Shrinking the Balance Sheet?

The big news last week came from the Fed, which announced two things. One, it hiked the Fed Funds rate another 25 basis points. The target is now 1.00 to 1.25%, and there will be further increases this year. Two, the Fed plans to reduce its balance sheet, its portfolio of bonds.

 

Assets held by Federal Reserve banks and commercial bank reserves maintained with the Fed – note that while asset purchases and bank reserve creation are connected, the connection is loose (there are other factors influencing movements in reserves as well). [PT] – click to enlarge.

 

It won’t do this by actually selling, but by not reinvesting some of the principal repaid as the Treasury rolls over each bond at maturity. This is like reducing the workforce by a hiring freeze and attrition, rather than by layoffs.

We are no Fed insiders, but if we were to take an educated guess, we would read the last part as a shuffle between the Fed and the banks. No one can afford rising long-term bond yields, as the banks hold plenty of them and this would be a capital loss. Also, if bond prices drop then all other asset prices would drop too. Banks would take another hit.

Right now, the banks are lending to the Fed at 1.25%. The Fed uses this cash to finance its purchase of long Treasury bonds. The 10-year bond closed on Friday at a yield of 2.16%. If the Fed can arrange for the banks to swap, basically slowly draw down their excess reserves and buy the bonds, then it would not cause the bond market to crash.

At the same time, the Fed can say that it has shrunken its balance sheet. There would be no change in the bond market, but the banks can bypass the Fed, while increasing their net interest by about 0.9%.

This move would have one non-obvious side effect. The duration risk moves from the Fed to the banks. This is the risk of capital loss, if the interest rate should move upwards.

At least the risk moves to the banks nominally. In practice, the Fed will have to bail out the banks should they get hit by this (or assure the banks that the Fed will do everything it can to prevent long bond yields from rising).

We present the issue in these terms, because bank solvency (and the Fed’s own solvency) is the real motivation of the Fed. Price stability — defined to make Orwell proud, as rising prices of 2% per year — is not occurring right now. That is, the Fed has failed to stimulate the price increases that it wishes.

And the Yellen Fed does wish for rising prices. In a key paper she wrote in 1990 with her husband George Ackerlof, Yellen presented her theory of inflation and the labor market. Let’s strip the academic regalia, to see it in plain terms.

 

  1. Disgruntled employees don’t work hard, and may even sabotage machinery.
  2. So companies must overpay to keep them from slacking.
  3. Higher pay per worker means fewer workers, because companies have a finite budget. Yellen concludes — you guessed it:
  4. Inflation provides corporations with more money to hire more people.

 

It’s not much as a theory of labor, but does rationalize money printing rather neatly.

The mainstream belief held by Yellen, along with her most trenchant critics, is that rising quantity of money causes rising prices. Never mind that it has failed to work out that way since the Fed turned on the printing press afterburners in 2008.

It remains the prevailing belief. So it is somewhat amazing that, with consumer prices falling short of the Fed’s official policy goal of 2% per annum, the Fed is decelerating.

 

US CPI, y-o-y rate of change. Money is not neutral, and increases in the money supply usually tend to affect consumer prices only with a very big lag.  The main effect is a shift in relative prices (for instance, titles to capital such as stocks, capital goods, or real estate prices will initially be affected to a much greater extent). [PT] – click to enlarge.

 

Maybe, Yellen feels that jawboning — saying the economy is getting stronger, etc. — will be more effective than another round of quantitative easing. Maybe. The Keynesians have a cherished belief that so called animal spirits animate markets (and Yellen is a member of the New Keynesian School).

Or, it could be that banks are getting strangled. Banks don’t care about unemployment, nor about consumer prices. They don’t even care about the dollar, being both long and short. That is, they are both borrowers and lenders. They borrow short to lend long.

While the short-term rate has been rising, the long-term rate is back to falling again (which has been the trend since 1981). The effect on banks is: margin compression. The banks are choking, for lack of net revenue oxygen. They will breathe a bit easier if they can make 2.16% rather than the 1.25% as now.

