China, I think markets have absorbed that.
These don’t look like the kinds of things that will set the world on fire, if you will, or start global contagion, but they are warnings of how unstable a lot of things are. I always say that the thing that will cause a global panic is the thing we don’t expect. We could see the Chinese event coming. I talked about it on television last year in 2014. I may have been early – that’s fine – but we could see it coming a mile away. And we’ve been talking about Greece for five years, so as dangerous as those things were, neither one of them were unexpected.
One reason to own gold, one reason to be prepared and not wait for a crisis, is that when the crisis comes, it will be something we don’t expect and there won’t be time to get ready. The time to get ready is now.
JW: That’s the black swan concept! Let’s stay with China for a minute. In your first book, Currency Wars, we read about your participation in a financial war game hosted by the Pentagon. I understand you’ve just taken part in a second such war game along with a handful of elite participants from the military, the CIA, the Federal Reserve, and so forth.
I’d like to ask you about it, but I’m struck by one implication. Clearly there are people at the highest reaches of government in the United States who are taking what you have to say very seriously. Is that your impression, too?
JR: This is being taken very seriously, but I wish it were taken a little more seriously at the Fed and Treasury. Senior officials of those agencies are invited to these war games, but sponsorship and hosting comes from the Department of Defense. Actually, I would give the Defense Department, the intelligence community, and the national security community generally slightly higher marks than the Fed and Treasury for thinking about these things as threats to national security.
The Fed thinks about bank risk and financial contagion, and the Treasury thinks about counter-terrorist finance, Iranian sanctions, and all that. Those things are a little more oriented to the banking system, so they are working on that rather than capital markets, which is different than following the money around the banking system.
The Treasury tends to chase money, freeze accounts, and interdict funds of bad guys whether it’s drug dealers or terrorists or whatever. The Fed worries about systemic risk in banks. Neither one of them is thinking as much about financial warfare. Financial wars are different than currency wars. Currency wars are an economic phenomenon where countries try to steal growth from each other by cheapening their currencies, try to import inflation, and try to export deflation to the other guy. There may be some rough elbows in the arena, but it is a kind of economic competition.
Financial warfare is different in that you’re actually using financial weapons to damage your enemy. I would point to U.S. sanctions on Russia in Ukraine, and Russia fighting back by joining hands with China through the BRICS Summit, the Shanghai Cooperation Organization, the Asian Infrastructure Investment Bank, and other institutions that they’re standing up to. They’re basically replicating the Western financial system on their own so they don’t have to depend on it and can’t be victimized by sanctions. That’s more in the nature of financial warfare.
We’ve done a number of war games. The first one ever was done in 2009, and I wrote about that in Chapters 1 and 2 of Currency Wars. Interestingly, that war game was sponsored by the Pentagon, specifically the Pacific Command, and it was conducted by something called the Office of Net Assessment and the Office of the Secretary of Defense.
We conducted it at the John Hopkins Applied Physics Laboratory because they have a war room there. It’s the same place they’ve been doing the Pluto planetary exploration with this New Horizons spacecraft. All the pictures you’ve seen in the last few days of the high fives and cheering from the ground control team for the New Horizons spacecraft that went past Pluto were all from the same place in which we did the war game in 2009, in a different building. They do a lot of weapons, space exploration, and war gaming for the Pentagon.
The most recent war game I did was on May 8th and was also sponsored by the Office of Net Assessment and the Secretary of Defense. We actually performed this at the Pentagon, and it was fun going there. It was an interesting day because May 8th was VE Day (Victory in Europe Day), the 70th anniversary of victory in Europe when the Nazis surrendered. The military arranged to commemorate it, and we were able to watch them fly over vintage aircraft. They had all these B-17s and B-29s, Stratofortresses and Flying Boxcars, Flying Tigers and other World War II vintage aircraft. It was striking and touching all at the same time to see the flyover.
This particular war game was different than the one we did in ’09 which was global, included teams from all over the world, and lasted two days. This was one day and was very specifically focused on China with a very interesting twist. When the U.S. was conducting financial warfare on Iran in 2012 and 2013 – before the President announced his detente with Iran, which has now led to this nuclear agreement, we were in a financial war with Iran and we kicked them out of SWIFT.
