Submitted by Michael Lebowitz of
720 Global
Shorting The Federal Reserve
“I’ve never let my guard down by saying, I do not need to be
hedged” - Paul Singer
Preservation of clients’ wealth is the most important fiduciary
duty guiding investment managers. This obligation tends to be
under-appreciated in the midst of financial asset bubbles when
recency bias blunts the desire to sacrifice the potential for
further gains in exchange for protection against losses.
Inevitably, this is made painfully clear when a bubble pops and
those once popular assets lose value and the manager’s clientele
suffer. 720 Global has repeatedly urged caution as valuations are
currently stretched on the back of reckless Federal Reserve
monetary policy and poor economic fundamentals. This article
presents the case for an asset that can help managers protect their
clients and uphold their fiduciary duty owed to them.
Gold - \?g?ld\ AU #79 - A heavy yellow elemental
metalof great
value
Gold is neither a claim on the promise of future earnings like a
stock, nor a liability owed by a public institution or a private
party like a bond. It also lacks the full faith and credit of most
governments, like a currency. Gold serves little industrial
purpose, unlike all other commodities and is most commonly revered
as a shiny metal used in ornamental display or jewelry. It is
precisely these failings that make gold a unique and valuable asset
and one that can play an important role in portfolio
construction.
Gold is one of the few stores of value that is limited in
supply, transportable, globally appreciated and not contingent upon
the faith and credit of any entity. It cannot be manufactured or
debased. Gold is the only time honored currency or in the words of
John Pierpont Morgan (J.P. Morgan), “gold is money, everything else
is credit”.
History
Thousands of years ago trade between people began through a
system of barter. This method of payment was effective but very
limiting. Trade could not occur unless both parties had the goods
or services demanded by the other. If a metalsmith, for example,
did not need wheat, a farmer seeking a new sickle would have to
find alternative goods or services to offer the metalsmith.
These stark limitations and the growing desires to conduct
trade with parties over further distances required a more robust
system. Accordingly, trade graduated from the barter system to that
of a common currency. Aristotle stated the rationale for a common
currency eloquently:
“When the inhabitants of one country became more dependent on
those of another, and they imported what they needed, and exported
what they had too much of, money necessarily came into use”. At
first, in almost all cases, the currency was a commodity. While
eliminating some of the problems associated with barter, this
system presented new ones. Carrying gold or other commodities such
as silver, grain, shells, or livestock can be cumbersome and
difficult to properly measure for weight and purity. Dividing most
commodities into fractions for ease of exchange produced additional
difficulties. Paying for an acre of land with a quarter of a cow
must have presented quite a quandary.
The next step in the advancement of currency was the use of
sovereign issued, standardized currency typically made with gold,
silver, copper and bronze. The first known instance of such a
currency, the Greek drachma (pictured to the left) dates back to
approximately 700BC. The benefit of this commonly accepted currency
was that the supply of money became regulated and standardized.
Additionally, the limited availability of the metals made it hard
to increase the supply of currency in any significant manner. These
currencies held their value well as the worth of the coin was
always tied to the weight and the price of the metal used. That
said, there are instances where governments abused their authority
by decreasing, or shaving, the metal used in each coin, temporarily
unbeknownst to the public.
While coins were a big improvement from the days of barter, they
could not fulfill the pressing monetary requirements of escalating
global trade. To fill this need national banks introduced bank
notes. Bank notes are essentially paper IOU’s, as we have today.
The dollar bill, for instance, is backed by the full faith and
credit of the United States. However, prior to the last 50 years,
full faith and credit was rarely acceptable and accordingly most
bank notes were backed by a commodity, typically gold or silver.
One holding a bank note backed by gold or silver could always
exchange the note for a fixed amount of the metal backing the
currency. In 1792 the Mint and Coinage act authorized the Bank of
the United States to establish a fixed ratio of gold to the U.S.
dollar. While the fixed rate fluctuated over time, there was always
gold and silver backing the currencies. Below is a picture of a $20
gold certificate.
On May 1st, 1933, President Roosevelt issued executive order
6102. This action ordered U.S. citizens to turn in their gold
coins, gold bullion and gold certificates to the government. The
order essentially made holding gold, in those forms, illegal for
private citizens. The government set a rate of $20.67 per ounce for
anyone exchanging their gold for cash. Surprisingly, and still
deeply entrenched in the memory of many, personal bank vaults were
raided in search of gold. 7 months later, having accumulated a
significant amount of gold, the Gold Reserve Act was passed which
raised the fixed rate of gold per ounce to $35.00. While rarely
discussed in mainstream economic text books, this simple act was a
massive devaluation of the dollar. With one swipe of a pen the
amount of gold supporting the dollar was increased by 70%.
Roosevelt’s actions highlight an important distinction in the
gold debate. Most critics of a gold standard today argue there is
not enough gold in existence to back the current monetary regime.
The truth is that the amount of gold is irrelevant, it is
the price of gold that matters.
While the gold standard no longer applied to U.S. citizens,
foreign nations were still able to exchange U.S. currency for the
gold or silver backing it. In 1971, President Nixon signed
executive order 11615 which suspended this right of exchange. The
act officially took the U.S. off of the gold standard. Most other
nations have since taken similar actions.
It has only been the last 44 years where gold plays little to no
role in the backing of any major currency. Although there is still
gold stored in Fort Knox and other vaults, it only represents about
7% of our monetary base at current prices. The nouveau logic
surrounding this fiat currency regime states that confidence and
trust for a piece of paper backed by faith will always trump the
desire for people to hold something tangible.
