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Gold, Deflation, Depression & Japan

How the Bank of Japan kick-started the bull market in gold using the same anti-deflation policy now adopted by the US Federal Reserve...

AMID THE WORST financial crisis and market meltdown since the 1930s, the world's top 20 central bankers and finance ministers are busy at work, inflating the world's money supply, slashing lending rates, and crafting stimulus packages in order to stop a "credit crunch" recession morphing into a Great Depression, writes Gary Dorsch of Global Money Trends.

  • The European Central Bank (ECB) has cut interest rates by 100 basis points to 3.25% since early October, and is telegraphing another 50 basis-point cut at the next policy meeting in December.
  • Last week, the Bank of England in London slashed its base rate a whopping 150 basis points to 3%, its lowest in 53 years, and just signaled more easing ahead.
  • With new construction in China collapsing to its worst level in a decade, Beijing pledged to spend $600-billion over the next two-years, for new housing, road and rail infrastructure, agricultural subsidies, health care and social welfare. The stimulus package equals 16% of China's total economic output.

It's not only happening in the United States, in short. But the dreaded "D" words – "Deflation" and "Depression" – are whispered only quietly by the G20 central bankers, behind closed doors.

Traditional monetary tools such as lowering interest rates are not working, because banks are hoarding cash and not passing along the lower costs to borrowers. And it seems there will be no light at the end of the tunnel until home prices finally stop falling, and banks can stop writing-off big losses.

"What this crisis reveals is a broken financial system like no other in my lifetime," said former Fed chief Paul Volcker on Nov. 17th. "Normal monetary policy is not able to get money flowing. The trouble is that, even with all this government protection, the market is not moving again.

"I don't think anybody thinks we're going to get through this recession in a hurry."

Gold, Deflation & Japan: The G20 Response

The sub-prime crisis has morphed into a diabolical monster, spreading its tentacles across the globe. Bank credit remains tight in the United States and Europe, even for top-notch investment-grade companies, who are confronted with borrowing costs that are indicative of junk bonds. And the unregulated $55 trillion credit default swap market is a nuclear time-bomb, which can explode at a moment's notice.

In the lead-up to the jaw-boning and time-serving G20 central bankers summit in Washington of mid-November, the World Bank warned that the global economy had suddenly stopped growing, and now predicts a meager growth rate of +1.0% for 2009, after expanding at 5% and more from 2003-07.

Global exports are seen tumbling 2.5% in the year ahead, a precipitous fall from growth rates of 5.8% in 2008 and 10%-plus just two years ago. In today's highly synchronized global economy, no nation has been left unscathed, not even Iceland.

The Baltic Dry Index (BDI), a composite of shipping prices for various dry bulk products such as iron ore, grain, coal, bauxite, and alumina, has plunged by ten-elevenths from a record high of 11,800-points in May, down to 840 points in mid-November.

This clearly signals a global depression. The largest cargo ships are unable to charge more than their daily operating costs, and must cut ship speeds in order to economize on fuel costs.

  • China accounts for 40% of the movement in commodities being shipped around the world, on the 22,000 ships that sail the world's shipping routes. Now Chinese steel production fell 23% in October from a record high of 47.1 tons in June. Some 90 million tons of iron ore are now stockpiled in Chinese ports – two months worth of imports;
  • With 52% of its GDP derived from exports, Korea's export shipments to China – its biggest customer – have plunged over the past six months, and were 3% lower in October than a year earlier. Korean factory output fell for a third straight month, the longest run of declines in eight years, adding to fear the Asian tiger is headed for its first recession in a decade.
  • India's industrial production was only 1.3% higher in August, than a year earlier, a 10-year low, while Indian exports fell 15% in October compared to a year earlier, the first such fall in five years.
  • Japan has entered its first recession since 2001 and Germany contracted for the first time in five years after its industrial output plunged 3.6% in September, the largest monthly loss in 14 years.
  • The jobless rate in the UK, has reached its highest since 1997 and its economy is expected to shrink 1.7% next year, its worst performance since the 1991 recession.

The United States remains the world's largest economy, meanwhile, and buys roughly 20% of the world's exports. But after a decade of living on easy credit, US consumers are now saturated with debt (300% of GDP), and – forced to de-leverage – they are leaving Asian exporter nations in a terrible bind.

