Gold, the Fed & Sterile Inflation
If the Dollar must fall, and no one trusts other currencies, it's very bullish for Gold...
LEADING AUTHORITY on gold, silver, precious metals and the commodities markets, CPM Group founder and managing director Jeffrey Christian recently spoke to The Gold Report about the apparent "demise" of the Dollar and the shape of this current recession.
A journalism graduate, he left his job as an editor at Metals Week – an industry publication – in 1980, moving to J.Aron & Company a year before Goldman Sachs acquired the firm. There, Christian soon managed the Commodities Research Group's precious metals and statistical work, and in 1986, he engineered a leveraged buyout of this group to create CPM.
It now counts among its many clients some of the world's largest mining companies, industrial users of precious metals, central banks, government agencies and financial institutions.
The Gold Report: Perhaps you could begin by giving us your macro overview of the world economy and the outlook as you see it.
Jeffrey Christian: If you go back to 2006 or 2007, our view was that we would see a relatively short and shallow recession in the first half of 2009. Beginning in late 2007, we said maybe the recession would start earlier, maybe in the fourth quarter of 2008. And then we said maybe the third quarter of 2008. Now we find from the National Bureau of Economic Research that the recession officially started in December of 2007.
We still see it ending around the middle of 2009. But it's obviously going to be much longer and much deeper than we had expected a year or two ago. Economic problems are much worse. What we really have is a financial crisis, a freezing up of credit availability, which has led to a domino effect of reducing demand for products. We started with a bank panic and a freeze-up in the credit market that has now spilled over into final demand for goods and services across the real economy. It's proving extremely difficult to treat.
I happen to think that the US government policies pursued in September, October and November have not necessarily been the best policies to resolve these issues. We're looking to see what the new government does after January; a different approach may be more palliative to the economy. But the bottom line is things are bad, they probably will get a little bit worse, and we're probably looking at a pretty weak first half of 2009.
Our view is that by the second half of 2009, maybe early 2010, you'll see an economic recovery come along. That economic recovery may be a lot more powerful on the upside than a lot of people expect. One of the things that we've seen and have written extensively about over the last few years – and it's become even more prominent with the government largesse – is an enormous amount of money sitting in cash and cash equivalents waiting for a signal that it's safe to invest again. All of this money is standing by, ready to invest in precious metals, invest in commodities, invest in real estate, equities and corporate debt. So we think that in the second half of 2009, or whenever the recession ends, you could see a rather rapid recovery in overall economic activity globally.
That's our economic overview, and I will say this. Everybody in the world is looking at the amount of money the governments have pumped into the market, saying it spells death and destruction for the US Dollar and inevitably will lead to hyperinflation. I'm not convinced that's true and I think that's a very important point.
When you look at all of the monetary liquefaction that's occurred, it's definitely going to lead to a lower Dollar and higher inflation than we've seen over the last 25 years. Still, we may well avoid a total collapse of the Dollar and hyperinflation if the monetary authorities of the world effectively are able to sterilize the inflationary implications of this once the recovery starts. We won't know that for a year or so.
TGR: What do you mean by "sterilize the inflationary implications"?
Jeffrey Christian: It means sucking the inflationary money creation out of the economy. I've spent a lot of time looking at what happened in the period of 1979 to 1983; the really critical point here is in the middle of 1982 we were two years into a double dip recession. At the time it was the deepest recession in the post-war experience. In the middle of 1982, Brazil, Argentina and Mexico were about to default on their government bonds. Paul Volcker called the central bankers of the world together and said, "We have to monetize ourselves out of this recession because it's about to become something much deeper and harder to solve."
The governments of the world opened the sluices and flooded the world with money. By December of 1982, the world was out of a recession, auto sales had rebound sharply, Geoffrey Moore's leading index of inflation indicators – which was basically money supply – had gone off the chart. Gold Bullion had risen from $290 in July of 1982 to $500 by the end of the year, because everybody was convinced that this was going to be inflationary and that the Dollar was going to collapse. But by the end of '82, early '83, it was clear that we were out of the recession.
Fortunately for Volcker, the administration of Reagan and his associate Donald Regan [Reagan's Treasury Secretary] had taken Jimmy Carter's $40 billion deficit and turned it into a $200 billion Reagan deficit and needed to finance it. So Volcker said, "That's easy; let's sell $300 billion worth of T-bonds and suck $300 billion out of the economy."
And they did it. They started selling a tremendous amount of bonds to monetize the debt that the government was racking up and thus sterilized the inflationary implications of their earlier monetary creation.