What does this have to do with inflation? Another news item this week illustrates. Amazon bought Whole Foods. Amazon has unlimited access to credit through the bond and stock markets. The lower the interest rate, the more access the big corporations have, to dirtier cheaper credit.

They can’t necessarily use this credit to grow their real businesses (one cause and also effect of it being so cheap), but they can use it to make acquisitions. Acquisitions that would not be economic at higher rates.

What will Amazon do with Whole Foods? We would guess that they will pursue Jeff Bezos’ stated vision for the future: that people will always want faster delivery and lower prices. Amazon will use its superior information technology, logistics, scale — and dirt cheap credit — to drive down costs, prices, and margins at Whole Foods. And all other grocers will likely have to follow suit.

 

Wholefoods, daily. On Thursday June 15 its CEO berated activist investors for pushing for a sale of the company and the price of the stock plummeted in response. One day later WFM received a takeover offer from AMZN, sending its share price up from $33 to $43. [PT] – click to enlarge.

 

So much for higher prices. An expansion of the credit supply (the dollar is not money, which would be gold) is supposed to stoke higher prices, and here is a case where it causes lower prices.

By the way, lest anyone think that this is good because consumers get lower prices, it’s not. Sure, consumers benefit for now. But the real damage comes from the fact that the whole process is fueled by burning investor capital. That is the real nature of too-cheap credit.

And this right here is the indictment of the dollar. Not rising prices, skyrocketing prices, or hyperinflation. At least not now nor the foreseeable future. Falling interest, capital consumption, wage pressures, and unfair advantages handed to crony corporations. All managed by a Fed Chair with a frivolous theory on inflation who knows not what she does.

What does this have to do with the price of gold? Well, the price jumped up early on Wednesday as weak retail sales and inflation data numbers came out. But when Yellen spoke, the gold price fell back down, giving back the whole move and then some.

Which is all just noise. Speculators are gonna speculate, but the fundamentals of gold supply and demand do not change with an inflation data report or a Fed Chair monetary policy announcement.

Over time, if people perceive gold as an inflation hedge, and continue to see a lack of inflation, maybe they won’t buy gold or even sell it. If so, they are betting on the dollar as it continues on in its ultra-low interest rate (and long-term falling) environment.

We will take a look at the Wednesday intraday gold basis overlaid with the gold price, below.

 

Fundamental Developments

This week, the prices of the metals fell. Gold went down about $13, and silver about 50 cents. As always, we are interested in the supply and demand fundamentals. But first charts of their prices and the gold-silver ratio.

 

Prices of gold and silver – click to enlarge.

 

Next, this is a graph of the gold price measured in silver, otherwise known as the gold to silver ratio. It moved up a sharply.

 

In this graph, we show both bid and offer prices. If you were to sell gold on the bid and buy silver at the ask, that is the lower bid price. Conversely, if you sold silver on the bid and bought gold at the offer, that is the higher offer price.

 

Gold-silver ratio, based on bid and ask prices – click to enlarge.

 

For each metal, we will look at a graph of the basis and co-basis overlaid with the price of the dollar in terms of the respective metal. It will make it easier to provide brief commentary. The dollar will be represented in green, the basis in blue and co-basis in red.

 

Here is the gold graph.

 

Gold basis and co-basis and the dollar price – click to enlarge.

 

We had a rising price of the dollar (the mirror image of the dropping price of gold). The abundance fell (the basis) and the scarcity increase (the cobasis).

Our gold fundamental price shows a decrease of about $10 (to $1,334—see the chart here).

Here is the intraday graph of Wednesday (all times are London) showing the gold price overlaid with the August basis.

 

Gold price and August basis intraday on Friday of last week – click to enlarge.

 

The basis starts a little over 0.6% and droops along with the price from about $1,266 to $1,265. As the price shoots up $12, the basis shoots up 12bps. Later, the price begins to drop and so does the basis.