SWIFT is the agency in Belgium that handles the message traffic for all bank wire transfers in the world. Of course, it’s all digital and runs through a lot of fiber optic cable these days, but whenever any bank moves money anywhere around the world internationally, it runs through this system.
We kicked Iran out of that system, which meant they couldn’t get paid. They could ship oil in violation of the sanctions, but there was no way to pay them. You literally couldn’t move euros, Swiss francs, Japanese yen, dollars or any currency through the payment channels because the message traffic was interdicted at SWIFT. Leave it to Washington bureaucrats to come up with a good piece of jargon for that. We call that “de-SWIFTing”, so the United States de-SWIFTed Iran.
This recent war game involved China in the South China Sea and the confrontation between the Philippines and China. The U.S. is a treaty ally of the Philippines. If the Philippines gets in a fight, it’s not just an option on the part of the United States to come to their aid, we have a treaty with them that says we will come to their aid. If China tries to de-SWIFT the Philippines, turnabout is fair play, so the message and lesson for the United States is, “Be careful what you wish for.”
The U.S. developed and perfected these financial weapons, but what we are finding is that people don’t just sit still and get pushed around by the United States. They are building their own systems, so I think there will come a time when we want to put some financial sanctions on Russia, China, Iran, Turkey or some other country, and it won’t mean anything because they will have built completely alternate non-dollar systems where they’re quite happy trading with each other, paying each other, moving money, and not relying on the United States. That’s one possibility.
The other possibility is that China will take the same tactics we’ve been using and apply them to our friends. Again, we would have this scenario where China goes to the SWIFT Board in Brussels and tries to de-SWIFT the Philippines on the grounds that the Philippines is an aggressor in some confrontation in the South China Sea. Interesting stuff. I commend the Pentagon for being forward-leaning and thinking about this.
To go back to your original question, they were very serious. I was one of the financial experts invited along with people from the CIA, other branches of the intelligence community, the think tanks, the Council on Foreign Relations, and people you might expect to be there from the Fed and Treasury. Those from the Pentagon who were hosting this were very attentive. They record everything and do a debriefing book and all that. I would say that even compared to 2009, this one had a lot more focus, and it does seem to be more on the radar screen.
I think we can say that the future of warfare is financial warfare. As if investors didn’t have enough to worry about with bank closures, inflation, deflation, contagion, and all the rest, they could be collateral damage in a financial war, which will be fought in cyberspace digitally. This is another reason to have gold. It’s a non-digital, physical asset that cannot be hacked or erased.
JW: Let’s pick up on that and talk about gold for a moment. There’s been quite a buzz in the gold blogosphere about a possible market corner of gold led by Citi and JP Morgan, with those banks taking excessive long positions in the COMEX futures market. Would you give us your view on this?
JR: I did see those articles giving information that JP Morgan and Citibank had massively large, long futures positions in gold on COMEX. Somebody looks at that and says, “A-ha! They’re trying to corner the market.” Then someone will write a blog about it, they’ll throw it out on Zero Hedge, and everyone gets spun up: “Here’s the smoking gun. Here’s the proof that Citibank and JP Morgan are out to corner the market. Look at these massive futures positions.”
I roll my eyes and say, “Have any of you people actually worked in a bank?” I worked at Citibank for ten years as one of their international tax lawyers. I worked on every kind of transaction in addition to working at other banks, investment banks, and hedge funds, etc., along the way.
If you want to corner a market, first of all, you don’t just do it with futures. It’s a three-step process. First you have to buy up as much physical as you can so it’s quite scarce. Then go buy the futures. Yes, a large, long futures position would be an indicator of a market corner. Then step 3, stand for delivery; give the exchange notice that you intend to take delivery. Now the shorts, all the people who sold you the futures, have to go out and get the physical to deliver. Lo and behold, there is no physical because you have that, too. That’s how you corner a market.
Something like this did happen in 2005 in the ten-year notes. There was a big bond investor that got massively long on ten-year notes and massively long on futures. They dominated the open interest in the ten-year note future on the Chicago Board of Trade, and then stood for delivery, and then caused a massive short squeeze. It’s really a three-step process: you have to be physical, futures, and stand for delivery.
Here, we only have one of the three. Yes, they have a large futures position, but no indication that they’re going to stand for delivery. In fact, I would be shocked if they did, and if they did, they would be told by the exchange that they can’t do that. That’s number one.