Then oil prices fell 15% in the first quarter of 1983, from $34 to $29 per barrel, gold prices fell $100, inflation went from about 7% to 3% and is only now getting back up there. We entered a 25-year period of the lowest inflation in a long, long time right when everybody was convinced that all of that money creation would lead to hyperinflation. The government has followed that model every time we've gone into a financial crisis since 1982. This time around everything is much bigger and the question is, "Can they do it again on an even grander scale?"
TGR: We didn't have the fundamental problems back then that we have today. We didn't have all these derivatives. So many things are so different, and we've seen nothing of this magnitude.
Jeffrey Christian: Actually, the two biggest and most important differences are that we had extremely high US interest rates then, and a very strong and persistently rising Dollar. The Dollar was rising then, as it is now, but it has been weak from 2003 until the middle of this year. You're right, however – we didn't have the derivatives and all of this enormous financial liquidity that we have now. And as I said, we're playing a much higher-stakes game this time around, and we're doing it in a situation with low interest rates and a fundamentally weak Dollar.
People talk about how strong the Dollar has been in the last few months, but it's still very low compared to what it had been. Funny, I just got an email from someone who attended a conference I spoke at in Zurich about a year ago. He said this is amazing, that a year ago everybody laughed at me because I said the Dollar would be strengthening – but I didn't say what kind of environment it would be strengthening in.
TGR: Isn't another difference between the current situation and the one 30 years ago the fact that back in '79 it was basically the United States and the Banana Republics that were having problems? It wasn't Germany, France, Switzerland – it wasn't everybody, was it?
Jeffrey Christian: No, it was everybody in fact. The US was in a deep recession, Europe was in a deep recession. That's when they coined the term "Eurosclerosis". I was working at J.Aron at the time, and we were doing a lot of gold loans with Eastern European governments, because they needed the money. We found ourselves in workout situations with sovereign debt in Eastern Europe in 1981; whereas Latin America didn't erupt until 1982. But it was pretty much universal. The US was a bigger part of the world economy back then, too.
TGR: So a decoupling, when you look at the BRIC countries [Brazil, Russia, India, China], will help carry us through or avoid an international recession this time around?
Jeffrey Christian: I don't think so. I think we're in an international recession. The IMF seems to think so. When everybody started talking about how the economies of the world could decouple from the United States, I said it's just one of those pater nosters that makes no sense and doesn't stand up to statistical scrutiny. You're seeing that. You're seeing India, China, and all of the other emerging countries really suffering from a decline in demand for their products, much of which are exported into the United States and Europe, and it's having catastrophic consequences.
Granted, there is a movement away from being dependent on the American consumer on a worldwide basis, but it's a very slow movement and hasn't progressed far enough to insulate the rest of the world from the problems in the US.
TGR: You were talking about Volcker, who issued something like $300 billion of debt – selling Treasury bonds – in the '80s and sold them to cover it and continued to do more of that. At some point, don't we have to pay that back? Isn't there a Piper to be paid?
Jeffrey Christian: In theory, yes. But there's a problem with the doomsayers. Look at Jim Grant, who publishes the Interest Rate Observer. I think it was in 1980 that he said, "Oh, my God, look at this $37 billion debt that Carter's ramping up. This is unsustainable; the Treasury market is going to collapse." At some point, he probably will be right and the Treasury market will collapse. But in the meantime, we've had 28 years that make a $37 billion deficit pale. We wish we could have a $37 billion deficit.
In the meantime, several things mitigate against any imminent collapse. One is the fact that the world economy basically always has been and always will be a giant confidence game, in the sense that there has to be a certain level of confidence to keep things going. The other thing is that for the Dollar to collapse, some other currency has to rise very sharply. The problem that the world's in right now is that for the Dollar to fall sharply, investors have to have greater confidence in some other currency. And this is really great for gold. It makes you really bullish for Gold Investment.
Another currency has to rise if the Dollar's going to fall. Ask people "Which one do you have more confidence in?" There's silence in the room and then people Buy Gold. No one has any confidence in any of the other currencies or the governments behind them – the Euro, the Yen, the Swiss Franc or anything else.
In a speech a few weeks ago, I said, "The Dollar is like your mother. You'll sit around and complain about her and how she's so mean and nasty and you've got to get away from her. But as soon as you cut your knee, you go running back to her crying." That's what's happening right now in the world economy, in the financial markets. Everybody has been saying for five years that the dollar is toast and the dollar is no good and the US debt is unsustainable. But as soon as you get into a banking panic, everybody converts their money into dollars and Treasuries and CDs held by banks that are guaranteed by the FDIC.
