March 12th Gold Chronicles topics:
*There will be no Grexit
*Greece exiting the Euro would be catastrophic
*Global contagion is a real possibility
*Greek negotiations will continue to be difficult but they will come to a deal versus a Grexit
*Austria Bail-In significance
*Depositors and Bond-holders have always been unsecured creditors of banks
*Depositors have taken it for granted that there is some kind of sacred agreement that deposits would be returned
*Any deposit made with a bank is an unsecured loan to that bank
*G20 Brisbane Summit communicated bail-in intentions
*Physical gold outside the banking system is not subject to bail-ins
*No Fed interest rate rise in 2015
*23 Central Bank rate cuts in the last three months
*This is currency wars on steroids
*Investors are looking at Fed rate hike as potential yield, dump global currencies and buy dollars
*Current deflation is crushing entities dealing with corporate debt denominated in USD
*$9Trillion of USD denominated corporate debt globally held in countries where they cannot print dollars, they have to buy dollars to meet obligations
*If the Fed raises rates it will be the ripple around the world that might cause a $20 trillion (with leverage) bubble to unwind
*At this point Jim likes gold, cash, and 10 yr treasuries
*Jims view on safety of money market funds
*Negative interest rates, how low can they really go
*Financial academics can do the math, but they cannot predict the psychology
*How to know if your physical gold is outside of the banking system
*Ratio of paper short positions versus real physical gold availability
*Why Physical Gold Fund is Jim’s favorite
*How low can the Euro go
*A stronger dollar is the same thing as a rate increase
Listen to the original audio of the podcast here
The Gold Chronicles: 3-12-2015
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 this series we’re calling The Gold Chronicles. Jim Rickards is a New York Times best-selling author and the Chief Global Strategist for West Shore Funds. He’s the former general counsel of Long-Term Capital Management and is a consultant to the U.S. intelligence community and the Department of Defense. He’s also an advisory board member of the Physical Gold Fund. Hello, Jim, and welcome.
Jim Rickards: Hi, Jon.
JW: We also have with us Alex Stanczyk of the Physical Gold Fund. Hello, Alex.
Alex Stanczyk: Hi, Jon, great to be here.
JW: Alex will be looking out for questions that come from you, our listeners. Let me just say that your questions for Jim Rickards today are more than welcome. You’ll see a box on your screen for typing in your question, and you may post them at any point during the interview. We’ll do our best to respond to you as time allows. Jim, let’s return to Europe where we spent quite a bit of time in our last webinar. The Greek drama continues to unfold, but just as you predicted, there’s no sign of a so-called Grexit, meaning a breakaway of Greece from the European Union. What we do see are some awkward compromises by Greece’s radical new government, such as raiding the country’s pension funds to pay back the IMF. How do you read this story?
JR: Your introduction is a pretty good capsule summary in itself, Jon. The story is not over by any means. If you went to the Acropolis 2,400 years ago, to a real Greek drama, it would be over in a couple of hours, but this one is going to continue for a few more years. My expectation is that there will be no Grexit. Greece will not leave the euro, they will not be forced out of the euro, and they will continue to use the euro as their currency. That’s the big picture and I think the significant thing that investors need to stay focused on. It’s a very big deal, because if Greece did exit the euro on its own or if they were forced out by Germany or other participants in the EU or IMF etc., that would not be a small event. It would be, in my view, catastrophic.
A lot of people have tried to write it as a small event, and their analysis goes as follows: Greece is a very small economy, which it is. It’s not only small relative to the world when you’ve got giants like China, U.S. and Japan, but it’s small relative to Europe. The Greek debt is significant relative to Greek GDP, but it’s not that substantial relative to European GDP, etc. The Greek economy is not that big a deal, but that’s not where it would end. In other words, markets always discount the future. They look two, three, four, moves ahead. Policymakers may not and a lot of analysts may not, but markets do, and I think that the best analysts are always trying to do the same thing. The market would immediately begin to discount the possibility of Spain leaving, the possibility of Portugal leaving, and then ultimately Italy and France, and then all the dominoes falling.
The problem with dominoes is that it’s not the first one that matters — it’s all the ones that are lined up after it. The idea that you could clinically, surgically remove Greece but nothing else bad would happen is not true. There’s a lot of history, but just go back to the two most recent episodes of contagion. Take the European debt crisis. That actually didn’t start in Europe; it started in Dubai. The day after Christmas, 2009, Dubai unceremoniously announced that they were not going to pay their debts, well over a hundred billion dollars. That caused everyone to say wait a second, if Dubai can’t pay, are there other weak links in the chain? Of course, people immediately took a look at Ireland, Greece, and Portugal. And that was the beginning of the European sovereign debt crisis.
The same thing occurred in 2007 and 2008. We saw those Bear Sterns-sponsored hedge funds collapse in July 2007, spreads started to blow out, and there was a lot of panic. By December, the view was that it looked like it was all under control with sovereign wealth funds coming to the rescue and the recap in U.S. banks. It was all good — but then boom! March 2008, Bear Sterns, boom! June 2008, Fannie and Freddie, and then the biggest explosion of all, September 2008, Lehman and AIG. We all know what happened from there. You can’t knock over one domino, or as I like to say, you can’t disturb one snowflake the wrong way without risking an avalanche. So that’s why Europe wants to keep Greece on board.