Number two, I don’t know how you could corner the physical gold market. You could buy a lot of gold, but there’s no evidence that that’s going on. Three, and the thing that I think is most incredible, is I wonder if people read the headlines. These are the same banks that have paid over $30 billion in fines, penalties, restitution, compliance costs, etc., for rigging foreign exchange, rigging energy markets, rigging LIBOR. It’s actually hard to think of something they haven’t rigged.
These guys have had enough fun with the regulators. The idea that they’re now going to launch in to a corner of the gold market when they’re under this much scrutiny and transparency, and they paid, as I said, tens of billions of dollars in fines is absolutely absurd. I think we can confidently dismiss the notion that they’re trying to corner the market, both because a lot of the ingredients are missing and also because they’d get caught in a minute, and probably somebody would go to jail.
They do have the long futures position, so my analytical frame is to say, “Okay, what’s up with that? You’re not cornering the market, but something’s going on.” If you know anything about how banks actually operate, they don’t like large, long speculative positions. Banks like to do arbitrage, spread trades or match long and shorts at two different price levels or two different markets. They want to have some difference so that they can squeeze out some spread, leverage it, and get decent returns on equity. That’s how banks actually operate.
When I see a massively long futures position, it tells me that they must be short somewhere else and are probably trying to hedge the short position by buying futures. If you suddenly find yourself short of gold, one of the things you would do is go out and buy futures. Now you have a hedge position long and short. It might take you a while to fix your short, but you have insurance against price movements. Once you’re long and short, it doesn’t matter if the price goes up or down. You’re locked in the spread and insulated. The classic purpose of futures markets is to hedge prices and other markets.
If that’s true – and that’s far more likely in my view than a corner – then where’s the short coming from? Just to be clear, this is a speculation on my part; I don’t have hard evidence of this, although I do think it’s a likely scenario. The likely suspect for the way the banks could be short would be the fact that they’ve been short all along in the London Bullion Market Association (LBMA) unallocated gold forwards market.
When people call these LBMA banks and buy gold, I’m not talking about a few coins from the mint or the local dealer. I mean a lot of gold such as a ton or $10 million worth — very, very large purchases of gold. There are the usual suspects like Citi, JP Morgan, Goldman Sachs, HSBC, and a few others. When they call the LMBA banks and buy gold from the bank, the bank gives them a standard LBMA contract which I’ve actually read. Generally what you get is called unallocated gold. Unallocated gold means that they say you own the gold, you do have a price exposure, and there’s some gold somewhere, but there’s no gold with your name on it. In other words, there’s no specific segregated bar with a serial number.
When I was in Switzerland for Physical Gold Fund, we actually saw the gold that belongs to the investors in Physical Gold Fund. We had auditors, they had bar numbers and manifests, and we went item by item. Those bars actually belonged to the fund.
That’s not true with these LBMA agreements. You don’t have any allocated gold. That means a bank can have, say, one ton of gold and they can sell 20 tons of gold. They use the one ton to back all 20 of those contracts. In effect, they’re short 19 tons. They own one ton physical and sell 20 tons to a bunch of institutional investors or high-net-worth individuals who want to own gold, so they’re short.
They depend on their customers not asking for the gold. As long as this is all on paper, it works fine. Where it breaks down is if the customer comes in and says, “You know that unallocated gold? I would like to make it allocated and actually have the physical gold. In fact, not only do I want it allocated, but I would like you deliver it from your vault to a private vault run by Brinks or Loomis or one of the big secure logistics providers.”
That is what’s going on. People are taking their gold out of banks and putting it into new vaults because they’re losing confidence in the banking system. These new vaults are private storage vaults owned by private companies, not by banks.
Going back to my original scenario, the bank has one ton of gold and they sell 20. If even five customers show up and say, “I’d like my gold,” one ton each, you’re now short four tons. You have one ton of physical, but you have five tons of requests from five different customers. You’re short four tons, so you have to go out into the market and buy four tons of market. Guess what? That’s a big order. Good luck finding it. You can find it eventually, but you might not be able to find it quickly. So you have price exposure. You’re suddenly short the gold because your customers are demanding it.