Federal Reserve Shifts towards "Quantitative Easing"

US retail sales plunged 2.8% in October, the fourth straight monthly decline, impacting across virtually all sectors of the retail economy. According to official figures, 10 million American workers are out of work and cannot find jobs, and over 85,000 home-loans were foreclosed in October.

Consumer spending will collapse if the job-cutting continues and US households are deprived of credit, as home values fall and banks tighten access to mortgages, auto loans, and credit cards. Amid fears the US economy is sliding towards a Great Depression, the 1-month US Treasury bill rose so high in price, its yield fell to just 0.04%, and the 3-month yield fell to 0.12%.

That leaves T-bill rates far-below their lowest levels in 2003-04, the last time the Federal Reserve pegged the Fed funds rate at 1%.

With T-bill yields approaching zero-percent as institutional investors flee for the safety of government debt, the Fed has clandestinely adopted a radical monetary policy known as "Quantitative Easing" (QE), first pioneered by the Bank of Japan (BoJ) earlier this decade in a desperate gambit to prevent its own Great Depression.

With falling retail sales, rising unemployment, collapsing commodity prices, and an international credit crunch in motion, the Fed is printing vast quantities of US Dollars in order to buy government agency debt, commercial paper, and toxic mortgages, and other paper, from the financial industry.

"At the beginning of this year, the assets on the books of the Fed totaled $960 billion," said Dallas Fed chief Richard Fischer on Nov. 4th. "Today, our assets exceed $1.9 trillion. I would not be surprised to see them reach $3 trillion, roughly 20% of GDP, by the time we ring in the New Year.

"The composition of our holdings has shifted considerably. Previously, almost 100% of our holdings were in the form of US Treasuries; today, it's less than a third. The remainder consists of claims deriving from our new facilities."

During Japan's quantitative easing campaign, the BoJ's balance sheet swelled to the equivalent of 30% of GDP. Today, the Fed has doubled its balance sheet in just five-weeks to 15% of US-GDP, printing money and swapping it for assets of the banking sector, some unmarketable.

The Fed has also arranged $800 billion of foreign currency swaps with a dozen central banks, increasing Dollar liquidity worldwide, and refusing to reveal the exact composition of its balance sheet despite a Freedom of Information request from Bloomberg News.

With so much excess cash floating around, Treasury bill rates have gravitated towards zero-percent. But at the same time, the Fed is preventing the Fed funds rate from tumbling towards zero-percent ahead of schedule by offering to pay 1.15% on overnight deposits. This comes under new powers it was granted in the financial stabilization bill, effectively putting a floor under US rates for the time being.

For the week ending Nov 5th, US banks deposited $592 billion at the Fed, up from $11 billion at the beginning of October, instead of dumping the excess cash into the Fed funds market and forcing rates lower still. Meanwhile, the Fed continues to print money and build its balance sheet.

Inflationary Boom to Deflation Bust

It was only five months ago, when the "Commodity Super Cycle" was flexing its muscles, and lifting inflation rates to multi-decade highs around the world, fueled by an unrelenting global flight from the US Dollar.

Ben Bernanke, vice-chief Donald Kohn and governor Frederic Mishkin – the Fed's three intellectual amigos – were pursuing a reckless policy of pegging "negative" real interest rates, even with inflation raging at a 17-year high in the United States, to support the financial sector.

For several months, the Fed appeared to be overestimating the risks of recession while underestimating the dangers of inflation. The Fed was too attentive to rigging the stock market, and not the inflationary squeeze on American's paychecks. Yet today, at remarkable speed, the inflationary boom has morphed into a deflationary bust, led by a stunning $90 per barrel plunge in the price of crude oil, with copper, corn, and soybean prices tumbling 50% or more.

In his infamous "helicopter" speech of November 2002 – amid the previous post-bubble "deflation scare" – Dr. Bernanke raised the question, "Suppose that, despite all precautions, deflation were to take hold in the US economy and moreover, that the Fed's policy instrument, the federal funds rate, were to fall to zero.

"What then?

"Well, the US government has a technology, called a printing press, or today, its electronic equivalent, that allows it to produce as many US-dollars as it wishes at essentially no cost..

"Under a paper-money system, a determined government can always generate higher spending and hence positive inflation. Normally, money is injected into the economy through asset purchases by the Fed. To stimulate aggregate spending when short-term interest rates have reached zero, the Fed must expand the scale of its asset purchases or, possibly, expand the menu of assets that it buys.