While the amount is coincidence, the relationship is not. It is causal. This is what first speculative buying, then speculative selling, looks like. All in one day.

Now let’s look at silver.

 

Silver basis and co-basis and the dollar price – click to enlarge.

 

In silver terms, the dollar rose more (i.e., the price of silver fell more). The decrease in abundance and increase in scarcity were correspondingly greater.

Our silver fundamental price increased two cents (to $17.54). That gives us a fundamental gold-silver ratio of 76.07 (chart available on the website). Not too far from the close on Friday of 75.12 bid and 75.29 offer.

Monetary Metals will be exhibiting and FreedomFest in Las Vegas in July. If you are an investor and would like a meeting there, please click here.

 

© 2017 Monetary Metals

 

Charts by: St. Louis Fed, StockCharts, Monetary Metals

 

Chart captions and annotations by PT where indicated

 

Dr. Keith Weiner is the president of the Gold Standard Institute USA, and CEO of Monetary Metals. Keith is a leading authority in the areas of gold, money, and credit and has made important contributions to the development of trading techniques founded upon the analysis of bid-ask spreads. Keith is a sought after speaker and regularly writes on economics. He is an Objectivist, and has his PhD from the New Austrian School of Economics. He lives with his wife near Phoenix, Arizona.

 

 

 

Emigrate While You Can... Learn More

 


 

 
 

Dear Readers!

You may have noticed that our so-called “semiannual” funding drive, which started sometime in the summer if memory serves, has seamlessly segued into the winter. In fact, the year is almost over! We assure you this is not merely evidence of our chutzpa; rather, it is indicative of the fact that ad income still needs to be supplemented in order to support upkeep of the site. Naturally, the traditional benefits that can be spontaneously triggered by donations to this site remain operative regardless of the season - ranging from a boost to general well-being/happiness (inter alia featuring improved sleep & appetite), children including you in their songs, up to the likely allotment of privileges in the afterlife, etc., etc., but the Christmas season is probably an especially propitious time to cross our palms with silver. A special thank you to all readers who have already chipped in, your generosity is greatly appreciated. Regardless of that, we are honored by everybody's readership and hope we have managed to add a little value to your life.

   

Bitcoin address: 12vB2LeWQNjWh59tyfWw23ySqJ9kTfJifA

   
 

Your comment:

You must be logged in to post a comment.

Most read in the last 20 days:

