Dr.Barbaric

Buying Gold and copper as central banks punish savers for the credit bubble...

THE INFLATION HAWKS at the European Central Bank (ECB) seem to have been outflanked by the counterfeiters, writes Dan Denning in the Daily Reckoning Australia – otherwise known as the money printers.

The ECB now joins the United States, Japan, and the UK in throwing caution to the wind and money from helicopters by pursuing a policy of Quantitative Easing. ECB president Jean-Claude Trichet said this week – while cutting interest rates to a new record low of 1.0% – that the bank will buy €60 billion worth of "covered bonds".

And it will do so with brand spanking new Euro notes.

In comparison with the "queasing" efforts in other countries, the ECB is late to the game and modest in ambition. The ECB's first foray into this strange new world is small, equal to just 0.5% of Eurozone GDP. That compares with Quantitative Easing of 2% of GDP in the US and 8% in the UK.

Just yesterday, in fact, the Bank of England said it would increase its bond purchases – creating more cash than currently exists to buy debt-investments, thus hoping to raise their price and so "quantitatively ease" their open-market yield – by £50 billion.

But what's important about the ECB's action, across the Channel, is that it was the last major central bank to at least pay lip service to inflation and how it is always and everywhere a function of excessive money creation. Whereas now, the world's major central banks are in ideological agreement that the response to falling asset prices is to support them directly through money printing. And that is an important development in financial markets. It means you can expect an even larger expansion of the global monetary base, the precondition for a big surge in inflation when banks begin lending again.

What to do? "Navigating the world is much harder than in the 1930s," reckons Black Swan author Nassim Taleb. "This is the most difficult period of humanity that we're going through today because governments have no control."

Taleb was speaking at a conference in Singapore. He warned of "big deflation" ahead as asset values fell. But Bloomberg reports that he also thinks Gold Bullion and copper could "rally massively" as governments print money.

We have tentatively named this the "Dr. Barbaric" trade...a combination of copper's nick name (Dr. Copper) and the moniker given to gold by John Maynard Keynes (the barbaric relic). Copper prices rise when an economy recovers, hence the PhD in that dismal science it's supposed to bear. Whereas gold typically rise when money-supply growth outstrips GDP gains. So we're assuming here that Taleb's forecast on copper is a kind of call option on future growth, while the gold forecast is a put option on paper money.

Copper will eventually be in demand again when global demand resumes growing (we're assuming that it will, some day, in the future, perhaps in China and India). So for now, copper stockpilers or futures traders might like the idea of being in a practical metal that has real industrial and economic demand as opposed to, say, government bonds. Of course not everyone is going to do this. But for some traders, copper might be a good place to park capital in the coming inflation.

And gold? Well, yesterday's Financial Times had three stories in a row on gold. The first was, "Beijing Bets on Bullion" and showed that even though China's gold reserves have doubled since 2003, the country still only has 1.6% of its total foreign reserves in gold. The world average is 10.5%. This means that China – like Russia before it – is likely to be a ready buyer of IMF Gold Sales or sales from Europe if (when) they renew their Central Bank Gold Agreement this September. It's yet another kind of Money Migration – wealth moving from West to East, pulled by the shift in economic power.

The second FT article said that "Gold sales cost Europe's central banks $40bn", because after central banks in France, Spain, the Netherlands, and Portugal followed Britain's 1999 example – and sold large chunks of their gold reserves when Gold Prices were around $280 an ounce – the price has tripled and more.

These European gold sellers got rid of some 3,800 tonnes of gold for around $56 billion, according to the FT. The paper reckons if they'd kept those gold reserves and not bought government bonds with the proceeds, those banks would be $40 billion better off. Which would come in handy today, wouldn't it?

As an aside, you can see here just how upside-down the world is today. The ECB prints money to buy bonds. The Bank of England, the Bank of Japan, and the US Federal Reserve all do the same thing. Meanwhile, central banks are selling a real tangible asset like gold. These people are supposed to be guardians of sound money with steady purchasing power. Yet they seem to be aiming for the exact opposite.

European central banks have a larger percentage of total reserves in gold compared to the rest of the world, of course. The FT says that even after years of sales, European central banks typically have around 60% of their reserves in gold. So in theory, selling the gold reduces their exposure to one asset class and gives them greater diversification. But at what price? Europe accumulated its large gold reserves through centuries of commerce and conquest. Now it's selling the continent's accumulated monetary treasure off in order pay for unsustainable social welfare promises made by nanny state socialists over the last 50 years.

Does that seem like a good long-term trade for Europe's future?

Maybe the rising Gold Price and anxiety over huge deficits is causing a re-think. The third FT article on gold reports that "Central banks succumb again to bullion's lure", since last year "central banks sold 246 tonnes of gold, which was the lowest amount in ten years." On an annual basis, Eurozone central banks sold the lowest amount of gold in the last ten years in 2008. And outside of Europe, central banks were net buyers of gold in 2008.

Our point? Serious, knee-rattling doubts about the financial system are held at the highest levels of global government and banking. So pay no attention to the drivel, pap, and platitudes you hear on a week-to-week basis. This latest market rally is a convenient distraction from fundamental changes that are afoot in the world's monetary system. As investors, we need to keep that in mind and be positioned to profit from the right commodity investments. Former Morgan Stanley analyst Andy Xie is certainly keeping it in mind...

"If China loses faith, the Dollar will collapse," he's recently written.

"Emerging economies such as China and Russia are calling for alternatives to the Dollar as a reserve currency. The trigger is the US Federal Reserve's policy of expanding the money supply to prop up the banking system and its over-indebted households. Because the magnitude of the bad assets within the banking system and the excess leverage of its households are potentially huge, the Fed may be forced into printing dollars massively, which would eventually trigger high inflation or even hyperinflation and cause great damage to countries that hold Dollar assets in their foreign exchange reserves."

Xie then makes a point that all investors ought to consider. Namely, the Fed's big expansion sets off a cascade of global currency devaluations. This is the catalyst for a higher Gold Price in all currencies, as your local reserve bank lowers interest rates and the government pursues larger deficits and more stimulus to deal with the crisis.

"As the US Fed expands the money supply," Xie writes, "it puts pressure on other currencies to appreciate. This will force other central banks to expand their own money supplies to depress their currencies. Hence major currencies may take turns devaluing. The end result is inflation and negative real interest rates everywhere. Central banks are punishing savers to redeem the sins of debtors and speculators."

So what is the end game?

"China is aware it must become independent from the Dollar at some point. Its recent decision to turn Shanghai into a financial centre by 2020 reflects its anxiety over relying on the dollar system. The US will not pay attention to something so distant. However, if global stagflation takes hold, as I expect it to, it will force China to accelerate reforms to float its currency and create a single, independent and market-based financial system.

"When that happens, the Dollar will collapse."

It may not happen this week or even this year. But we agree with Xie. That's where we're headed – with copper, oil, and gold all beneficiaries of money printing and the inevitable, of grinding, decline of the US Dollar.