Greece for their part wants to stay in the euro. Poll after poll shows that Greek citizens want the euro. This surprises a lot of Western analysts, but they do. They know what happens when they go to the drachma. The government devalues the drachma: they inflate the value of the drachma and steal your savings, pension, retirement, and insurance. Any fixed income obligations go up in smoke. The Greek people have seen that movie many times over the last 30 or 40 years, so they like the euro. Basically, what would happen if Greece left the euro? The currency would hyper-inflate. That would cause more social unrest than they already have and dry up direct foreign investment. No more Chinese investment coming in to Greece, no more ability to borrow money, and no more ability to roll over debts. Greece would be reduced to possibly less than a Third World economy — something more like the Balkans. That might even be an insult to the Balkans.
The dynamic is Greece has a lot of reasons not to quit and Europe has a lot of reasons not to kick them out. Put those two things together and they’re not going to quit, they’re not going to get kicked out. Now beyond that, is this negotiation going to be messy? Yes. Is it going to be volatile? Yes. There will be a lot of accusations; there will be good days and bad days.
Under the Schengen Agreement, if you’re in the European Union, you can go to any other country in the European Union without customs or immigrations. You can just drive from Athens to Paris and cross seven or eight countries without any immigration formalities.
Now I guess they have some detention camps in Greece where illegal immigrants show up and they keep them in detention. I saw the Greek Defense Minister the other day, not the Finance Minister, but the Defense Minister who said we’re going to open up the detention camps and release all these people. By the way, he said, we think some ISIS terrorists are probably included. There’s the threat in effect that they’ll release ISIS terrorists who will be on their way to Paris by tomorrow morning. Thank goodness he’s the Defense Minister, not the Finance Minister. This is really like putting Don Rumsfeld in charge of the TARP; I’m not sure how that would’ve ended up! But the point being, it’s messy, there will be volatility, and I’m not saying this is easy. With a lot of posturing, at the end of the day Greece is going to stay in and the euro is going to stay together. So again, get ready for more fireworks but don’t read too much into it.
JW: Staying in Europe, Jim, something happened in Austria that echoes another story we’ve been tracking, and that is the so called bail-in. There’s a major bank, Hypo Alpe Adria, that was nationalized in Austria when it ran into trouble some years ago. Well, it’s in trouble again, but this time, the response is different. The Austrian regulators are going after the bank’s bondholders rather than providing the classic government bailout. What’s the significance of this?
JR: I think it is significant as a matter of policy. Just to be clear, there’s nothing new here. As a matter of law, a bondholder has always been an unsecured creditor of a bank. A secured bond is different. If you have a mortgage on the bank headquarters, maybe you can foreclose on the headquarters. There are ways to get a secured obligation, but most bonds issued by banks are not secured obligations. Deposits have never been secured obligations. They might be insured by a deposit insurance scheme, but they’re not protected by a security insurance. Again, depositors and bondholders have always been unsecured creditors of the bank except for a deposit insurance or in a small number of secured bonds. So that’s not anything new.
It is true that for about 80 years since the Great Depression, depositors have taken it for granted that if you’re a depositor, you have some kind of sacred obligation from the bank to give you your money back, and you’re not at risk. That’s never been legally true, but it has been taken to be true. It’s the same thing with bondholders because of the famous Greenspan Putt, which turned into the Bernanke Putt, which turned into now the Yellen Putt, and the whole doctrine of too big to fail. People who are lending on security banks said maybe I’m not a secured bank holder but banks are too big to fail; if this bank gets in trouble, the taxpayers are going to bail it out. I’ll get my money back.
That actually was true. As recently as 2008, no bondholder took a nickel of losses. I’m incredulous of that. I know it as a fact, but to this day, I can’t believe that nobody had to take a haircut. To my knowledge, the only bondholders who took haircuts in that whole 2008 fiasco were some hedge funds who owned Chrysler bonds — not the unions, by the way, just the hedge funds. Of course, Chrysler is not a bank, but Fannie, Freddie, Citibank, JPMorgan, Goldman, Morgan Stanley, Bank of America, you name it, no bondholder took a nickel of losses even though taxpayers bailed out the banks to the tune of trillions of dollars in terms of guarantees, etc.
What’s happened since then? I’ll say the regulators, but really it’s people more powerful than the regulators — this is more the G20 finance ministers, people at the IMF and on the Board of Governors, the Fed more so than, say, the New York Fed who are in bed with the banks — they came to the realization that we can’t afford this anymore. Maybe we did in 2008 because we weren’t ready for it and the alternative was worse. (I disagree with that, but I’m just trying to describe how they viewed it.) The alternative was worse, but basically, we can’t keep running this again because one of these days it’s going to be bigger than the central banks. Listeners and others have heard me say before that the next crisis will indeed be bigger than the central banks, but there’s an extent to which the central banks will start to realize that themselves. Certainly politically, the taxpayers have no appetite for this. The taxpayers did bail out the entire system in 2008, but that was politically unpopular.
Remember the TARP which was the big U.S. bailout program. When that was put to the House of Representatives, it failed on the first vote. The stock market fell 800 points that day, from a much lower level, by the way. In equivalent terms, that would be well over a 1,000-point drop today. That spooked the Congress, and then Bernanke said, look, if you guys don’t do this, the whole system is going down, so now how do you feel? So Congress passed the TARP on a second vote, but it was close. It shows how unpopular this is with the taxpayers. It’s a combination of: A) are we feeding a crisis bigger than ourselves, bigger than our own central bank capacity to squash it? Or B) are we politically jeopardizing the ruling parties by doing something so unpopular that the electorate is going to throw us out? If the answer to both of those questions is yes, then they have to try to prevent it.