  • Trade War Game On!
      Interesting Times Arrive “Things sure are getting exciting again, ain’t they?”  The remark was made by a colleague on Tuesday morning, as we stepped off the elevator to grab a cup of coffee.   Ancient Chinese curse alert... [PT]   “One moment markets are gorging on financial slop like fat pigs in mud.  The next they’re collectively vomiting on themselves. I’ll tell you one thing.  President Trump’s trade war with China won’t end well.  I mean, come...
  • The Dollar Cancer and the Gold Cure
      The Long Run is Here The dollar is failing. Millions of people can see at least some of the major signs, such as the collapse of interest rates, record high number of people not counted in the workforce, and debt rising from already-unpayable levels at an accelerating rate.   Total US credit market debt has hit a new high of $68.6 trillion at the end of 2017. That's up from $22.3 trillion a mere 20 years ago. It's a fairly good bet this isn't sustainable....
  • US Stock Market: Happy Days Are Here Again? Not so Fast...
      A “Typical” Correction? A Narrative Fail May Be in Store Obviously, assorted crash analogs have by now gone out of the window – we already noted that the market was late if it was to continue to mimic them, as the decline would have had to accelerate in the last week of March to remain in compliance with the “official time table”. Of course crashes are always very low probability events – but there are occasions when they have a higher probability than otherwise, and we will...
  • Rise of the Japanese Androids
      Good Intentions One of the unspoken delights in life is the rich satisfaction that comes with bearing witness to the spectacular failure of an offensive and unjust system. This week served up a lavish plate of delicious appetizers with both a style and refinement that’s ordinarily reserved for a competitive speed eating contest. What a remarkable time to be alive.   It seemed a good idea at first... [PT]   Many thrilling stories of doom and gloom were published...
  • Claudio Grass on Cryptocurrencies and Gold – An X22 Report Interview
       The Global Community is Unhappy With the Monetary System, Change is Coming Our friend Claudio Grass of Precious Metal Advisory Switzerland was recently interviewed by the X22 Report on cryptocurrencies and gold. He offers interesting perspectives on cryptocurrencies, bringing them into context with Hayek's idea of the denationalization of money. The connection is that they have originated in the market and exist in a framework of free competition, with users determining which of them...
  • Getting High on Bubbles
      Turn on, Tune in, Drop out Back in the drug-soaked, if not halcyon, days known at the sexual and drug revolution—the 1960’s—many people were on a quest for the “perfect trip”, and the “perfect hit of acid” (the drug lysergic acid diethylamide, LSD).   Dr. Albert Hoffman and his famous bicycle ride through Basel after he ingested a few drops of LSD-25 by mistake. The photograph in the middle was taken at the Woodstock festival and inter alia serves as a...
  • No Revolution Just Yet - Precious Metals Supply and Demand Report
      Irredeemably Yours... Yuan Stops Rallying at the Wrong Moment The so-called petro-yuan was to revolutionize the world of irredeemable fiat paper currencies. Well, since its launch on March 26 — it has gone down. It was to be an enabler for oil companies who were desperate to sell oil for gold, but could not do so until the yuan oil contract.   After becoming progressively stronger over the past year, it looks as thought the 6.25 level in USDCNY is providing support for the...
  • The “Turn of the Month Effect” Exists in 11 of 11 Countries
      A Well Known Seasonal Phenomenon in the US Market – Is There More to It? I already discussed the “turn-of-the-month effect” in a previous issues of Seasonal Insights, see e.g. this report from earlier this year. The term describes the fact that price gains in the stock market tend to cluster around the turn of the month. By contrast, the rest of the time around the middle of the month is typically less profitable for investors.   Due to continual monetary inflation in the...
  • Flight of the Bricks - Precious Metals Supply and Demand
      The Lighthouse Moves Picture, if you will, a brick slowly falling off a cliff. The brick is printed with green ink, and engraved on it are the words “Federal Reserve Note” (FRN). A camera is mounted to the brick. The camera shows lots of things moving up. The cliff face is whizzing upwards at a blur. A black painted brick labeled “oil” is going up pretty fast, but not so fast as the cliff face. It is up 26% in a year. A special brick, a government data brick of sorts, labeled...
  • From Fake Boom to Real Bust
      Paradise in LA LA Land More is revealed with each passing day.  You can count on it.  But what exactly the ‘more is of’ requires careful discrimination.  Is the ‘more’ merely more noise?  Or is it something of actual substance?  Today we endeavor to pass judgment, on your behalf.   Normally, judgment would be passed on a Thursday, but we are making an exception. [PT]   For example, here in the land of fruits and nuts, things are whacky, things are...

Support Acting Man

Item Guides

Top10BestPro
j9TJzzN

The Review Insider

Austrian Theory and Investment

Archive

350x200

THE GOLD CARTEL: Government Intervention on Gold, the Mega Bubble in Paper and What This Means for Your Future

Realtime Charts

 

Gold in USD:

[Most Recent Quotes from www.kitco.com]

 


 

Gold in EUR:

[Most Recent Quotes from www.kitco.com]

 


 

Silver in USD:

[Most Recent Quotes from www.kitco.com]

 


 

Platinum in USD:

[Most Recent Quotes from www.kitco.com]

 


 

USD - Index:

[Most Recent USD from www.kitco.com]

 

Mish Talk

 
Buy Silver Now!
 
Buy Gold Now!
 

Oilprice.com

Diary of a Rogue Economist