Gold News

A dangerous divergence

The gold market says the bond market vigilantes are asleep in the US. But they're waking up in Frankfurt, London, Seoul, Shanghai...

ONCE UPON A TIME, many years ago, the US stock market lived in fear of a violent band of traders known as the "bond market vigilantes".

   Whenever the Federal Reserve's money supply measures grew too rapidly, or the US economy grew too strongly – threatening to stoke higher inflation – these "bond market vigilantes" would take matters into their own hands.

   The bond market vigilantes would jack-up 30-year Treasury bond yields as much as 25 basis points – or short-term T-bill rates by 50 basis points – in a single day.

   Former US Treasury secretary Robert Rubin convinced his boss, President Bill Clinton that taming the "bond vigilantes" by reducing the US budget deficit was the best way to reach long-term economic prosperity.

   As Clinton political guru James Carville famously put it, "I used to think if there was reincarnation, I wanted to come back as the president or the Pope or a .400 baseball hitter.

   "But now I want to come back as the bond market. You can intimidate everybody."

Bond market vigilantes now asleep

   During the first-half of this Bush administration, however, when the US Treasury's budget span out of control with a $445 billion deficit in fiscal 2004, the infamous "bond market vigilantes" slipped into hibernation. Instead of bond market vigilantes pushing down prices to keep yields higher, a new band of traders – with much deeper pockets – began cornering the US Treasury market.

   The Bank of Japan, the People's Bank of China, and the Arab Oil kingdoms have kept US bond yields pinned near historic lows ever since.

   Tokyo and Beijing acquired a combined $2.1 trillion of foreign exchange reserves, mostly held in US Dollar bonds, through massive intervention to keep the Japanese Yen and Chinese Yuan weak. They've also ploughed their newly acquired Dollars into US bonds.

   After purchasing $334 billion US Dollars in 2003-04, Japan now owns $612 billion of US Treasuries. Beijing owns $420 billion of US Treasuries, plus more than $500 billion of US agency and corporate bonds, with little regard for the outlook for inflation.

   Opec's oil revenues reached $968 billion in 2006 – up from around $300 billion in 2002 – as crude oil prices more than doubled to over $65 per barrel. The Arab Oil kingdoms invested about $314 billion into the US Treasury market through their London brokers, representing one-fourth of the $1.3 trillion in Petro-Dollars invested globally over the preceding three years.

   Last week, the US Treasury said holdings of US securities by foreign central banks and governments had risen to $2.3 trillion by the end of June 2006.

   Perhaps the most important single factor allowing the global economy to grow at 5% or more for each of the past four years has been historically low bond yields, courtesy of Asian central banks and Arabian Petro-Dollars.

   Indirectly, these abnormally low bond yields spawned $1.5 trillion of US mergers and takeovers in 2006, plus $1 trillion's worth so far in 2007 – up 70% from the same period a year earlier.

   Globally, M&A has mushroomed to $3.6 trillion in 2006 and $1.9 trillion so far this year.

   Also behind the boom in global stock markets, hedge-fund assets have tripled in the past decade to $1.57 trillion. Private equity companies have been bidding $447 billion for listed companies so far this year, versus $228 billion in the year-ago period.

   Quite simply, corporate treasurers are exploiting the gap between the low yield on bonds and the higher earnings yield on stocks through record share buybacks, driving equity prices sharply higher.

   The Bernanke Fed is also operating behind the curtain, inflating the broad M3 money supply at an annualized 12.2% rate – its fastest clip in five years. Each morning, before the opening of the NYSE, the Bernanke Fed buys Treasuries to accommodate strong loan demand from private equity groups and leveraged takeover artists. That prevents short-term borrowing rates from rising.

   The global stock buying frenzy might not have been possible if the "bond vigilantes" weren't sedated by Arab Oil kingdoms, China, Japan, and other central bankers.

   But interestingly enough, when the Dow Jones Industrials climbed above the psychological 13,000 barrier for the first time, the "bond vigilantes" began to crawl out of their cave. On June 1st, the Treasury's 10-year yield rose to 4.96%, its highest level in nine-months. Treasury yields were rising despite news that the US economy slowed to a scant 0.6% growth rate in Q1, its weakest in four-and-a-half years, due in the most part to a sharp downturn in the housing sector.

   Fed officials believe the correction in the housing market is likely to "weigh heavily" on economic growth for the remainder of the year, but "the risk that inflation would fail to moderate as desired remained the committee's predominant concern," as the Fed said on May 30th.

   So as hopes fade for Fed rate cuts this year, traders are dumping long-term T-Notes in favor of high flying US and foreign stocks.