History is littered with financial crises and other disturbing
events resulting from reckless monetary policies. Part II of this
piece, soon to be released, will chronicle one example of the ills
of uncontrolled money printing, namely the actions that ultimately
led to the French Revolution (1789-1799). This example is not as
well-known as recent money printing schemes such as the Weimar
Republic in 1923, Argentina in 1981 or Zimbabwe in 2008, but the
lesson it provides is invaluable. The scale of money supply growth
today is enormous but far from those achieved in the aforementioned
countries. Nonetheless, all investors should have an appreciation
for the path we are on and the fate that befell others that took
similar paths.
The Era of Easy Money
Without a mandate for gold or silver to back a currency, most
nations can freely increase or decrease the supply of money with
few restrictions. The Federal Reserve (Fed) and many other central
banks have done just that. Central banks now use their ability to
manipulate the money supply to help them decrease interest rates,
incent borrowing with the intent of spurring economic growth.
Consider the stark differences in the annual growth of the money
supply before and after Nixon’s removal of the gold standard:
Post WWII era (1950-1970): +3% annualized
Removal of gold standard until the financial crisis
(1971-2008): +19% annualized
Period since financial crisis (2008-today): +29%
annualized
It is important to highlight that the Fed has quadrupled the
money supply since 2008, dwarfing the 100% increase in the money
supply during the great depression.
This “get rich quick” mentality generated limited shots of
synthetic economic growth instead of fostering productivity to
nurture and support lasting organic economic growth. This strategy
is not without cost. In the words of Aldous Huxley: “One can’t have
something for nothing”. Laying in the wake of money printing and
extraordinarily low interest rates is an unprecedented accumulation
of public and private debt, the decline of productivity growth and
a fragile economy. These costs have been mounting for years,
requiring higher degrees of central bank intervention to avoid
paying them.
It is becoming more and more apparent that the so called “era of
easy money” is quickly coming to an end. Debt levels are at a point
where they challenge the economy’s ability to grow them, let alone
service them. Interest rates have been lowered to zero with some
countries now targeting negative rates. As stressed earlier, the
U.S. money supply has quadrupled since 2008 and those of other
economic powers have done likewise. Productivity growth has ground
to a halt in the U.S. and is in decline in most major economies. To
put the situation in blunt economic terms: the Minsky moment has
arrived. The saying, derived from the works of Hyman Minsky,
describes the sudden collapse of assets values which were driven
higher by the gross misallocation of capital. Years of easy money
and unregulated money printing has created this condition
today.
The graphs below help visualize the enormous growth of central
bank balance sheets and total U.S. debt outstanding. The table
following the graphs show the stunningly low current level of short
term interest rates of selected major economic powers. 5 of the 7
countries in the table have interest rates below zero.
Growth of Central Bank Balance Sheets
U.S. Total Debt Outstanding (Public and Private)
Why Gold
Gold is denominated in US dollars meaning it is quoted as the
amount of dollars required to buy or sell one ounce of gold. The
price of gold rises and falls with supply and demand for gold
however a big determinant of its price is the value of the U.S.
dollar.
Commonly, the U.S. dollar is quoted as an index or ratio. For
example, the closely followed dollar index (DXY) is currently
trading at 96.00 and the dollar’s exchange rate versus the Euro is
1.12. These are valid price indicators, yet also misleading, as
they solely describe the value of the U.S. dollar relative to other
currencies.
If another country debases their currency more aggressively
than the U.S., the dollar may rise in price but has it truly gained
value? The exchange quotes and pundits may say yes but the answer
is clearly no.
The only proper measure of the value of a dollar is its
purchasing power. In the 1950s, $1 bought a couple a full meal at
McDonalds including a burger, fries and a shake. Not only that, but
the couple walked away with change. Today a similar meal at
McDonalds would run the couple well over $10. The easy conclusion
from that example is that prices have increased. However, one could
more accurately state the value of the dollar has diminished. Had
one been able to preserve those burgers, fries and shakes for over
60 years they would have retained the original purchasing power of
their dollar bill (currently $10+ at McDonalds). Although storing
food and most every product/commodity is fraught with risks and
complication, one takes the additional chance that there may not be
demand for such goods in the future. Had one bought $1 worth of
gold in the 1950s, they would have $33 worth today.
Therein lies the value of gold. While theft of gold is a risk
like anything else, gold doesn’t spoil or rot, it is relatively
compact and easy to store, and it is not easily destroyed. Most
importantly though, one can have about as much confidence as this
world offers that someone will be willing to buy their gold in the
future as has been the case throughout the history of civilized
human existence.
Brazil and Turkey provide us with current examples of the
virtues of owning gold. Year to date the Brazilian Real has dropped
25% and the Turkish Lira 30% versus the U.S. dollar. Despite the
significant depreciation, Brazilians and Turks holding gold were
able to retain their purchasing power. In both countries gold is
trading at all-time highs offsetting the depreciating effects of
their respective currencies.
This article should not be mistaken as advice to increase your
allocation to gold to 100% and sell all financial assets. What it
does imply is that in periods of economic strength, central bank
credibility and dollar strength that the need to hold gold for
protective purposes is minimal. Conversely, in times, like today,
when debasement of currency is the Fed’s last remaining policy tool
of any significance, one should retain some protection. Holding
gold is simply recognition that the Fed’s actions over the last 30
years have potentially severe consequences that pose threats to the
value of most financial assets, the almighty dollar and ultimately
your clients’ purchasing power.
Owning gold is in effect not only a short on the dollar and
on the credibility of the Federal Reserve, but most importantly a
one of a kind asset that protects wealth.
“Gold, unlike all other commodities is a currency… and the
major thrust in the demand for gold is not for jewelry. It is not
for anything other than an escape from what is perceived to be a
fiat money system, paper money that seems to be deteriorating.” -
Alan Greenspan 2011