This is not some deep, dark conspiracy. These are G20 finance ministers, people from the IMF, and people who have names. They’re real people, and they put out public documents. What they said is that from now on, if banks fail, bondholders will suffer losses, and you depositors, if you have more than the insured amount, you’re going to suffer losses. I think the insured amount is $250,000 in the U.S. which is a lot of money for the average saver. Certainly for the average citizen, that’s a huge amount of money, but it’s not for corporations and even for small businesses. You don’t have to be Exxon. You could be a dry cleaner, a successful pizza parlor operator, run a small manufacturing company or own a small distribution company and easily have working capital balances in excess of $250,000.
The regulators are advertising in effect that you are not safe, you are an unsecured creditor. If your bank goes down, your money is at risk. There are two examples of this. The best known one was Cyprus, which is on the euro and a member of the Eurozone. A few years ago we saw bank depositors in Cyprus suffer losses, bondholders suffer much larger losses, and stockholders get wiped out when they had to bail out Cyprus banks. The other example is the case you mentioned, the Hypo Alde Adria Bank in Austria, where the same thing happened. So you’re on notice. They’re telling you, so don’t be shocked or outraged or say oh my goodness, how could this happen? First of all, it’s always been the law. It wasn’t always the policy, but it was always the law. Secondly, they’re telling you loud and clear.
One of the things I say about the monetary elites is that they do tell you what they’re doing. Now, it’s real geeky, and they use a lot of jargon, and you must dig hard to find the stuff. I call it transparently non-transparent, meaning they tell you what they’re doing, but good luck finding it or good luck understanding it if you do find it. I would refer interested parties back to the G20 Summit in Brisbane, Australia, last November. Go to the communiqué, look at the appendices to the communiqué, and go into the working papers where you will find blueprints for the bail-in. They actually used the term ‘bail-in,’ so there’s no mystery about it.
Get ready to lose money when the banks go down, which by the way is a good reason to own gold. Gold in physical form outside the banking system is immune to this, so I would not have all my money in the bank. You need some money in the bank as working capital, but I would have some in physical gold outside the banking system, because you’re not going to get bailed in.
JW: Clearly, by implication, what happened in Cyprus and in Austria could also happen here where you and I are, in the United States.
JR: That’s exactly right. The U.S. is a member of the G20, and we signed on to the Brisbane communiqué. As I say, it’s always been the law. I don’t claim to be an expert in banking laws of 185 members of the IMF, but I am a U.S. lawyer, and I have worked for banks, bank holding companies, and investment banks, and I’ve had a long career as a regulatory counsel to banks. Any deposit in excess of the insured amount is an unsecured loan to a bank; it’s not an entitlement. Any bond not secured by specific assets and with the right legal pledges is at risk. So get ready to lose money if the banks go down again, which is probably just a matter of time.
JW: Let’s come back here then to the United States for a minute for our next thought, and that’s about what’s going on with the Federal Reserve. Once again, even more euphoria about the economy, the latest job reports, a significant rise in new jobs, and a drop in unemployment figures. This is leading naturally to talk about the Federal Reserve raising interest rates. I feel as if I’ve asked you all these questions before, but here we go again. In this context, will the Fed announce a rate rise at the upcoming FOMC meeting? And if not, why not?
JR: We have discussed it before, Jon, but it’s one of my favorite topics because I’ve been able to strike out a little bit of a contrarian view on this. I’m happy to update the listeners. Whenever I’m in a seminar like this or asked to give my views on something, I always give my best, most thoughtful, up-to-date view, but new stuff comes out every day. One of the benefits of this webinar series, The Gold Chronicles, is that we do them once a month and it is a good opportunity to update. One of my analytical techniques is called ‘inverse probability.’ It’s how you analyze things, or I should say how I analyze things. We do this in the intelligence community and elsewhere, but it’s not usually done on Wall Street and certainly not done at the Federal Reserve.
A lot of the problems we confront are what we call ‘underdetermined.’ Underdetermined is just a fancy way of saying we don’t have enough information. So what happens is, the statistics geeks build models, take the data they have, crunch the numbers, and come up with forecasts. If you’re the Fed, you’re almost always wrong. I would actually say always wrong, because I haven’t seen any good Fed forecast since I can remember. The inverse probability technique I use is a little bit different. I’m candid about the fact that I don’t have enough information so I come up with a hypothesis based on whatever scraps of information I do have. I also use other things — intuition, history, and things that statisticians and 160 IQ finance PhDs don’t like to talk about, but they work pretty well. I do the hypothesis first and then test it against the data every day and challenge my own assumptions. If the data comes in confirming what I thought, then I strengthen the hypothesis. If it goes the other way, I throw it away and come up with something else.
I have said since last year — not in prior months this year but going back to 2014 — that in my view the Fed would not, and I’ll say could not, raise interest rates in 2015. So far, so good, but it’s early in the year so we’ll see what happens. I based that on a couple of things. Number one, let’s go all the way back to December 2013 when Ben Bernanke started the taper. Remember, Janet Yellen did not take over until January 2014. Ben Bernanke was still chairman in December 2013 and started the taper. I’m sure Yellen was on board, but it was Bernanke’s idea. Yellen finished it; she saw it through and they kept tapering during 2014. This was based on an assumption that the U.S. economy was getting stronger and growth was pretty good. They said we’re going to do the following sequence: First we’re going to taper, meaning reduce and then stop long-term asset purchases. Then we’re going to pause. Then we’re going to raise rates. Then we’ll raise them some more. Then we’ll start to reduce the balance sheet. And we’ll all live happily ever after. It was a multi-year sequence.
