Chart - TA, page-1768

I am sure that many here are somewhat perplexed aboutthe price performance of the shares of DEG as well as the strange behaviour forthe price of gold. There are reasons for this. They are both complex and simple. The simple explanation is that we appear to be about to enter a period of economic turmoil. The complex reason is how the monetary system has been patched up since the GFC. I have put this into two parts, the background and the prognostication. I have high confidence in the details provided in the background. As for the prognostication it is my best guess at the outcome. As I am not in league with the Devil there is no guarantee that I am on the right track. You can decide for yourself whether or not you think that I am a nutter and act accordingly. Before you read any further it may be an idea to get yourself a stiff drink and not put the bottle away because you may need several stiff drinks. Some of this stuff is quite disturbing.

From the macro perspective we are looking at a period ofdeteriorating fundamentals. The probability of this leading to a bad outcome is high. The surest indicator for this is that bond yields are falling despite a surplus of cash. You would think that if there is a surplus of cash we would be in an inflationary environment but we are not. Friedman’s dictum that “Inflation is always and everywhere a monetaryphenomenon in thesense that it isand can be produced only by a more rapid increase in the quantity of money thanin output” had a very important qualification to it – the velocity of money had to be constant. Right now the velocity of money is at its lowest level since they began recording it and it has been falling since the GFC. This is a consequence of Quantitative Easing which traps money in the financial system and asset prices go up but wages and spending power are static at best if not in a slow decay.

We are presently in a disinflationary environment if notan outright deflationary environment (for the record, a disinflationaryenvironment is one where the inflation rate is falling but still positive –that is the inflation is slowing - while a deflationary environment is onewhere the inflation rate is below zero). It is important not to confuse a rising CPI with inflation. Rising costs and not enough income to be able to afford to pay higher prices is not an inflationary environment. The disinflation is evidenced by the present decline in the hard commodities. Iron ore, copper, palladium and lumber as well as oil which was attempting to break back to parity with the price before the slump but W
TI, Brent and heating oil have all rolled over, retested the high, failed, made a second attempt at retesting the high and it is not looking convincing. How can this be so? What are we missing here? Clearly we are missing something very important.

The conventional wisdom is that there is too much USTreasury debt but this is actually wrong. The reality is that the US Treasury paper supports the markets around the globe and this is because it is the US Dollar that is the senior global currency. The US has the deepest credit markets and these credit markets can and do hold more capital than anywhere else in the world. That is why New York is where governments come to borrow money as well as many of the largest transnational corporations when they need money or capital. They float bond issues in New York denominated in US Dollars and the principal and the interest payments must be made in US Dollars. This is also why commodities continue to be traded in US Dollars and the reason why the switch to trading commodities in currencies other than the US Dollar is so slow – there is a need to get the US Dollars required to service those obligations and that is why calls for the demise of the US Dollar are premature. It will not happen until confidence in the US Dollar has been lost and that is not happening just yet.

In the financialised economy those who lend money requiresecurity in the form of collateral. The borrowers in the financialised economy are mostly hedge funds and institutions (life offices and superannuation funds and the like) or other banks that have proprietary trading desks. These are the very same people who take leveraged bets on the price of interest rates, collateralised mortgage bonds, securitised credit card loans, securitised automobile loans, foreign exchange obligations, credit default contracts and commodities. The collateral that greases the wheels of these transactions are US Treasury bills, notes and bonds (they are all bonds but the specific terms relate to the duration of the product with treasury bills being the shortest term items). If you do not have US Treasury paper to pledge for the overnight loans that you need to square your book for your day’s trading (assuming that you do need to square your book by borrowing to cover any drawdown on your investment) then you are shut out of the market and that can have dire consequences for the liquidity of the firm – think of what happened to Lehman Brothers and Bear Stearns.