Why? Because even though we've lost a tremendous amount of faith in the US Treasury, we still have more faith in the US Treasury than we do in, say, the European Central Bank or the Bank of Japan or the Bank of England.
TGR: So if the Dollar devalues and some other currency has to rise, it bodes really well for gold. But considering the trillions of dollars of debt out there, is there enough gold for it to be a viable alternative currency? Or will the price for every ounce of gold become something cataclysmic like $3,000 or $4,000?
Jeffrey Christian: Yes. If you tried to monetize the debt in Gold, or if you tried to go back to a rigid gold standard, you would either have to have $3,000 or $4,000 or $5,000 or $6,000 gold, or you would have to severely contract the world economy back to where we were in, say, the 17th century. But I don't think that's what you're looking at. Rather, you're looking at some portion of the world's assets moving into gold as an alternative to currencies. In that situation, you "only" see $1,000 or $2,000 gold.
TGR: Some of us might like $5,000 or $6,000 gold, but maybe not everything else that would be going on with gold prices at that level.
Jeffrey Christian: Right. You definitely wouldn't like everything else going on. It's interesting. It depends on how a gold standard would be created.
The last time we had a "serious" discussion of a gold standard in the United States was during the 1980 election campaign. The Republicans actually had a platform plank written by Arthur Laffer to return to a gold standard. What Laffer said was that for the US Treasury notes in circulation, you would have to have 40% of the value of the Treasury notes in gold held by the US Treasury, or a 40% cover. It sounded really stringent, but then you realized that since the 1960s almost all of the bills printed actually had been Federal Reserve notes – not Treasury notes. When asked about that, Laffer said that's right. What you need from a gold standard is the public's sense of confidence in it. If you tell them Treasury notes are backed by gold, they'll be more confident in the value of the Dollar. They won't bother looking at the fact that we're printing Federal Reserve notes 'til the cows come home. It was a very disingenuous and cynical approach to the American voters.
TGR: So we may see some rush to Gold, which may lift it up to $1,000 or $2,000. What about other precious metals like silver? Will that tail along with gold?
Jeffrey Christian: I'm actually now in a situation where I like silver, platinum, palladium and the other platinum group metals as well as gold. I like silver for a couple of reasons. One is it's a financial asset like gold, it is benefiting from the move of investors into silver and gold, and it will continue to benefit from that. But you'll also see several other things. First off, there is not a lot of metal in the silver market, half a billion ounces in bullion and maybe a half a billion ounces in bullion coins. In gold you have a billion-plus ounces that investors own and another 980 million ounces that central banks own. There aren't those large enormous stockpiles of silver if you're looking at it on a dollar value basis.
In addition, silver is an industrial metal with some very interesting new uses coming up. It's losing some of its traditional uses such as photography; but in other uses, such as batteries and electronics, it's actually growing very sharply and could grow more sharply over the next few years. So I think silver's got a lot of good things going for it. It's an alternative financial asset like gold. It's a smaller, less liquid, more volatile market than gold. And it has the industrial base that gold doesn't have. So I like silver for those three reasons.
TGR: What brought silver down so much? It got up to $21; now we're at $9 and change.
Jeffrey Christian: The massive amount of leveraged investment in these things has brought all of these metals down. Everybody keeps talking about de-leveraging, but if you ask them to explain it, they can't. But let me try to explain what I mean when I say leveraged investment. You had hundreds of billions of dollars of institutional money invested in gold and silver forwards, gold and silver over-the-counter options, and gold and silver indexed notes – all written by banks and all with major leverage factors. Some were 10:1; some of them were actually 30:1 or 40:1. As the financial crisis occurred, institutional investors had their credit lines pulled back. Consequently, they had to reduce the amount of investments that they'd borrowed money to make.
So a hedge fund that has $10 billion under management and a leverage factor of 20 might have $200 billion of leveraged trades. Then suddenly you don't have the money to support $200 billion worth of leveraged trades. You have to liquidate most of them because you really only have $10 billion – which is going down in value fast. So there's been this massive sale of leveraged products. It's like running for the exit in a theater when somebody yells fire. It's a very small door, a very illiquid market, and all of a sudden there's no provision of credit. Everybody's trying to get rid of their leveraged exposure all at once and these prices have just plunged down. That's really what it's been.
TGR: But silver has lost nearly half, while gold is down less.
Jeffrey Christian: Silver prices are always more volatile than gold prices. That's just a fact of life. It has to do with the fact that the silver market is about one-twelfth the size in dollar terms. The other thing is that gold is money and silver is like money. Silver has this schizophrenic personality. It is an industrial commodity, but it's also a financial asset and you do see more people investing in gold than in silver worldwide right now. As the prices plunged, you have seen an unprecedented volume of physical gold and silver being purchased by investors around the world. So you have this dichotomy, where the price is being hammered down by de-leveraging in the paper market, while people – in some cases the same people – are taking what's left of their chips and putting them into physical gold.