   The "bond market vigilantes" might have greater room to maneuver in the months ahead, as Beijing observes its massive US bond portfolio – estimated at over $900 billion – slide into a free-fall. US Dollars converted back into Chinese Yuan are showing a sharp depreciation.

   China's massive $233 billion trade surplus with the US last year is going up in smoke, in short, even before the "bond vigilantes" have a good crack at the bat.

   China controls $1.2 trillion in foreign exchange reserves. But its steady purchases of longer-dated Treasuries could evaporate after the People's Bank widened the trading band for the Yuan on May 18th, allowing for a swifter devaluation of the US Dollar. Beijing could decide to recycle its massive trade surplus into riskier assets.

   Fed chief Ben Bernanke is not worried about Beijing dumping US bonds, however. "I think the cost to them of doing this would be greater than the cost to us. A substantial move on their part would be disruptive in the market in the short term, but in the longer term, the Dollar and Treasury yields would largely recover," he told the Senate Banking Committee on Feb 14th.

   "I do not believe China's substantial accumulation of reserves [recycled into US bonds] in itself represents a problem for the United States or for US monetary policy," Bernanke wrote on March 26th. "Because foreign holdings of US Treasury securities represent only a small part of total US credit market debt outstanding, US credit markets should be able to absorb without great difficulty any shift of foreign allocations," he said in a letter to Sen. Richard Shelby, an Alabama Republican.

   "And even if such a shift were to put undesired upward pressure on US interest rates, the Federal Reserve has the capacity to operate in domestic money markets to maintain interest rates at a level consistent with our economic goals," Bernanke added.

   Would Bernanke speed up the printing presses to buy bonds from Beijing?

Bond market vigilantes unleashed in Europe

   While American bond vigilantes are just stepping into the batter's box, the German bund vigilantes are already on first base, jacking up European benchmark yields to multi-year highs.

   Germany's 10-year bund yield rose to 4.48% this week, its highest since Dec. 2003, while two-year yields climbed to 4.42%, a five-year high.

   "Eurozone inflation risks are rising and the European Central Bank is keeping its options open on how much further to raise interest rates," said Greek central banker Nicholas Garganas on May 30th.

   "All the options for a further increase in interest rates and the pace and size of further adjustment are open. Inflation risks are on the upside and increasing," he warned.

   "A number of factors are pointing to an inflation rate which is higher than expected so far this year," Garangas said, pointing to strong money and credit growth, higher oil prices, and lower unemployment.

   Indeed, "the ECB needs to exercise strong vigilance to keep price pressures in check," warned Bundesbank chief Axel Weber on May 16th.

Since March 13th, Eurozone traders have been dumping German bunds and switching into high-flying European blue chips stocks. The ECB has spoken a million words about the risks of higher inflation, but it has only lifted its repo rate a half-point this year.

   The ECB has tolerated explosive growth of the Euro M3 money supply, which hit a 24-year high of 10.9% in March, far above the central bank's target of 4.5% - the level that it believes is consistent with low inflation.

   "It would be unwise to discard monetary analysis, especially now that asset prices are at a high and liquidity at an unprecedented scale worldwide," warned the BBK's Weber on June 3rd. "Interest rates are low in the Euro area," added Dutch central bank chief Nout Wellink on June 4th. "These low interest rates show up in asset prices, not only in the stock market, but also the housing market and other financial markets."

   The ECB's slow-motion tightening strategy hasn't restrained the growth of the European money supply. In fact, Euro M3 money supply is now growing at a much faster rate than when the ECB began raising its repo rate in Dec. '05.

   So while the mainstream media points to ECB rate hikes as proof of a tighter monetary policy, double-digit money-supply growth points to a super-easy ECB money policy.

   The ECB pursues a clandestine policy of pumping up European real estate and stock markets, to boost consumer confidence and spending at home by inflating M3. The ECB's sleight of hand is part of its game of "Smoke and Mirrors", designed to lull German "bund vigilantes" to sleep, while it quietly pumps up asset markets.

   But the Norwegian government recognized the shell game on April 13th, and said it planned to raise the equity component of its $314 billion oil fund to as much as 60% of total assets from 40%, while reducing the portion held in bonds. According to the Norwegian Pension Fund's 2006 report, it owned 154 billion crowns ($25.7 billion) of German Bunds, and 44 billion crowns in European Investment Bank bonds.

To restore its badly tarnished image of an inflation fighter, the ECB had already telegraphed a quarter-point rate hike to 4.00% in June. It's also pointed the way to 4.25% by Sept.

   The ECB was forced into the tightening mode by gold is flirting with the psychological level of €500 per ounce. In Frankfurt, Euro Libor traders are now pricing in the possibility of a third ECB rate hike to 4.50% by year's end.