What would you do? You’d go out and buy the futures. Now you’re hedged. You’re short to the customer who sent you the notice, you’re long on the futures, but you’re price exposure is hedged. Now you can take 30 or 60 days or however long it takes to source the physical and make delivery to the customer. The customer may think the gold is sitting in the vault and can be delivered tomorrow, but trust me, they can’t. They’ll be lucky to get it in 30 days and could even take a few months.
When I see a massively long futures position, it suggests to me – again, to be clear, I cannot prove this – that banks are turning up short in some other part of the operation, probably on these unallocated gold forwards. Customers are taking their gold out of the bank, the bank has to deliver to those customers, they’re short, they’re getting long futures to hedge, and they’re going to spend the next couple months going out and buying gold.
That’s actually bullish for the price of gold. The banks are smart. They’re not going to go out and buy it all at once. They’re going to work the order in small increments over a couple of months. If they’re in the process of doing that now, which I suspect they may be, they’re also running right into the fourth quarter. We’re not there yet, but the fourth quarter is traditionally a seasonally good time for gold.
We also have our friends, the Fed, and a lot expectation that they’re going to raise interest rates. I don’t think they will; in fact, I’m pretty sure they won’t and I’ve said they won’t. If they do, it will only be because inflation took off. The Fed is not going to raise rates if inflation remains weak. Period. Full stop. Janet Yellen said that. She expects and has forecast that inflation will pick up, but she has the worst forecasting record of anyone I can think of, so I actually don’t expect that, and I don’t expect them to raise rates.
If they do so because inflation took off, that is good for gold. When the market expects them to raise rates but they don’t, that is equivalent of easing, which is also good for gold. The Fed has painted itself into a corner. Either way, raising rates on higher inflation expectations or not raising rates when the world thinks you’re going to are both good for gold. So it’s a combination of seasonal factors: the Fed’s conundrum, the fact that banks are probably out shopping, and the dollar price of gold going down. This looks to me like a very good entry point.
JW: Speaking of the Fed, you were recently invited to a financial conference in Seoul as one of two keynote speakers. The other keynote speaker with you was former Federal Reserve Chairman Ben Bernanke. That’s quite some invitation. I understand you had the opportunity to engage Mr. Bernanke in an extended private conversation. Tell us about that encounter and what you gleaned from it.
JR: We were in Seoul, South Korea. It was a large conference, but we were the only two keynote speakers along with a couple of other panelists. They had a VIP reception for about ten of us including me, the former Chairman, and the VIPs of the Korean banking establishment. There was the head of the Korean Stock Exchange, one officer from the Korean Central Bank, and the head Korean securities regulator. Chairman Bernanke and I were the only Americans.
We had a nice chat and actually had a few laughs. I was one of a group of people who had helped to organize and set up the Center for Financial Economics at Johns Hopkins University. We worked hard to get an absolutely first-rate director, which we did, and no sooner did we get our director than Bernanke called him up and hired him away to come work at the Fed to be head of communications for a couple of years. I tease my friend and call him the Minister of Propaganda, because he’s the guy who was writing all these forward guidance statements that people were pulling their hair out over. I accused the Chairman of picking off our guy. He said, “Well, we didn’t pick him off. We just borrowed him. We gave him back,” which is true because our Director is back at the center, I’m glad to say.
Mr. Bernanke was very kind. I had a copy of his book with me and asked him to inscribe it, which he did very nicely. As an author myself, I know that whenever anyone asks you to sign a book, you always do it in a heartbeat. You never turn it down. He was very kind to sign the book.
He said a number of interesting things one of which was very striking to me. When talking about a rate increase, because that’s all anybody wants to talk about, he used the phrase, “The rate increase, when it comes, will be good news for the U.S. economy because it means growth is getting stronger.”
That’s a perfectly sensible thing to say. This idea that you raise rates and that makes the economy stronger is exactly backwards. The way it works is the economy gets stronger and then you raise rates. In other words, the Fed always follows the market, it doesn’t lead the market. There’s almost this magical or mystical belief that if Janet Yellen raises interest rates, it must mean everything’s all good. It doesn’t mean that all. In fact, if she raises rates in a weak economy, it would be a disaster. We’d have a meltdown.
What Bernanke said did make sense. He said, “The rate increase, when it comes, will be good news because it means the economy in getting stronger.” But then you have to look at the data, which is really weak. By saying “when it comes,” it told me that he wasn’t expecting it anytime soon. In other words, he was conditioning it on economic growth but didn’t suggest at all September, December, this year or any particular time, and he clearly conditioned it on stronger growth, which there is no sign of.