The second basis for my view is that they did the taper but… a funny thing happened on the way to the forum. By the time the taper finished in late 2014, the U.S. economy was already showing signs of weakness, and those signs of weakness have become a lot more visible, a lot more apparent by now. Certainly January, February, and March so far shows a lot of the data is coming in really weak. Plus another thing happened which they didn’t anticipate, which is the fact that the whole world is easing. Europe has QE, China reduced the reserve ratio requirement and cut interest rates twice. There have been 23 central bank rate cuts in the past two and a half months — again, 23 central bank rate cuts in the past two and a half months. This is the currency war on steroids.
We have this massive rate cutting or easing around the world, and here’s the Fed, the lone central bank (except Switzerland — I’ll put Switzerland in a separate category) saying we’re going to raise rates. Guess what that does to global capital flows? It brings them to the United States. If you’ve got capital anywhere in the world, and Europe’s paying you nothing, and China says we’re going to pay you less, and the U.S. says we’re going to pay you more, that capital is going to come to the United States. This means the dollar gets stronger because people are dumping emerging market currencies, dumping the euro, and buying dollars because they want the dollar return they see coming. That’s a strong dollar. What does a strong dollar mean? It’s deflationary. What is the Fed’s stated goal? The Fed says we have an inflation goal.
Let’s think about this for a second. The Fed says we want two percent inflation. That’s not a secret; they say that all the time. Then they say or strongly imply that they’re going to raise rates. They’ve given markets no reason to think that they won’t raise rates, but raising rates makes the dollar stronger, which is deflationary and pushes the Fed away from their inflation goal. How does that work? The answer is it doesn’t work. If you actually go down that path, you will get a stronger dollar and deflation, you will be defeated in your inflation goal, and you may actually have to cut rates later which is a complete loss of face and confidence. I already know the Fed doesn’t know what they’re doing because Fed governors have told me privately they don’t know what they’re doing. But that would just tell the whole world that they don’t know what they’re doing.
They could even go to QE4 in early to mid-2016. They don’t want to do that, so they’re between a rock and a hard place. My expectation is they will not raise rates, but let’s just say I’m wrong and they raise them. If they raise rates, look out below, because that’s going to accelerate and exacerbate the trends I’ve just described. It’s going to be more deflationary.
As a side note, deflation is hurting the overseas earnings of U.S. corporations. If you make money overseas as a U.S. company, you report in dollars. If you have to convert those overseas earnings back into dollars when the dollar is stronger, that’s going to reduce your earnings. What’s that going to do to stock prices? It’s going to take them down. What’s it doing to bond markets? Yields are going down because deflation is getting worse. So bonds are going up, stocks are going up, the dollar is going up, everything is going the wrong way for the Fed at least in terms of their inflation goal. That’s what’s going to happen if they raise rates.
This is all going to come to a head Wednesday of next week because the Fed has a meeting and there’s a press conference. This shows how ridiculous things are. Why are all the smartest people in the world having sleepless nights over the word ‘patient’? The question is will the Fed remove the word ‘patient’ from the statement they release after each FOMC meeting because they’ve said they will not raise rates until two meetings after they take out the word ‘patient.’ Now just follow me on this. There’s a meeting in April and a meeting in June, so if you want to raise rates in June, you have to take out the word ‘patient’ in March so that after two meetings (April and June), you can raise rates in June.
If they take out the word ‘patient,’ they’ll think maybe we’ll raise rates in June, maybe we won’t; that gives us a free option. But we all know what the markets are going to do. The markets are going to anticipate they will raise rates in June. Markets always discount and bring the impact forward. Taking out the word ‘patient’ in March is equivalent to a rate increase, because the markets will assume they’re definitely going to raise them in June and then discount it back to March which is only like 60 days — that’s the same thing. So it’s equivalent to raising rates in a world where the dollar has gone to the moon. The dollar hasn’t been this strong in 12 years. If they don’t take the word out, if they leave the word ‘patient’ in, the markets are going to think now they can’t raise them in June, so let’s look at July.
In this game, the Fed keeps painting themselves into a corner. They seem incapable of thinking two moves ahead. They can barely think one move ahead because they have to make a decision by Wednesday. This is what happens when you manipulate markets — you have to keep manipulating just to keep the whole thing from falling apart. I don’t know if they’re going to take out the word ‘patient’ or not. My gut tells me that they’re going to leave it in because they can see this train wreck. I don’t want to put a stake in the ground on that, because they might take it out, but I do feel strongly that if they do take it out, the dollar is going to spike, the bond market is going to rally on that, and stocks will go down.
This is a fiasco for emerging markets. Look at it from their point of view. I’ve been talking about the impact of the Fed and the dollar and U.S. stocks and bonds, but let’s go overseas. They’re short in dollars by nine trillion. There is approximately $9 trillion of emerging markets dollar-denominated debt. That’s corporate debt, not sovereign debt — put that to one side. It’s not local currency debt; put that to one side. U.S. dollar-denominated corporate debt, emerging markets, $9 trillion. If you’re in Turkey, Indonesia, Mexico, Brazil, Korea, Singapore, Thailand or for that matter China, your central bank can’t print dollars, but you owe dollars. You make local currency, so to pay back the dollars you have to get $9 trillion. That means you’re short $9 trillion. This is what I call the big short.
