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Currency Wars: ‘Race to Debase’ spurs central banks’ gold-buying spree

March 25, 2013
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Today’s unbacked fiat currencies are at the root of an emerging global monetary problem.  While the talk of “recovery” in recent months now populates headlines, the desperate actions of politicians and central bankers show the contrary.

The Federal Reserve (Fed), European Central Bank (ECB) and the Bank of Japan (BOJ), cannot stop creating new base money. Central Banks want to present confidence to the markets. Where the risk lies for monetary policymakers is in the value of the debt on bank balance sheets, and the value of the debt across the broader economy.  This debt is being held at par because interest rates should be much higher.  All of this has led to a situation where interest rates do not reflect true inflation.

There is a saying “the further back you look into the past, the more certain you can be about the future.” History has shown that currency debasement ALWAYS leads to inflation and ultimately hyperinflation. This happened to the Roman Empire, the Weimar Republic in Germany, Argentina and most recently Zimbabwe where inflation peaked at 7.96 billion percent.

You would think that people would learn from history. Well, apparently not.

The Federal Reserve and the US Dollar

The most recent FOMC statement is a confirmation that the Fed cannot end Quantitative Easing (QE), and if anything they are probably going to increase it in the future. The Fed cannot withdraw QE, unless they want to see deterioration of credit in the banking system.  This would result in deterioration of debt in the broader economy. As it stands now, the FED is engaging in an open-ended program (QE4) in purchasing USD$85 billion of bonds – USD$45 billion in Treasury bonds and USD$40 billion in Mortgage Backed Securities (MBS), until the unemployment rate falls below 6.5%.

How the FED is going to lower the unemployment rate by expanding QE purchases is debatable as these purchases arguably do not contribute towards jobs growth. The way we see it, buying MBS is the FED’s way to remove these liabilities from the banks’ balance sheets. So the banks will look more credible and solvent. Again it is all about building public confidence with a hope that it will translate into more borrowing from the banks. However, with the economy sputtering, consumer spending and borrowing is unlikely to increase. If consumer spending is not picking up, businesses will suffer. Where will the jobs come from if businesses are not doing well? So in my opinion, purchasing MBS bonds makes the banks richer but does not contribute towards economic growth.

I also maintain that the Fed’s purchase of Treasury bonds is meant to keep the Treasuries rate low. By keeping the 10-year Treasuries rate low, the Fed hopes to project the perceived economy ‘recovery’. Again, this is a confidence building exercise.

Bank of Japan and the Japanese Yen

Not to be outdone, Japanese Prime Minister Shinzo Abe is preparing the market for inflation targeting in 2013.  The general consensus has been that the Bank of Japan (BoJ) will pursue aggressive QE until the Japanese annual inflation rate reaches 2%.

Sure enough the news hit the tape on 21 January ��“ the BoJ was to adopt a more aggressive stance focusing on open-ended asset purchases without a specified limit, a close reflection of the Fed’s QE4 program.  Japan took this even further, and unlike the Fed, did not set specific parameters as to when to stop easing. Thus, it seems that Shinzo Abe’s plan to implement limitless currency creation was accomplished without much struggle. His goal is simple: revive the Japanese economy and kick off the shackles of crippling deflation through increased exports from a weakening Yen, even if it means reducing the purchasing power of Japanese citizens.

The importance of outright inflation targeting by Prime Minister Abe cannot be understated for holders of all global currencies and precious metals. By threatening inflation targeting, Japan placed the world on notice that it was willing to stop at nothing to cheapen its currency.  And if you look at all the Yen currency pairs, they are succeeding.

The European Central Bank and the Euro

In Europe it has been a little quiet as attention was on the US ‘fiscal cliff’ debacle. Ever since the President of ECB Mario Draghi announced the Outright Monetary Transactions (OMT) program, it has brought some semblance of stability to the region’s finances, even though none of the member country has actually asked for the funds through the OMT. The mere promise of ‘we will do whatever it takes’ by Draghi was enough to place some confidence in the market.

The ECB has reported that some banks will repay a portion of the funds issued to them under the Long Term Refinancing Operations (LTRO). This will reduce the balance sheet of the ECB – the first major central bank to do so. Ironically, this early repayment has made some market participants a little concerned. If the ECB continues to allow its balance sheet to shrink, it could continue to drive up money market rates and along with it, the EUR.

With the US and Japan vigorously debasing their currencies, an appreciating EUR can’t be tolerated. This prompted Draghi to issue a statement assuring that the ECB has excess liquidity even after the LTRO repayments and they stand “ready to offer liquidity to the banking system as needed”. It is a clue that the ECB will not allow the EUR to strengthen too much, as a strong EUR will make European products and services more expensive and will force the ECB to increase the interest rate, which means higher interest payments for indebted nations.

Rise of the Precious Metals

Jens Weidmann, President of The Bundesbank, has warned of the dangers of central bank politicization, claiming that this will trigger a race to debase currency values ��“ which is a currency war. Under this scenario, every nation (claiming price ‘competitiveness’ as a justification) prints as fast as possible, increasing demand for its exports, while crushing the purchasing power of currency savers and citizens at home.

Recently, Germany has requested the repatriation of its gold from Paris and New York. Perhaps it is all too clear to the German central bank that whether they like it or not, currency debasement quickly becomes a game of forced participation. The Bundesbank must have considered the costs and implications of a currency war and is concerned enough to want its gold back in its homeland.

It is just a matter of time before more and more countries demand the return of their gold bullion No one wants to be left behind in the race to debase, much less in another very important race: the rush for monetary assets (Gold and Silver). These precious metals are increasingly viewed as currency. Central banks know this very well. Rather than buying real estate, lumber or diamonds, central banks around the world are buying gold. According to the World Gold Council (WGC), in 2012, central bank demand totaled 534 tons, a level we have not seen in nearly 50 years.

Gold and silver are viewed as monetary metals, not commodities. As such, supply does not dictate the price. Demand and supply are inelastic. Thus, demand rises with a higher price, while supply falls with a higher price. With the central banks getting into the act and dwindling above ground stockpiles, we expect the precious metals to break out of the its consolidation phase and propel past their all-time highs this year.

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