I thought he pulled the rug out from under Janet Yellen. Janet Yellen is trying to have it both ways. She’s trying to get out there, put on a brave face, and talk every day about raising rates later this year. All the headline writers and reporters run right out and write a headline: “Janet Yellen Says We’re Going to Raise Rates This Year.” Forget the headlines. If you actually read the speeches or listen to the testament and look at what she says, it’s always conditioned on stronger growth and economic conditions meeting her forecast. The forecast is three parts: lower unemployment, higher inflation, and stronger growth.
We’re not getting to any three of the levels that she specified in her May 22nd Providence speech. I read an interesting speech she did last Friday in Cleveland, and I found the May 22nd Providence speech to be a lot more specific about the numeric goals she’s looking at. I think she really told us what her playbook is. Based on that, we’re not getting close to any of them, so I don’t see a rate increase. That was consistent with what Bernanke said, and I agree with the former Chairman. People who are expecting Janet Yellen to raise rates are not listening carefully enough to what she’s truly saying.
Another interesting thing he expressed was when he talked about the international monetary system. Now we’re talking about IMF, currency wars, Special Drawing Rights (SDR), and all the things I spend a lot of time researching and writing and talking about. It’s a little unusual for the Fed Chairman to be immersed in that because that’s really the job of the Treasury.
The Treasury Secretary is supposed to be worried about the international standing of the U.S. dollar, and the Fed is supposed to worry about domestic monetary policy. The Fed’s not supposed to have a big footprint in the international monetary system, yet he told me that he was involved working with the IMF to restructure Chinese participation in the voting rights of the IMF.
I was a little surprised at that. He’s clearly competent to do that, but to see the Chairman of the Fed working hand-in-glove with the IMF and the Secretary of the Treasury on Chinese voting rights in the IMF was a little bit unusual. I thought, “Gee, you’re really out of the Fed’s comfort zone.” Then he went on to say that the international monetary system is incoherent. That was his exact word – “incoherent” – which I agree with. It is incoherent. It’s a mess. About ten days later I was in the United States down in Washington and had a conversation with John Lipsky. John is the former Director of the IMF. In a separate conversation, he used the exact same word. He said. “The international monetary system is incoherent.”
I don’t think Bernanke and Lipsky were coordinating their remarks, certainly not to me, but I did find it striking that the former Chairman of the Fed and the former head of the IMF both used the exact same word to describe what’s going on, specifically “incoherent,” which tells me that’s it’s in the air. The elites – the people who really run the global monetary system – are on the same page. We’re going to need new rules to the game, new rules to the playbook for the international monetary system, starting in the fall with the inclusion of the Chinese yuan in the SDR. I think we can all see that coming. They may go beyond not only changing Chinese voting rights, but also maybe issuing some SDRs. We have to watch that.
We’re halfway back to Bretton Woods. We have an informal peg right now going on between the Chinese yuan and the U.S. dollar, around 6.2 to 1. That’s been very stable. The Chinese are not playing the currency war card as they did from 2006 to 2014. They’re on their best behavior hoping to join this exclusive SDR club. I’ll certainly watch that very closely.
It was an interesting conversation, and I’ll briefly mention a third thing Bernanke was very candid about. He used the word “experiment” repeatedly. In other words, he said that what they and the Fed did with monetary policy from 2007 to early 2014 when he left was an experiment, which means they didn’t really know what they were doing. They were just trying stuff. He talked about FDR, Franklin Delano Roosevelt, and what was a very popular term in the ‘30s during the Great Depression. The New Deal was a government-instituted series of experimental projects and programs. “We were just going to experiment to see what worked.”
The thought crossed my mind that most experiments actually fail, and I was hoping that he hadn’t blown up the laboratory in the process. The jury is still out on the success of his time at the head of the Fed, but he was candid about the fact that they don’t really know what they’re doing.
JW: When I look back over the last 50 minutes, we’ve covered an extraordinary amount of ground. It’s always a pleasure and education having you with us. Thank you, Jim
JR: Thanks, Jon.
JW: Thank you to our listeners most of all for spending time with us today. You can also follow Jim on Twitter. His handle is @JamesGRickards.
Goodbye for now, and we look forward to joining you again soon.
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