   So it was surprising that on June 1st, the ECB decided to suspend its remaining share of gold sales through to Sept. 26th – the end of the 2006-07 year of the Central Bank Gold Agreement.

   That news gave a small shot of adrenalin to the gold market, jumping back to €500 per ounce. It also lifted the yield on the Euro Libor rate for December by 7 basis points to 4.57% – because such stubbornly high gold prices in Europe provide more fodder for the German "bund vigilantes" in Frankfurt. They set the benchmark yields for the rest of the Eurozone.

The Bank of England faces a backlash

   For the past three years, the ECB has operated under the same modus operandi as the Bank of England, inflating the money supply to buoy home and equity markets. But last week, the British gilt vigilantes, who have been locked in a tight box for the past eight years, came very close to breaking out.

   Two-year British gilt yields climbed to 5.78% on June 1st, a level not seen in seven years. Ten-year gilt yields climbed to 5.28%, the highest since mid-2002.

   For the past eight years, the UK's ten-year gilt yield has been locked in a tight range between 4.00% and 5.35%, benefiting from foreign capital inflows seeking to profit from the strengthening British Pound.

   But how much longer can the long-term gilt market ignore this monetary abuse by the Bank of England? On April 24th, a group of leading UK economists – including former BoE member Charles Goodhart – criticized the Old Lady for ignoring double-digit growth in the money supply since 2005.

   A week later, current BoE chief Mervyn King admitted that, "the growth of money and credit may signal in advance of other indicators that the Bank rate is set at a level inconsistent with bringing inflation back to the target in the medium term."

   Then, on May 10th, the BoE lifted its base lending rate by a quarter-point to a 6-year high of 5.50% –its highest in more than a decade.

   Even so, consumer inflation continues raging at 3.1%, and UK house prices jumped 0.9% in April and 0.5% in May, even after three BoE rate hikes. Real estate prices now stand 10.3% higher from a year ago. The price of a typical UK house is £181,584 – or about £17,000 higher than at this time last year.

   That's not surprising, of course, with the UK's M4 money supply standing 13.3% higher from a year ago.

Asian bond market vigilantes lift yields half a percent

   The Korean Kospi Index has been on a record-breaking rally over the past two months. It is up 20.6% so far this year, surpassing the 1,700-point mark for the first time after extending gains for a 13th straight week.

   A quarter of listed Kospi stocks have risen by 50% or more this year, and one in every twelve Kospi stocks has now more than doubled.

   South Korea's economy, Asia's third-largest after Japan and China, has expanded for 16-quarters in a row, marking the longest winning streak since the early 1990s. Behind the scenes, the Bank of Korea (BoK) is inflating its M3 money supply, buoying stock prices but rattling the bond market.

   Last year the Korean central bank lifted its overnight loan rate by 125 basis points to 4.50% last year. It also raised bank reserve ratios by 2% to 7%, but in defiance of its baby-step tightening maneuvers, Korea's M3 money supply exploded from a 7% growth rate to an annualized 12.3% in April 2007. That's its fastest rate in 4 ½-years.

   Korean house prices are growing four times as fast as consumer prices, 9.7% higher in May than a year before, compared with a 2.3% annual rise in consumer prices. Despite the explosive growth of the money supply, coupled with a strong economy, the BoK is holding its overnight loan rate steady at 4.50% for a tenth consecutive month.

   Korea's bond market vigilantes are alarmed by the BoK's super-easy money policy. That's why they have jacked up the government's borrowing costs by 50 basis points over the past three months.

   Seoul plans to sell 3.74 trillion Won of government bonds in June, compared with 4.45 trillion worth offered in May. That only adds to bearish sentiment. But the half-percent increase in 5-year yields hasn't been sufficient to knock the Kospi Index off its upward trajectory.

   "Abundant global liquidity is one of the risky factors that all countries need to monitor," South Korea's finance minister Kwon O-Kyu told reporters on May 17th.

   "We have to monitor how much the US economy slows down and how much growth in China and India can compensate. Global liquidity may be maintained for some period but the China effect cannot continue forever," he warned.

   The Bank of Korea is disturbed by the double-digit growth of the M3 money supply. So what's preventing the BoK from raising its interest rates, and what other powerful force in the global marketplace is helping the Korean Kospi Index to defy the law of gravity?

   The answers are inter-related – and they were provided in the June 1st edition of Global Money Trends (click here to subscribe now).

Dangerous divergences & the Chinese "Bond Market Vigilantes"

   It's easy to say that what goes up, must come down. But stock markets don't necessarily follow the laws of Newtonian Physics.

