2012

Many bloggers and commentators have been pumping out their visions for 2012. I would do the same, had I not done it in October:

Gold is up against a wall of incorrect perceptions: namely, that haven assets are limited to dollars, and to US treasury bonds. In the mainstream lexicon, gold is used to hedge tail risk and to make jewellery, and until that perception is shattered (specifically by an event that reveals Treasuries and dollars for the risky and debased assets that they really are) then I don’t think the funds will begin to significantly increase gold allocations (when they do, they will claim they are “hedging tail risk”).

There are two very strong pieces of evidence here for dollar and treasury weakness: firstly, the very real phenomenon of negative real interest rates (i.e. interest rates minus inflation) making treasury bonds a losing investment in terms of purchasing power, and secondly the fact that China (the largest real holder of Treasuries) is committed to dumping them and acquiring harder assets (and bailing out their real estate bubble). So the question is when (not if) these perceptions will be shattered.

What would a treasury crash look like? Most likely, it would be dictated by supply — the greater the supply of treasuries coming onto the market, the more there are for buyers to buy, the lower prices will be forced before new buyers come onto the market. Specifically, a treasury crash would most likely begin with a big seller dumping significant quantities of treasuries bonds onto the open market. I would expect such an event to be triggered bylower yields— most significant would be the 30-year, because it still has a high enough yield to retain purchasing power (i.e. a positive real rate). Operation Twist, of course, was designed to flatten the yield curve, which will probably push the 30-year closer to a negative real return.

A large sovereign treasury dumper (i.e. China with its $1+ trillion of treasury holdings) throwing a significant portion of these onto the open market would very quickly outpace the dogmatic institutional buyers, and force a small spike in rates (i.e. a drop in price). The small recent spike actually corresponds to this kind of activity. The difference between a small spike in yields and one large enough to make the (hugely dogmatic) market panic enough to cause a treasury crash is the pace and scope of liquidation.

Now, no sovereign seller in their right mind would fail to pace their liquidation just slowly enough to keep the market warm. After all, they want to get the most for their assets as they can, and panicking the market would mean a lower price.

But there are two (or three) foreseeable scenarios that would raise the pace to a level sufficient to panic the markets:

  1. China desperately needs to raise dollars to bail out its real estate market and paper over the cracks of its credit bubbles, and so goes into full-on liquidation mode.
  2. China retaliates to an increasingly-hostile American trade policy and — alongside other hostile foreign creditors (Russia in particular) — organise a mass bond liquidation to “teach America a lesson”
  3. Both of the above.

If such an event was big enough to cause yields to spike 1% (very conservative estimate) it would jar the status quo enough to trigger a significant gold spike, as funds and banks move to cash positions (sensing both the post-crash buying opportunities, and margin hikes) and seek to “hedge tail risk”.

Now the pace and scope of China’s coming treasury liquidation is still uncertain and I expect it to very much be dictated by how the Chinese real estate picture plays out — the worse the real estate crash, the more likely Chinese central-planners are to panic and liquidate faster.

The pace of events might also be significantly accelerated in the light of a Greek default.

Now 365 days is a strangely arbitrary period over which to make long term economic predictions. The business cycle is not tied to years, nor even decades. It wends and shifts in the winds of history, fluttering and flurrying. I have no idea if this scenario (or something similar) will play out in 2012, or 2013.

But I do know this: unless there is a real recovery in America — in employment and industrial output, as well as GDP — as well as a shift away from reliance on foreign oil and goods, and a successful deleveraging of the entire economy — especially government debt and shadow banking — it will play out sooner or later.

I took great pleasure last month to present a very similar scenario predicted by none other than Paul Krugman in 2003:

During the 1990s I spent much of my time focusing on economic crises around the world — in particular, on currency crises like those that struck Southeast Asia in 1997 and Argentina in 2001. The timing of such crises is hard to predict. But there are warning signs, like big trade and budget deficits and rising debt burdens.

And there’s one thing I can’t help noticing: a third world country with America’s recent numbers — its huge budget and trade deficits, its growing reliance on short-term borrowing from the rest of the world — would definitely be on the watch list.

I’m not the only one thinking that. Lehman Brothers has a mathematical model known as Damocles that it calls “an early warning system to identify the likelihood of countries entering into financial crises.” Developing nations are looking pretty safe these days. But applying the same model to some advanced countries “would set Damocles’ alarm bells ringing.” Lehman’s press release adds, “Most conspicuous of these threats is the United States.”

Is America safe, despite its scary numbers?

The crisis won’t come immediately. For a few years, America will still be able to borrow freely, simply because lenders assume that things will somehow work out.