"One approach, similar to an action taken by the Bank of Japan, would be for the Fed to commit to holding the overnight rate at zero-percent for some specified period, which would induce a decline in longer-term rates. A more direct method, which I prefer, would be for the Fed to enforce interest-rate ceilings by committing to make unlimited purchases of securities up to two years from maturity at prices consistent with targeted yields. If this program were successful, not only would yields on medium-term Treasury securities fall, yields on longer-term public and private debt, such as mortgages, would likely fall as well."

What might investors want to do ahead of this policy response to deflation and depression?

"Quantitative Easing" – the Japanese Experience

In March 2001, the Bank of Japan (BoJ) began its radical monetary policy known as "Quantitative Easing", pegging its overnight loan rate at zero-percent and purchasing ¥1.2 trillion of Japanese government bonds (JGBs) each month in an operation known as "Rinban".

At the time, Japanese banks were hobbled by ¥44.5 trillion of bad loans, and bank lending was 4.4% lower than a year earlier. The aim of the BoJ's operations was to flood the Japanese financial system with ¥35 trillion yen of excess liquidity, and inflate asset values, stoking investment and thus demand.

The BoJ's long-term commitment to quantitative easing was an important element of the policy's success. The market was able to expect that the BoJ's zero interest rate policy would continue for years, and that Yen Libor rates and two-year government yields would stay close to zero as well.

Throughout this decade, the BoJ has since targeted the benchmark 10-year JGB yield in a narrow range between 1.20% and 2%, a remarkable feat of controlling the world's second largest debt market.

On those few occasions when JGB 10-year yields threatened to move above the psychological 2% level, the Japanese Ministry of Finance was quick to jawbone them lower. And it also sought to talk them higher within that tight band, too.

On June 12, 2003 for instance, when JGB yields hit a record low of 0.43%, former BoJ chief Toshihiko Fukui warned traders that yields had fallen too low. "Now, we are implementing measures to boost the economy, aimed at creating situations which would drive up long term interest rates," he warned.

Three months later, JGB yields had quadrupled to 1.65% and have stayed above the BoJ's lower target of 1.20% ever since.

JGB yields hit historic lows in 2003, even though Japan had the largest government bond market in the world, with ¥562 trillion yen in marketable securities ($4.7-trillion outstanding), compared with the US Treasury's $3.3 trillion.

Tokyo floated ¥36.5 trillion of new bonds in 2003, and the Bank of Japan monetized roughly 40% of the debt by making direct monthly purchases with freshly printed bills. And even today, with the JGB market equaling 180% of GDP, the BoJ continues its mastery over the market.

Deflation, Depression & the US Bank Bail-Out

The Bernanke Fed might be inclined to follow the BoJ's blueprints, by monetizing most of the US Treasury's upcoming auctions that according to varied estimates, could mushroom to $1.8 trillion in fiscal 2009. The US Treasury is borrowing $550 billion in the fourth quarter, and $368 billion in the first quarter of 2009.

That figure could climb higher if Social Democrats vote to widen the scope of bailouts for state governments and city municipalities, and key industrial companies. But with China already looking to fund $568 billion of its own, domestic stimulus package, where will the money come from to finance today's New Deal under President Obama?

Mindful of Japan's serious policy errors of the early 1990s – as well as America's experience in the 1930s, both in the aftermath of historic stock market meltdowns – the Federal Reserve under Alan Greenspan moved forcefully to contain the damage from the bursting of the Nasdaq bubble in 2000-01. The Fed slashed its overnight loan rate 550 basis points to a 45-year low of 1%, and pegged it there for an entire year, until it was confident that deflation wasn't going to take hold in the broader economy.

As a result, the US economy has still not seen sustained deflation since the Great Depression of the 1930s.

On December 20, 2002, St. Louis Fed chief William Poole said the central bank would not make the same mistakes as the BoJ in its failed bid to ward off falling prices in the early '90s.

"Japanese authorities failed to lower interest rates quickly enough to ensure the money supply kept growing after bubbles in its real estate and stock markets burst," he said. "We're not going to make that mistake in the United States.

"The Fed is well aware that we must maintain money growth."

Greenspan's original sin had been fueling the Nasdaq bubble with excess liquidity, when legions of speculators were taking collective leave of their senses and succumbing to delusions of ever-expanding wealth. If left unchecked, "Bubble-mania" always engenders a massive, largely uncorrected rise in valuations that discounts not just the present and the near future, but a distance far over the horizon as well. Greenspan now says bubbles can't be accurately detected by central bankers, nor popped without severe collateral damage to the economy. Instead, he suggests that central banks should only attempt to mitigate the fallout by slashing interest rates.