   The Russian Trading System Index, for example, stays perched in the stratosphere, with the Russian central bank inflating its money supply at a 57% annualized rate – and central banks have to make a determined effort to deflate stock market bubbles, even at the cost of a slower economy.

   Explosive money supply growth, stock buybacks, and mergers & takeovers, are all linked to today's super-easy money policies worldwide. They're being played out within the context of a larger game of competitive currency devaluations.

   However, the most powerful force moving global stock markets today hasn't even been mentioned in this article so far. It's highlighted in each weekly edition of the Global Money Trends newsletter – and so far, this powerful force moving stock markets shows no signs of abating.

   What are the early warning signals of a possible reversal of the market's good fortune?

   In Shanghai, the Chinese "bond vigilantes" have jacked-up yields on the benchmark five-year Treasury bond by 105 basis points over the past two months. Hitting 3.82% today, the highest in 3-years, that includes a 50 basis point surge over just two days.

   So while the mainstream media points to Beijing's tiny 0.2% tax increase on stock transactions to explain the wicked 21% correction in Shanghai red-chips, little is spoken of the Chinese "bond vigilantes," emerging from hibernation.

   On May 23rd, guru Al Greenspan said the recent boom in Chinese stocks could not last. "It is clearly unsustainable. There's going to be a dramatic contraction at some point," he correctly predicted, but did not say why.

   On May 31st, PBoC deputy Wu Xiaoling told a seminar on global imbalances, "In my view, every market develops in twists and turns. The Chinese stock market is growing too rapidly. We hope it can grow in a steady manner."

   At its peak, the combined market value of the two bourses in Shanghai and Shenzhen hit a record $2.5 trillion, exceeding the country's savings deposits for the first time in history. The value of shares in China surged more than six-fold in the past two years, to become the world's fifth-biggest equity market.

   Policy makers were not sympathetic to the plight of over zealous red-chip bulls on June 4th.

"The speed that stock prices have soared by is extremely unusual," the state-owned China Securities Journal wrote, "which underscores the structural bubbles in the stock market.

   "China's increase in stamp duty is a proper forward-looking adjustment to avoid greater systemic risks in the market and to ensure its healthy development."

   Put another way, "the huge price fluctuations within each trading day reflect the fact that this trading is unsustainable," as the Xinhua News Agency said.

   Thus the Shanghai Stock Index tumbled 7.25% on the morning of June 5th, down to as low as 3,402 after People's Bank chief Zhou Xiaochuan left open the possibility of further monetary tightening.

"There are many reasons for price changes, including money supply, international market movements, domestic supply and demand and so forth. The central bank will use monetary policy to cope with it," he warned.

   Yet Shanghai red-chips finished the day with a furious 10% rally off their intra-day low, closing 2.6% higher at 3,767 points. Bargain hunters swooped into the marketplace after Shanghai red-chips tumbled as much as 21% in four trading days, wiping out $450 billion of market value. Buyers also spread rumors that Beijing would not introduce a capital gains tax for 3-years to stabilize the market.

   There is an unshakeable belief in China that Beijing can move the red-chip market to its desires by remote control, using the old techniques of jawboning and adjustments in the money supply. The rise in China's five-year bond yield to 3.82% is not as threatening as it appears when one considers that China's official inflation rate is expected to accelerate to 3.5% to 4% in the months ahead, reflecting sharply higher food prices.

   However, there is a much bigger storm looming on the horizon that could overwhelm Beijing, and wreak further havoc on Chinese red-chips, its economy, and the Asian region. This gathering storm was under the spotlight in the May 25th and June 1st editions of Global Money Trends, with further updates for the June 8th edition.

   This article is just the tip of the iceberg of what's available in the Global Money Trends newsletter, published on Friday mornings. Click here now to order 44 issues per year for just $150 annually – or call toll free from within the United States, Sunday to Thursday, 2am to 4pm EST, on 866-576-7872.

GARY DORSCH is editor of the Global Money Trends newsletter. He worked as chief financial futures analyst for three clearing firms on the trading floor of the Chicago Mercantile Exchange before moving to the US and foreign equities trading desk of Charles Schwab and Co.

There he traded across 45 different exchanges, including Australia, Canada, Japan, Hong Kong, the Eurozone, London, Toronto, South Africa, Mexico and New Zealand. With extensive experience of forex, US high grade and corporate junk bonds, foreign government bonds, gold stocks, ADRs, a wide range of US equities and options as well as Canadian oil trusts, he wrote from 2000 to Sept. '05 a weekly newsletter, Foreign Currency Trends, for Charles Schwab's Global Investment department.

See the full archive of Gary Dorsch.


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