Michael Lewis had a very successful book a few years ago called The Big Short about the mortgage crisis. It tells the story of a few investors such as John Paulson, Kyle Bes and a few others who in ’06 could see the mortgage train wreck coming and they said my goodness, this is the greatest opportunity of a lifetime. How do I short this thing? They went to Goldman Sachs who cooked up a bunch of derivatives. (Of course, they sold the other side of the trade to somebody else, but that was their problem. That’s good old Goldman.) But Kyle, John Paulson, and others managed to put on the big short. John Paulson personally made $5 billion. That’s not his investors; his investors made more. He personally made $5 billion on that trade. That was a one-trillion-dollar trade levered up 5 to 1. Look around the world today. What’s the big short? We have a nine-trillion-dollar emerging markets short dollar position without leverage. If we put some derivatives around them, I’m sure we could get it up to 20 or 30 trillion without too much difficulty. Just to give you the order of magnitude, that’s 50 percent of global GDP. And don’t think people aren’t doing this.
So you’re Janet Yellen sitting there in your little Fed bubble on the second floor outside the boardroom on the marble hallway of the Federal Reserve with your little incredibly flawed models that you learned at MIT. You’re sitting there saying we have to raise interest rates, but meanwhile you could be popping a 20- or 30-trillion-dollar bubble. To me this looks a lot like 1997, more so than 2008 which might actually be small compared to what happens next. This looks like 1997 that ended famously in August – September 1998 with the default by Russia and the collapse of Long-Term Capital Management. I think we mentioned at the beginning of the webinar that I was general counsel of Long-Term Capital Management at the time. I negotiated that bailout, so I had a front-row seat on that one. I know how these things go down.
That actually started in June 1997 over a year earlier in Thailand where there was a loss of confidence and the hot money started to come out of Thailand. People started selling the Thai baht and taking their dollars out of Thailand. The central bank couldn’t maintain the peg, so they broke the peg. That immediately caused contagion, i.e. loss of confidence in Indonesia, South Korea, and it went around the world before it got to Greenwich, Connecticut, where we were. Something similar is happening today. I hope someone’s explaining this to Janet Yellen. Actually I hope she’s listening. I doubt it, but I hope she’s on the call. If she raises rates, that’s going to be the beginning of a snowflake that’s going to ripple around the world, and it has that kind of catastrophic potential.
Let’s see what happens. I believe they think that they can take out the word ‘patient’ and act like nothing happens to June and may free up an option. That misreads the situation. I think the markets are going to say you don’t have a free option. We’re going to treat it as a done deal. We’re going to discount it to March. We’re going to act like you just increased rates. Then this sort of cascade will bubble all around the world. It’s a good time to own gold and to have cash. I like bonds for the same reason because in strong-dollar panics, flight-to-quality panics, treasuries will rally. I may not like stocks.
Here’s the problem. Let’s say the Fed doesn’t raise rates and they leave in the word ‘patient.’ Let’s say we get to June or July and the data continues to come in weak. They continue to remain ‘patient’. Maybe they call Jon Hilsenrath from the Wall Street Journal who receives calls from the people of the Fed, and they say we’re going to be very patient. Jon is a good reporter, so he puts it out there. People like to beat him up, but the guy’s just doing his job. Then they start to say, well, yeah, patient, we’re actually going to be very, very patient. If the market is pricing in a rate increase and the Fed doesn’t raise rates, that’s the same as a cut, right? They can’t cut because they’re at zero, but if you’ve priced in an increase and they don’t increase, that’s like a cut. So markets could actually rally on that.
That rally won’t be in the next couple of months. It’s something that would probably play out in the second half as the Fed folds their hand. It’s a problem for investors. I can give you a scenario, in fact I just did, where stock markets collapse based on the rate increase path. By the same token, I can give you a scenario where the Fed blinks, doesn’t raise rates, and markets rally because it’s like a rate cut. That’s not being wishy-washy; that’s just being very candid about how the dynamics work. It’s also a very good illustration of how the Fed should just get back to doing their job and stop trying to micromanage the entire world.
Let’s watch it very carefully. My view now is that we’re going to have the worst of both worlds. What I mean by that is the Fed is not going to be able to raise rates for the reasons I’ve mentioned but they’re going to keep acting like they can. The markets are not going to know which way to turn, so we’re going to get volatility. Again, I like gold here, I like cash, and I like 10-year notes. And stocks? I don’t want to short them because if they don’t raise rates, they could rally, but you don’t want to back up the truck either because if they do raise rates, there could be no bottom. I’ll stop there, but that’s where we are.
JW: It’s an extraordinary story. I was trying to figure in my mind if it’s Alice in Wonderland or Gulliver’s Travels. When the global economy stands or falls on the presence or absence of the word ‘patient,’ that’s totally bizarre. Thank you, Jim. We do have some questions from our listeners, and here’s Alex Stanczyk with those questions.
AS: Thank you very much. I have to just make a quick comment. I was doing my best not to split my sides with laughter with the whole “I hope Janet Yellen is listening” comment. As usual, we have way more questions than we probably have time to answer. The first one comes from Jim L., and his question is: “A large part of our funds are currently in money markets. I’m a Canadian. Is this a satisfactory place to be at this time?”
