Thursday, January 7, 2010

Kitco's Nadler on Markets and the Fed

Jon Nadler had written an article on Kitco a few days ago suggesting that Ben Bernanke's public statement that he would tighten this year ought to give gold bugs pause. Today Nadler writes:

"Bloomberg reports that: “A prospect of higher interest rates in the U.S., the world’s largest economy, probably will strengthen the dollar further and may take 'some of the wind out of the commodity markets’ sails,' said Royal Bank of Scotland Plc’s commodity analysts, led by Nick Moore. The dollar may rally some 15 percent this quarter, they said.”

Nadler recommends a holding of 10 percent of your portfolio in gold. The breakdown in my brokerage account now is as follows:

Cash 45%
Stocks 22%*
High-yield bonds 6%
Gold (GLD) 15%
Agricultural commodities index (DBA) 6%
Silver (SLV) 6%

*Stocks include Kayne Anderson (a gas pipeline investment trust), GE, the health industry index (IYH), a drinking water stock fund (FTSIPCE9R), and several general stock funds.

My pension account, which is 60% larger than my brokerage account, is almost entirely in cash and a GIF (interest bearing account) that TIAA-CREF offers. In addition, I hold cash in two banks totaling about 30% of my brokerage account. One of the banks, Everbank, offers international CDs such as Euros and Yen, but I have it all in the dollar now.

Nadler argues that unless you think that hyper-inflation is a possibility that gold is not a good hedge against inflation. He argues that the 1970s's gold boom was an anomaly that occurred because of the absence of investment alternatives such as small business stock funds.

However, you will recall that the inflation of the 1970s took the following path. First, the Vietnam War debt precipitated aggressive Fed policy and Nixon added inflation in the early 1970s. By 1970 the inflation rate was about 4%, only slightly higher than it has generally been during the past 25 years. But at that time people perceived the 4% as high. Today they perceive 3.7% inflation as no inflation.

The taste for gold did not accelerate until later in the decade, the late 1970s, when the Johnson/Nixon money had circulated for five to fifteen years. This occurred because of speculation that was in reaction to visible inflation approaching and exceeding 10%.

At the time that the inflation was reaching its peak, the Carter Fed under Paul Volcker adopted the monetarist policy of raising interest rates to limit monetary growth and inflation. This resulted in high interest rates occurring at the same time that inflation was peaking. High unemployment and high inflation coincided, resulting in "stagflation". Today, the monetary policy of the past two decades which was almost as inflationary as under Johnson and Nixon has been counteracted by international central bank intervention. Thus, national central banks hold US bonds. This creates a market situation that is inherently unstable in the long run. We all have faith in the rationality and dependability of governments to manage the world economy wisely because of the numerous historical precedents such as......? In other words, I am not clear as to what makes central bankers more judicious investors in the dollar than Americans were investors in Nasdaq tech funds.

In any case, the Fed has required Americans to rely on the sensibilities and market judgments of global central bankers. In response to excessive lending and apparently uncontrolled and incompetent use of derivatives in the past two decades, the banking system contracted its loan volume last year. The Fed's response was to triple the monetary base. Since 2006 the money supply has been growing at an 8% clip, more than double the recent inflation rate. Some fear a banking collapse leading to deflation, others fear increasing Fed aggressiveness in expanding the money supply. In any case, the Fed needs to balance three factors: unemployment; the prospect of the collapse of incompetently managed money center banks that rely on fresh Fed money; and inflation. Any tightening will threaten the incompetently run banks and may result in higher unemployment. Thus, the Fed will likely have to choose between short term unemployment and the risk of additional inflation in the already unstable system.

In reaction to global concerns about inflation and, as Nadler points out, tightening in China, there may be some Fed tightening in the near term, which is why I am holding dollars. Over time, however, there are obvious risks as to Bernanke's judgment.

Mr. Nadler has forwarded me some interesting comments. I had written to him this e-mail in response to an article about Ben Bernanke's statement that he is going to tighten:

"I have about 25% of my portfolio in gold and commodities at this point, about 30% in stocks and high-yield bonds and 45% in cash at this point and have been following your column for the past couple of months. The quote from Bernanke sounds compelling but I'm curious if you have (or know of anyone who has) compared Fed chairmen statements with actual policy decisions over the ensuing two years, say tracking back to the 1970s? My guess is that there have been frequent statements about tightening and austerity but much less frequent examples of actually following through. So what is the real content of a Fed chairman's statement that he will tighten? My guess is that the statements frequently do not match reality. Any opinion?

Mr. Nadler wrote the following response Q&A style:

Langbert: So what is the real content of a Fed chairman's statement that he will tighten? My guess is that the statements frequently do not match reality. Any opinion?

Nadler: Not in all cases. The most notorious example was Volcker, in 1982. There is a CPM Group report that illustrates just how much people had geared up for massive inflation but an equally massive interest rate hike sterilized any such nefarious outcomes. Surprise. In any case, I can find that text next week for you if you require.

L: If the Fed tightens and the dollar strengthens, do you think that there would be an effect on the stock market and employment, which in turn would make Obama's political position worse than it has been becoming? In that case, the guy who is investing in stocks will get creamed along with commodities.

N: Investments in anything (other than dollars and debt instruments) would probably take a hit. Commodities more than stock, likely. Foreign currencies and emerging market equities, as well.

L: Recall that in the 1930s Mariner Eckles tightened in 1935 or so and that led to the bottoming in the late 1930s that was below the initial bottom. I suspect Bernanke is aware of that history and doesn't aim to repeat it. Also, if he tightens, it might be a repeat of Carter's administration, with a tightening at the end which sealed Carter's coffin.

A: The political 'palatability' might indeed be low, but someone has to explain that you cannot rebuild and get on with it without some short-term pain. The sooner Obama makes it clear that the problem was hatched and aggravated during the Bush years, the more likely he is to succeed in selling rate hike and tax hike programs. The Fed is independent and will thus act when it sees fit, not when Obama gives the 'all-clear' signal.

Q: tightening two years into the Obama administration will lead to a couple of years of even higher unemployment and a rough ride for the Messiah. Or will the Fed respond to political pressure and tighten a bit, rescinding the tightening at the first sign of stock market declines and higher unemployment? It seems to me that the political pressure to follow the inflationary path at this point is still greater than the threat of inflation. Also, the reserves already created are going to be inflationary if the banking system decides that the risk of the problems from last year have passed. If Bernanke continues to pander to them, they will relax.

A: The liquidity will be mopped up with various tools. There is no quid-pro-quo that inflation must result from all of this injecting. What is needed more than anything is more regulation, less lobbying, and far less corporatism. Which, is, what America now has - not capitalism.

You will be all right I trust. Though it will have to be a nimble run...

I am not quite as confident as Mr. Nadler that there will be a nimble Fed and banking response to the massive liquidity that the Fed has handed to the banks or that regulation will help, but hopefully you, dear reader, and I will be nimble in responding to the current monetary risks.

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