One of the things I think you will see going forward over the next many years is a lot of institutional investors, including sovereign wealth funds and government funds, wanting exposure to gold and silver but not on a leveraged basis where they're really owning IOUs issued by major banks. They are wanting the physical material.
TGR: Does that hold true for retail investors too? So rather than buying ETFs or Central Fund of Canada, should they be buying actual physical?
Jeffrey Christian: It really depends on the investor and their perspective. The high net worth individuals we deal with own some physical gold and silver and maybe platinum group metals that they actually store in their own vaults. They own other material that's being held for them in depositories in various parts of the world. They also own some ETFs, some options, some mining companies and some exploration companies. So it's really a diversified portfolio.
Except for these high net worth individuals, we don't deal with retail investors directly as customers at CPM Group. We talk to them, though, and we do deal with people who supply the retail market. A lot of people are moving into the physical material. Demand in the ETFs also has been strong over the last few months and some of that demand comes from people who can't get their orders filled for one-ounce coins or 100-ounce silver bars. They're buying ETF shares instead because they seem the next best thing.
TGR: Suppose the economy actually does start to turn around, as you're projecting maybe in the second half of 2009, and you have all this money on the sidelines, which you indicated might flow back into the marketplace rapidly. Does that mean gold will rise through the recovery and then go back down?
Jeffrey Christian: Because gold is money and an alternative asset, gold and silver probably will rise in the first half of 2009 in response to the economic distress that we expect at that time. And then as the economy recovers – let's be hopeful and say it starts in the second half of 2009 – you actually might see gold and silver come off some.
Platinum group metals, which we've only mentioned in passing, are the other way around. They're really industrial metals, heavily tied to auto sales and so probably will remain weak until auto sales recover. But when that happens, expect platinum group metal prices to rise sharply.
I thought platinum was overvalued years ago and it just kept rising and rising, but now it's clearly undervalued. The cost of producing platinum or palladium at most mines in the world is higher than the current prices. About 50% of platinum in the world goes into auto catalysts, 60% of palladium and 80% of rhodium. With the auto industry and the auto market on their back in North America and Europe, these markets have spiraled down. A lot of investors who poured into the platinum markets partly based on the auto story are now pouring out. I think platinum group metals prices will rise sharply once the auto industry turns around.
And the auto industry will turn around. Not necessarily because of the situation in the United States, but if you look at the BRICs, for example, you have a tremendous growth in auto sales and it's fallen. In China it's gone from 15% per year down to about 8% per year, but that's a cyclical thing. It will turn itself around and people will start buying more. And an interesting thing about platinum is that you don't have the share market similar to what you have in gold and silver.
TGR: With costs exceeding current prices, the issue on the production side is clear, but what's the problem on the exploration side?
Jeffrey Christian: They can't get financing. And insofar as some of these companies are exploring in South Africa, problems related to electricity and electricity allocations predate the bank panic. South Africa basically has not really invested in electricity-generating capacity for a decade. Those power shortages and outages are going to take many years to solve. They're saying they'll pay attention to existing mining companies, existing corporations, existing consumers of electricity. When you're building a mine, you have to go to Eskom, the state electrical utility. Unless you're already in the construction phase and have your electricity allocation, they're just going to say they don't know when they will be able to supply you electricity. That's going to delay exploration and development. On top of that, the financial freeze will delay a lot of new capacity coming on stream. That will make the platinum group metals that much tighter.
TGR: As we come out of this recession, many people say certain sectors will emerge faster than others. You talked about how gold's going to have a nice run up while we're in recession. What commodities should we expect to come out of the recession first?
Jeffrey Christian: I think gold and silver come out first. We're looking at some specialty metals like ferroalloys – vanadium and molybdenum – because those markets are much tighter. The prices have been beaten up, as have the prices of larger metals like aluminum and copper. But if you look at molybdenum, for example, a lot of its uses are in transmission pipelines for gas and oil, offshore platforms for gas and oil production, and drilling pipe and production pipe for oil and gas.
Even with lower oil and gas prices, these areas are going to be very strong over the next five, 10, 20 years. So we think you'll see a relatively fast turnaround for a lot of these specialty metals, things that are harder to come by, but generally speaking are indispensable in critical economic applications. I think steel will also do very well because I expect the new government in the United States to undertake a major new program to rebuild all of these bridges that are about to fall down. I think you'll see steel do very well from that perspective.