JR: The answer is no, and let me explain why. We talked earlier about how bank deposits are not safe beyond the insured amount. I think they are safe up to the insured amount, so I just want to be clear on that, but beyond the insured amount, you’re just an unsecured creditor. Now you can go to a too-big-to-fail bank. Bank of America or Citibank are in some ways the most reckless, worst managed banks in the world, but our system is so messed up that the most reckless banks might be the place you want to have your money because they are too big to fail, and they’re the ones that are least likely to actually collapse. This is another example of how messed up things are.
People think money market funds are like cash. That’s why they were invented. They were invented in the 1970s when a lot of usury laws were still on the books. Most of those laws have been repealed since then, but at the time, interest rates were on their way to 20 percent. Around January of 1980-81, Paul Volcker took short-term interest rates to 20 percent, but there were a lot of usury laws that said the banks could only pay maybe 10 or 11 or 12. Merrill Lynch invented the money market fund so they could pay whatever they wanted because they weren’t a bank. That’s a little bit of history.
Money market funds were invented as, first, a cash substitute and then they later became a cash equivalent. If you call any investor in America or Canada – I don’t think it’s different – and say, is your money market fund cash, they’ll say, yes, absolutely. You can call your broker today and the money will be in your bank tomorrow. It’s not same-day cash; it’s next-day cash. If you have a big bill to pay tomorrow, you call up your broker today and say, I want you to move money from my money market fund to my bank account, and the money will be there tomorrow good to go. Other than the one-day lag, it’s cash.
Well, last summer the SEC finalized a rule stating that money market funds can suspend redemptions, which means they’re not giving you your money back. This has always been true in hedge funds. As a hedge fund lawyer for many years, I’ve probably read 300 or 400 hedge fund offering documents, and they all have suspension clauses. You may read a hedge fund document that says you can get your money back on 30 days’ notice or three months’ notice, but oh, just in case things get hairy, we don’t have to give you your money back. It’s called the suspension clause and is just the way hedge funds work.
That’s now the law for money market funds as well. That’s new. I’m sure that last August or September, hundreds of millions of Americans opened their money market fund account statements and there was a little high-gloss flyer stuck in the pages that told you this. I would think that 98 percent of people threw it in the trash, because who wants to read the fine print? What it said is that just in case we feel like it, we don’t have to give your money back. This is what we call ‘conditional correlation.’ Conditional correlation is when there’s no correlation except when there is. With regard to money market funds, that means when you really, really don’t need your money, you will be able to get it. When you really, really, really want your money like when the world’s collapsing around you, you won’t be able to get it.
I’m sure you could call your money market fund right now and have your money tomorrow because there’s nothing really bad going on. If this emerging markets collapse that we talked about happens or a replay of 2008 or banks are failing or they’re using the bail-in clause, things are falling apart left and right – and don’t tell me that can’t happen because it’s going to happen – when you want your money the most, you could say I really have to get my money because I want to go buy some gold or whatever, that’s when you won’t be able to get it. That’s when these suspension clauses will be put in place because every trade has two sides. You say I own a money market fund. That’s fine. What did the money market fund do with your money? They went out and bought commercial paper from banks. The point is, do you think the banks can pay in that world where under Dodd-Frank they’re being shut down?
The money market fund needs the ability to suspend because people are going to suspend from them and they don’t want the money market fund managers dumping paper on an oversaturated market. The whole thing is going to break down. The short answer is yes: for working capital or some small slice, you might need some money in money market funds, but you are at risk to an asset freeze. So what can you do? You can’t walk around with hundred-dollar bills in your pocket. If you have too many, the police will think you’re a drug dealer. What you can do is have short-term treasuries. I’m not a fan of how the government runs its finances, but I do think that 30-day treasury bills (although they pay almost nothing) are liquid. Very short-term treasury notes owned directly will be liquid, so you should be able to get those. Think of the extra little yield you get by being in a money market fund. Nothing’s free. Think of the delta between the yield on the money market and yield on the treasury as the premium that you get for selling a put option, because when things get bad, you’re going to be stopped out. You’re not going to be able to get your money back, so in effect you’re selling an option not to pay your money and you probably don’t even realize it.
AS: That was an excellent answer. The next question we have comes from Juha who asks, “How far can NIRP or negative interest rate policy go? Are we going to have two percent central bank interest rates in a few years? And is something going to break if it continues like this?”
JR: When I was in high school, there was a dance craze called the limbo rock. Two people would hold what they called the limbo stick and you’d form something like a line dance. When it was your turn, you had to bend backwards to get under the limbo stick. Really acrobatic people could put their fingers on the ground although sometimes that was against the rules and you’d fall down. The song they played was “Limbo Rock.” At one point in the chorus it said, “How low can you go?” That was the point of the dance, and it’s the same thing with negative interest rates. It’s a big psychological, operational, and policy threshold. Going from 0 to -1 basis point is a very big deal. Once you do, what’s the limit? How low can you go? Why not -1,-2, -3?
I think crossing the threshold is a very big deal. We’ve crossed the threshold; we’re through it. It wasn’t like Y2K that turned out to be a non-event. Remember Y2K on January 1, 2000, when everybody was concerned that computers wouldn’t work because they’d all been programmed to have 1-9-9-9. A lot of programs didn’t account for the two zeroes. It turned out to be a non-event and this was similar. Could you actually program computers to deduct money from peoples’ accounts instead of adding money to peoples’ accounts? The answer is yes, no problem. Now that we’ve crossed the threshold, I think they can go as low as they need to go.
