So Why Did Gold Barely Budge?

So Why Did Gold Barely Budge?

A tediously dull gold market appeared yesterday to shrug off the extremely inflationary implications of the Fed’s latest rescue plan for the banking system. The central bank sent shares soaring on Wall Street with the announcement that it will set aside $200 billion of Treasurys to lend to banks and securities dealers. The unsubtle subtext was that the central bank would accept as collateral for such loans any worthless or nearly worthless scraps of paper the borrowers might have lying around. That would represent a radical and unprecedented augmentation of the Fed’s role as lender of last resort, especially since no one believes that the initial, $200 billion will prove to be much more than the ante in this global-stakes game.

Considering the news, gold’s yawning reaction was most puzzling. Is it possible that bullion finally agrees with the theory, broached here with increasing urgency in recent months, that deflationary forces emerging in the financial sector have grown too powerful to be countered by loose monetary policy, no matter how profligate?

Nose-Deep in Garbage

The plan will effectively shift the risks in the banking system onto the Fed’s own balance sheet, so that instead of holding mainly Treasury securities, the central bank will soon be nose-deep in loans and mortgage-backed securities of dubious value. For individual investors looking for a way to respond to the news, the correct course of action would seem to be: keep buying gold and silver. Of course, this has been more or less true since the Federal Reserve was created in 1913, empowering the government to create money out of thin air. But given the inability of gold to achieve new highs yesterday, and because of its equally stolid reaction to last Friday’s alarming unemployment report, we would suggest that gold bugs ratchet up their cautiousness a notch or two in the weeks ahead. In practice, this will mean closely monitoring gold’s vital signs as it flirts with the $1,000 level.

Under the Fed’s new plan, bond dealers would be able to borrow up to $200 billion in Treasurys by pledging mortgage-backed securities (MBS) as collateral. The loans would be for up to 28 days instead of overnight, as is presently the case. To further buttress its intentions, the Fed has tripled the size of swap agreements with the European Central Bank and the Swiss National Bank, allowing them to borrow up to $36 billion dollars from the Fed that could be loaned to their own client banks.

Liquidity Not Enough

With the news, the U.S. stock market opened dramatically higher -- as well it should have, given the bracing dose of liquidity the changes will provide to the financial system. But we hasten to point out that the prospect of enhanced liquidity alone may not do much to boost consumer borrowing or collateral asset values, both of which have begun to implode for psychological reasons that go much deeper than any concerns most of us have about bank-system reserves. Although the banks’ freshly perfumed reserves will briefly exude the aroma of rose petals, there are probably few “worker bee” borrowers among us who still have a taste for imbibing more “nectar”. More likely is that raising banks’ credit limits and weakening the rules governing collateral will only temporarily lubricate interbank lending and sustain for a while longer the illusion that the banking system is solvent.

Recognizing that there is no way it can induce consumers to borrow-and-binge once again with the economy slipping into a real estate deflation, the Fed has seized on an extremely risky alternative. By assuming effective ownership of all the bad paper that has clogged the credit markets, the central bank has given the banks the statutory ability to create more loans. But if the demand for loans fails to materialize and now-burgeoning bank reserves go unused, then we are about to see a collapse in money velocity that would be deflationary in the extreme.

No Hyperinflation

That is what we expect, and it implies there will ultimately be no hyperinflation. However, as long as the threat of one seems real, gold and silver quotes are likely to remain firm. But the threat could vanish quickly if and when the speculative blowoff that has seized commodity markets ends, presumably taking the stock market with it. Even then, precious metals are bound to outperform other classes of investment assets and hold their purchasing power. But it nonetheless remains a possibility that this will come about because their price has fallen less steeply than that of other assets and investables.

That is what we expect, and it implies there will ultimately be no hyperinflation. However, as long as the threat of one seems real, gold and silver quotes are likely to remain firm. But the threat could vanish quickly if and when the speculative blowoff that has seized commodity markets ends, presumably taking the stock market with it. Even then, precious metals are bound to outperform other classes of investment assets and hold their purchasing power. But it nonetheless remains a possibility that this will come about because their price has fallen less steeply than that of other assets and investables.