But at a certain point we’ll have a Wile E. Coyote moment. For those not familiar with the Road Runner cartoons, Mr. Coyote had a habit of running off cliffs and taking several steps on thin air before noticing that there was nothing underneath his feet. Only then would he plunge.

What will that plunge look like? It will certainly involve a sharp fall in the dollar and a sharp rise in interest rates. In the worst-case scenario, the government’s access to borrowing will be cut off, creating a cash crisis that throws the nation into chaos.

Readers are, of course, encouraged to share their views on 2012 (and the future in general) in the comment section.

Meanwhile, here’s some prescience from Jefferson:

Happy New Year.

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Gold in 2012 & the Coming Bond Crash?

Since that spurt up to $1917, and the slump down to $1528 gold has been on ice below $1700. The technical analysis suggests that there is little to get excited about until gold breaks out of the $1600 to $1700 range, and I tend to agree. This is a slow-motion degeneration: triggers for a breakout seem limited to a deeper Euro meltdown (coming — and ultimately leading to a default cascade, and a derivatives meltdown), more American money printing (coming), or (most importantly) a large scale and visible dumping of dollars or treasuries by foreign creditors. Black swans like another Fukushima, incidences of terrorism, or broader social unrest might be bullish for gold in the long term, but gold right now (at least in the West) is up against a wall of perceptions: namely, that haven assets are limited to dollars, and to US treasury bonds. In the mainstream lexicon, gold is used to hedge tail risk and to make jewellery, and until that perception is shattered then I don’t think the funds will begin to significantly increase gold allocations.

There are two very strong pieces of evidence here for dollar and treasury weakness and instability: firstly, the very real phenomenon of negative real interest rates (i.e. interest rates minus inflation) making treasury bonds a losing investment in terms of purchasing power, and secondly the fact that China (the largest real holder of Treasuries) claims to be committed to dumping them and acquiring harder assets (and bailing out their real estate bubble). So when these perceptions will be shattered? Here are bond yields since 2007:


The bond market is a market, and like any other it is determined by supply and demand (Zero Hedge readers — algorithmic trading is still a form of supply and demand, albeit a fucked-up one). Low yields mean high prices, which mean that demand is still high — pretty close to all-time highs — which means that in the market the belief that treasuries are a haven still mostly holds.

A large sovereign treasury dumper like China with its $1+ trillion of treasury holdings throwing a significant portion of these onto the open market could very quickly outpace the institutional buyers, and force a small spike in rates (i.e. a drop in price). The small recent spike corresponds to this kind of activity. The difference between a small spike in yields and one large enough to make the market panic enough to cause a treasury crash is the pace and scope of liquidation.

Now, no sovereign seller in their right mind would fail to pace their liquidation just slowly enough to keep the market warm. After all, they want to get the most for their assets as they can, and panicking the market would mean a lower price.

But there are two (or three) foreseeable scenarios that would raise the pace to a level sufficient to panic the markets:

  1. China desperately needs to raise dollars to bail out its real estate market and paper over the cracks of its credit bubbles, and so rashly goes into full-on liquidation mode.
  2. China retaliates to an increasingly-hostile American trade policy and — alongside other hostile foreign creditors (Russia in particular) — organise a mass bond liquidation to “teach America a lesson”.
  3. Both of the above.

Now the pace and scope of any coming treasury liquidation is still uncertain and I expect it to very much be dictated by how the Chinese real estate picture plays out — the worse the real estate crash, the more likely a Chinese liquidation.

The pace of events might also be significantly accelerated in the light of a full-blown Eurozone default.

So in conclusion — give or take the inevitable QE3 spike — I expect gold prices to be stable or lower — even in the context of low real interest rates — up ’til a significant treasury liquidation. I don’t know when or if this will occur, but if it does, I would expect gold prices to soar in the following months. If it doesn’t occur and markets return to stronger organic growth, the gold bull market will probably end.

It must also be noted that a stock market crash will probably send gold lower in the short term, as with 2008. Ironically, the subsequent flight into treasuries (driving rates lower still) might be a NASDAQ-esque “blow-out top” that signifies the end.

The Housing Bubble Priced in Gold

In the United States, the post-sub prime housing crash has meant that consumer spending has stagnated. People are simply not remortgaging their homes to buy boats or other such consumer goods anymore, because there is no longer the expectation that price rises will pay for the boat. This is because prices are slumping due to excess supply built during the peak years. For people who don’t own property in the United States, this price crash has allowed them to get a foot on the property ladder, which is broadly a good thing. Keynesians might argue that the slump in consumer spending is broadly a bad thing, but it’s not: it was never sustainable in the first place. Boosting GDP through unsustainable spending is a short recipe for bubbles.

In the United Kingdom, the story is different. Property prices haven’t really crashed:


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