What’s the significance of it? Let’s talk about what it actually means. The central banks are trying to get to negative real rates. Negative real rate just means that the interest rate they pay you is lower than inflation. A negative real rate steals money from savers and gives it to borrowers. For example, if inflation is three percent but interest rates are two percent, an investor is losing money in real terms. I’m losing one percent a year because I’m getting two percent interest but my money is worth three percent less. I’m actually losing one percentage point a year. That’s what a negative real rate does. The central banks want that because it’s a great incentive to borrow. We want people to borrow, because we want people to spend money they don’t have to increase aggregate demand and follow all these Keynesian cookbook recipes to get the economy moving.
How do central banks get to a negative real rate if there is not only no inflation but you’ve actually had deflation? Deflation of one percent with an interest rate of two percent is a real rate of +3. You have to take the two percent nominal interest. Normally you take nominal interest and subtract inflation to get the real rate, but I think we all learned in the sixth grade when you subtract a negative, you have to add the absolute value. That equation looks like 2 minus -1 which is 2 plus 1 equals 3, so the real rate is actually quite high. When people say interest rates are really low, I say no they’re not. Interest rates are close to an all-time high. Nominal rates are really, really low, but real rates are really high because of deflation.
As a way to understanding the bond market, the nominal rate is chasing deflation down a rabbit hole. Think of zero as not being a boundary. Just going from +1 to -1, think of that as down 2. The more deflation declines, the lower the interest rate has to go until you get to a negative real rate because the nominal rate has to be lower than the deflation. In theory, to get to a negative real rate, you’d have to have something like 2 percent deflation and -3 percent interest rates. Now just think about that for a second. Two percent deflation with a -3 percent interest rate would be -1 percent real rate which in theory is supposed to encourage borrowing. I think if we ever got to that position, most people would be running for the hills. This is where the eggheads get it wrong because they can do the math but they can’t do the psychology.
A short answer to the question is, I think there’s almost no limit to how low rates can go although there is some limit. The second part of the question was brilliant and that was, is something going to break? The answer is yes, something’s going to break. On the way to trying to get nominal rates below deflation through financial repression, they’re going to print too much money, they’re going to destroy confidence, there’s going to be something coming up in exchange rates. Remember, interest rates are just reciprocal exchange rates, so if you mess with interest rates this much, you’re going to break the exchange rate. That’s what the currency wars are all about. I think that for now, nominal rates are going lower, and there’s no theoretical limit on how low or how negative they can go. Nominal rates are chasing deflation down. That’s why I look for U.S. 10-year notes to get down to 70 basis points, why not, right? But in the process of doing that, we’re in totally uncharted territory. The central banks don’t know what they’re doing and something’s going to break. Again, another reason to have some cash, have some treasury bills, have some gold outside the banking system. That’s your insurance against all these bad outcomes.
AS: Our next question is from Lorna S., and it’s a really good one, because I think there’s a lot of confusion in the marketplace about what actually constitutes owning physical gold inside and outside of the banking system. Lorna’s question is, “Is having your gold in a bullion bank the same thing as having it outside of the banking system?”
JR: Absolutely not. That’s probably the worst place to put it for two reasons. Number one, anything in a bank, in a bank vault, etc. is at risk to regulatory shutdown. I think we’re talking about the LBMA (London Bullion Market Association). There are seven or eight lead bank members of the LBMA. It’s all public and easy to look up. They are what I call the usual suspects, Goldman Sachs, HSBC, ScotiaMocatta, and a few others. They have standard contracts, so read the contract, painful as it may be. When you buy gold from them, they sell it on what’s called an unallocated basis. That means they sell you gold but you don’t actually have physical gold, and they say that in the contract. They say you do not have bars — serial-numbered, inventoried bars — that belong to you. What you have is an unsecured claim on some gold.
If you say I actually would like my gold, please, you have to do a bunch of stuff. First of all, you have to give them notice, then you have to pay more, and worst of all you have to wait. Alex and I and others have heard horror stories about people who did this and a month or two went by, they said come back next week. They couldn’t get the gold. What that means is that the bank is out there in the market talking the whole spiel to dealers trying to cover a short position, trying to get some physical gold. It’s impossible to know the exact number, because this market is all over the place and no one has all the information, but there is easily a hundred times more in paper short positions if you count the Comex and these unallocated gold forwards than there is physical gold. If all the people who had a paper claim on gold said give me the physical, it’s not even close. The price of gold would skyrocket overnight, they’d shut down all the contracts, and send you a check for yesterday’s closing price. You would not get today’s closing price. It’d be a nightmare.
There are two reasons why that’s not a good idea. One, even if you had allocated, you’re in a vault that could be seized by regulators, and two, you don’t have gold. You have a paper claim. Physical Gold Fund is our host on the call today. There are others, but Physical Gold Fund is my favorite and the one I’m most acquainted with. I’ve actually had the pleasure of going to Switzerland and visiting their vault, not just with the sponsors but with outside auditors and lawyers and tons of security. We went into the vaults and the gold actually came out in a crate where they opened it up and there’s your gold. You have a list with serial numbers on it before the crate is opened. After the crate is opened, not us but the auditor checks every number on a bar against every number on the list. Everything is checked out a hundred percent. That’s when you know you’ve actually got the gold.