Greenspan's second error, however, was pegging interest rates too-low and too-long at 1%, before moving too slowly to lift the Fed funds rate to a more neutral level that could have taken the wind out of the housing bubble.

Instead, Greenspan was a "serial bubble blower", inflating commodity and housing prices at the same time, while casting a blind-eye to reckless sub-prime lending in the mortgage market.

Gold & the Japan's Deflation

After stock market bubbles collapse, coinciding with economic recessions, it can take several years until the forces of inflation gain the upper-hand over deflation.

The textbook way to combat deflation is for central banks to rapidly expand the money supply or bank credit, and slash interest rates. That's what the Bank of Japan and Fed did in 2001, in a double-barreled assault against depression.

It served to kick-start a global bull market in Gold Prices.

While the BoJ adopted quantitative easing to ward off deflation, the Greenspan Fed dropped the Fed funds rate to a 45-year low, and warned Treasury bond traders that it could follow the BoJ's blueprint.

"Even though short-term rates are something slightly over 1%," Greenspan said on May 21, 2003, "longer-term rates are significantly above that. We do have the capability should that be necessary, of moving out on the yield curve, essentially moving long-term rates down.

The Fed would do that by buying Treasury securities with longer maturities and setting a cap on their yields."

The Fed hadn't relied on long-term Treasury securities as a tool of monetary policy since the 1940s. But the threat of the Fed resorting to quantitative easing gave a big psychological boost to the Gold Market. The Fed laid the groundwork for a sustained rally in all precious metals, in fact, which carried gold above $400 per ounce in New York, and above ¥42,000 per oz in Tokyo six months later.

"Should it turn out that pressures drive the federal-funds rate down close to zero, that does not mean that the Federal Reserve is out of business on the issue of further easing," Greenspan added.

On May 18, 2004, President Bush nominated "Easy" Al Greenspan to a fifth-term as Fed chief, because "Sound fiscal and monetary policies have helped unleash the potential of American workers and entrepreneurs.

"Alan Greenspan has done a superb job."

Greenspan was set free to begin a "baby-step" rate hiking campaign, as "the current highly accommodative stance of monetary policy must be returned to a more neutral setting at some point in order to foster price stability and maximum sustainable growth," Greenspan said on June 2, 2004.

Utilizing Gold Bullion prices as an indicator of inflation expectations, the Greenspan Fed waited until gold prices climbed above $400 per oz before lifting the fed funds rate a quarter-point to 1.25% on June 30, 2004; the Bank of Japan waited until March 2006, to begin dismantling its quantitative easing framework. By then, Tokyo gold was trading near ¥75,000 an oz, up 150% in value from five years earlier, or an annualized gain of 30%.

The Tokyo Gold Price vaulted sharply in late-2005, even though Japan's government reported no inflationary pressures at all in the local economy. Tokyo gold traders understood the government was fudging the numbers, however, and thus understated the true rate of inflation.

The manipulation of inflation statistics still helps the Bank of Japan to manhandle the giant JGB market within a narrow range, and at artificially low yields. So instead, Tokyo gold traders watch for other visible signals in the marketplace, to gauge the real direction of inflation.

The Bank of Japan's ultra-low interest rate policy helped to triple the price of Tokyo gold to a record high of ¥100,000 an ounce, while also inflating bubbles in numerous other markets around the world.

Tokyo gold peaked in July, when government reports showed consumer prices galloping ahead at a +2.3% clip, the fastest in 10 years. In recent months however, there has been a sharp 30% setback in Tokyo gold towards ¥70,000, alongside tumbling commodity markets worldwide.

Now, however, and for the first time in seven years, the Bank of Japan has lowered its overnight loan rate, down by 20 basis points to 0.3% as part of a coordinated effort with other G20 central bankers. The Bernanke Fed has meantime shifted towards "Quantitative Easing" with a slightly different twist on the BoJ's experiment.

How will gold perform when central banks are inflating their money supplies to prevent a Great Depression? The next issue of the Global Money Trends newsletter takes a special look at gold's future, and whether the global economy is about to experience a "decade of lost growth..."

For full details, and to subscribe now, visit Gary Dorsch's site here...

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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