University of Texas puts big sign on the Wall
A Couple of days ago someone asked me, why everyone seems to think that holding physical gold and silver is the way to protect yourself from inflationary onslaught. He claimed that the price of gold was, in much the same manner as paper (fiat) money established by mutual agreement. When I explained that gold and silver have been money for millennia, dictated by scarcity, and paper money is nothing more than an “I Owe U” issued by the leadership of a nation, it started to dawn a bit more. Of course there is a lot more to the issue than just that. In the US and many countries around the world the current issue is debt ceiling versus how to go about dealing with debt.
As a matter of fact it is clear that all fiat currencies are in a race to the bottom. However, even with this view, a few currencies differentiate themselves. Some will cross the finish line much more quickly than others. And that is what worries a lot of fund managers and investors these days and some of their action create some form of panic.
Last Friday for example, the University of Texas Investment Management Co (UTIMCO) took delivery of 6,643 gold bars, worth slightly under one billion U.S. dollars, sending shockwaves across the gold community. This action is particularly significant here in the US because UTIMCO is the nation’s second largest university fund behind Harvard’s.
Amidst the current uncertainty surrounding U.S. sovereign debt and inflation fears, this decision looks like a good solution to lock the institution’s ownership of gold under management. But the major risk UTIMCO was trying to do away with was the possibility of surging demand for physical gold. There was another, even more significant part to this trasaction because until now few investors have taken physical delivery of bullion. But this situation could disappear rather quickly if debt and inflation-induced fears manage to build enough demand momentum and subsequent physical delivery requests. Or, more specifically, if perception of counterparty risk among once-venerable institutions (no one is going to forget Lehman Brothers anytime soon) shifts the thinking towards taking delivery.
UTIMCO’s choice may not be a shift of cosmic proportions, but increases in demand for physical gold would definitely be a significant bullish factor for gold, which has been on a steady rise and last week surpassed US$1,500 per ounce.
And there is good reason to be on the early part of the spectrum. At thsi point no one really knows if the Federal Reserve will keep on buying our government debt after QE2 has run its course by June 30. And even if not, they have increased the number of dollars in circulation more than 3 fold in the last 12-18 months. There is no doubt that this is creating tremendous monetary inflation on the dollar. And the rest of the world has been taking notice of this.
Let’s have a look at Asia.
World Gold Council figures show that among the generally robust investment demand in 2010, there were growing volumes of physical delivery in that part of the world.
Investment activity in China remained high. Physical delivery at the Shanghai Gold Exchange totaled 836.7 tonnes in 2010, with 236.6 tonnes delivered during Q4. Moreover, physical delivery as a percentage of trading volume had increased to 33% by the fourth quarter, as Chinese investors sought to get hold of gold bullion.
Source: Gold Investment Digest Fourth quarter and full year 2010
The reasoning behind the behavior of UTIMCO and some of the Asian gold traders is rather obvious: to secure ownership of a safe-haven investment tool (physical gold) in times of uncertainty while it is still possible.
As the pace of global economic growth remains a major concern and the risk of another collapse dauntingly possible, the inclination to take physical delivery should gain popularity in other parts of the world, with significant consequences to the price of gold. In the U.S., UTIMCO set a precedent; the question now may be, “Who’s next?”
• Best Case: For a time, post-June the Fed becomes a relatively less important player at the Treasury auctions, buying ~ $17 billion in Treasuries, vs. the $100 billion or so they are buying now, and the market responds favorably to the policy shift. The gap left by the Fed is filled in by institutions, and by friendly governments, looking to roll back their diversification into the euro and the yen – given the poor outlook for both. For a while Treasury rates remain relatively stable. And that encourages the U.S. government to continue spending willy-nilly and keeps the party for equities continuing for awhile longer, albeit with participants on edge and watching the exits for any movement.
A rebound in the dollar, one result of an inflow of renewed foreign buying, would hit the commodities, causing them to underperform until it becomes obvious to all down the road that the Fed will have to once again begin monetizing.
• Medium Case: Post-June, participation at the Treasury auctions weakens, but not disastrously. Rates rise, but also not disastrously. The economy teeters on the edge, but doesn’t fall. Neither does the dollar rise overly much, and something akin to a twitchy status quo continues as people wait for the other shoe to drop, as it inevitably must given that the overarching problem of sovereign and household debt has not been resolved. Volatility in equities and commodities increases, but there is no sustained move one way or the other. Yet.
• Worst Case: Post-June, treasury auction participation falls significantly, and interest rates begin to accelerate to the upside, sending equities markets into a tailspin, dragging commodities down with them. The Fed quickly reverses course and begins writing the big checks to the Treasury, stabilizing interest rates but sending shock waves through FX markets as the dollar hits the floor and discovers the floor is made of glass.
The precious metals and other commodities soar. With nowhere else to run, investors begin bargain shopping for fallen equities – which are linked to tangible businesses, after all – and they bounce relatively quickly as well. Meanwhile, as the dollar collapses, the cost of everything begins to soar, crushing the unprepared and triggering real hardship. Unable to push interest rates higher to head off the price inflation, the Fed heads retreat to a hidden bunker and begin looking for friendly countries willing to give them sanctuary.
Of course, no one can see the future – but keep in mind that all three of those scenarios are likely to materialize in the relatively near future, one after the other from Best to Worst.
If I am right, then the way to play it is to expect a near-term rally in the dollar. While the U.S. dollar is no more than toilet paper, it is still of a better quality than the euro or the yen. Which is not to say that it doesn’t deserve its ultimate fate – the fate of all fiat currencies – but rather that, as long as the Fed shows some restraint here, it may be able to stave off that fate a bit longer.
Like in movie sequels we may witness Quantitative Easing 3, 4 even maybe 10 or more, until all roads are blocked. And with the voracious appetite for government spending, that may happen much sooner than we think.