That particular vault operator is one of the largest secure logistics firms in the world and is not a bank. Interestingly, we had a very pleasant meeting after we saw the gold and said okay, all the gold’s there, that’s good. We went in and met with the head of logistics, had a little Swiss coffee, and asked how’s business. He replied that business is great. He said we cannot build vaults fast enough. They’re actually in negotiations with the Swiss Army to take over some fortifications that have been abandoned by the Swiss Army inside of mountains that they can use for vault space in the future. If you know anything about the Swiss Army, those vaults are nuclear bombproof. If you drop a nuclear bomb on it, it wouldn’t affect what’s inside.
We asked him, where’s the gold coming from? He said a lot of it is coming from the Swiss banks. In other words, it was coming out of UBS and Credit Suisse going into whether it’s VIA MAT or Brinks or G4S or some of the other big secure logistics providers. The smart money is well aware of this. They’re getting out while the getting’s good. I’ll just wrap up there, but the short answer is I’m a big fan of physical gold. Don’t go all in. I think 10 percent is a fine allocation. Most people don’t have 1 percent, so there’s a lot of headroom between 1 percent and 10 percent, but even if you’re a 5 percent person, whatever it is, do it in physical for security. It’s hard to beat the Physical Gold Fund. As I say, I’ve been to their vaults and that gold isn’t going anywhere, it’s quite safe. That would be my recommendation.
AS: Very good. Thank you also for the kind words there, Jim. The next question came in by e-mail from a gentleman by the name of Jordan T. who is asking, “Is dollar strength basically the same thing as interest rate hikes? Also, could the euro fall even more than it has, and can it really get out of hand?” In other words, something like the Russian ruble, etc.
JR: I love the second part of the question about how low can the euro go. One of my favorite vacations was in the Swiss Alps when the euro was 81 cents. All these people see the euro drop recently from 1.30 to where is it right now at 1.06 today and think it’s the end of the world. Well, I was in Europe when the euro was 81 cents, 0.81. It was terrific because we’d go out to dinner and have a four-course meal at an excellent French restaurant, order wine, dessert, and after-dinner drinks. For a party of seven, we couldn’t spend $100. That’s how low the euro was, so for Americans, it was great.
I don’t get too bent when I see this because remember the IPO price for the euro was 1.16. That’s where it came out. It has traded as high as $1.60 and as low as 80 cents, so there’s a wide range of where the euro can go. If you wonder could it go lower, of course it could go lower. Like I say, I was in the French Alps when it was 81 cents. Will it go lower? That’s the question, and it’s a good question. I guess the right answer is it could, but think about what that means, because the euro doesn’t go lower by itself. If the euro’s going lower, that means the dollar’s going higher. That’s the great thing about analyzing cross rates; it’s a zero-sum game. If something’s down, something else is up.
Could the euro go lower? Yes, but that means the dollar is getting stronger. What does that mean? That means more deflation, a slower U.S. economy, the Fed getting further away from their inflation goal, and a lower likelihood of the Fed raising rates. In other words, it causes all kinds of headaches in the United States. There’s no free lunch here. My view is that the euro is at the low end of where it’s going to go, but again, I don’t want to put a stake in the ground on that. If it goes to 99 cents, don’t tell me I’m an idiot. Maybe it will, but I do think it’s kind of at the low end.
Even if it does go lower, remember that’s not good news for the U.S. economy, corporate earnings, the U.S. stock market, or for Janet Yellen. Don’t just focus on the rate and get into a binary up, down, right, wrong kind of mindset. Think about the dynamics and what it really means.
The first part of the question was: Is a stronger dollar the same as a rate increase? Absolutely. That’s why I said that the way to understand exchange rates and interest rates is that they are reciprocal. They’re two sides of the same coin generally. There are all kinds of exceptions and leads and lags, but generally speaking, higher interest rates mean a stronger currency. The opposite is also true. A stronger currency is the same as a rate increase even if the Fed says zero. That’s what we’re experiencing right now.
Maybe the way to think about it is easing / tightening. This is what my first book The Currency Wars is about where I talk more about these kinds of dynamics. My second book is The Death of Money where I talk a lot more about instability in the international monetary system and the role of gold. Again, this is not just pop economics. It’s very rigorous economic research that had a big influence on Ben Bernanke when he was still at Princeton before he went to the Fed. That is, when you are at the zero bound, you can still ease by cheapening the currency. That’s what started the currency wars. And the opposite is true. When you want to raise rates, you can tighten by raising your currency even if you don’t raise rates. In effect, the Fed’s getting the rate increase without raising rates just by a strong dollar. But it begs the question, do you want to raise rates, too, or is that doubling down? It might be doubling down.
AS: That about does it as we’re out of time. We still easily have another dozen questions in the queue. I just want to really quickly thank everybody who has sent questions in by e-mail, by Twitter, and also live on this webinar. With that, I’ll hand it over to Jon.
JW: Thank you, Alex, and thank you, Jim Rickards. I’d like to pick up on that very characteristic remark, “They can do the math but they can’t do the psychology.” For me, what makes these discussions so illuminating is this multi-dimensional perspective you bring to the issues. So thank you for that.
And thank you to our listeners. You can follow Jim Rickards on Twitter. His handle is @jamesgrickards. Let me remind you that you can find recordings of all The Gold Chronicles webinars with Jim Rickards online. Visit the website Physical Gold Fund Podcasts and register for updates. Goodbye for now, and we look forward to joining you again soon.
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