A shortage of US Treasury debt happens periodicallybecause of poor financial engineering on the part of the central banks, mostly arisingfrom flaws that were contained in the rescue package for the GFC. The present problem had its origin with the Basil III regulations that were imposed upon the financial system to prevent a replay of the GFC. These regulations were far more extensive than just the restrictions on trading paper gold that have recently taken force in Europe and the US (although not in the City of London). The Basil III regulations include a tight definition of tier 1 capital and a tier 1 leverage ratio which stipulates how much shareholder capital must be allocated against the assets on the books of the banks. This has imposed an upper limit on the size of the balance sheet for all of the banks and particularly the big systemically important banks. The Basel III rules limits the amount of lending in which a bank can engage but it also places a limit on the amount of money that can be held on deposit from the customers of the bank. This regulation applies across the board. The covert purpose of the Basel III regulations was to force the banks to shrink without resorting to government break ups of the systemically important banks as it is thought that this could cause a crisis of confidence. It may be the case that this was not well thought out.

In the Basel III rules one of the more interesting riskcategories for the banks is money on short term deposit. This is because short term money can be withdrawn at any time without any notice and without any penalty – and that is how these deposit accounts carry risk. Cash on deposit must have provisions set aside to cover demand in order to prevent a bank run. The simplest means of provisioning against cash on deposit is to hold short term treasury bills to offset the liability but short term bills are in short supply so shareholder capital must substitute for any shortage of the treasury bills. Term deposits required less provisioning by the banks because the time duration (or the associated penalties for early withdrawal) made these products less liquid and the provisioning can be made using longer dated treasury notes. That makes sense so far. But because of financial repression (a lovely term used to describe the suppression of interest rates) there is no incentive for depositors to have money locked up in a term deposit because the duration risk is not worth the paltry interest offered by the banks. Far too many customers are no longer rolling over their term deposits, preferring to be liquid instead. At the same time the banks are not originating the loans needed to absorb this large pool of cash – loan growth is actually negative at the moment. Worse still, balance sheet capacity imposed by the Basil III regulations has been shrunk by share buybacks which have diminished the shareholder capital base of the banks.

To counter the surplus of cash in the banking system thebanks are getting their clients to move funds to cash management trusts whichpay a higher return than the banks. The S.E.C Rule 2a-7 mandated that cashmanagement trusts must keep their funds invested in short dated securities withmaturities no longer than 13 months and with a weighted average maturity of 60days. The trouble is that there is a shortage of credit worthy borrowers with suitable short term collateral to cover the amount of cash in the cash management accounts. The reverse repo operation being run by the US Fed has plugged this gap but at the same time the US Fed is now de facto backing the entire money market fund industry in the US. It is likely that the reverse repo operation could blow out to $3 trillion or more in the next few years as fewer term deposits are rolled over. Make a note to keep an eye on that.

With every breakdown since the GFC a new Band-Aid hashad to be put on the financial wound when it hemorrhages capital. Four times the markets have broken down since the GFC and now we are breaking down for a fifth time. Each time capital was lost and collateral was lost. Just as there is a capital multiplier there is also a collateral multiplier – and the collateral multiplier is much larger and much more important because good quality collateral can be repledged. A footnote in the Morgan Stanley annual report for 2020 revealed that Morgan Stanley had received US$724.8 BILLION in collateral that could be repledged or resold and that Morgan Stanley had resold or repledged collateral to the value of US$524.7. To put this into perspective that US$724.8 BILLION dollars is the equivalent of the global trade in iron ore, metallurgical coal and natural gas combined – and this is just one bank. When you add the other big systemically important banks you can see that the amount of collateral that is being traded must indeed be huge.

The real problem is that clear title for the ownershipof these securities is not certain. Academic studies have suggested that good quality collateral has been repledged from 6 to 8 times and as the Fed sucks treasuries out of the market via their quantitative easing operations (currently about US$65 Billion per month) the banks have to stretch the existing supply of treasuries further and that means extending the multiple of the number of times that a security has been repledged. There are whisper numbers in the industry which suggest that in some cases US Treasury bonds have been repledged up to 30 times. This risk factor will amplify any downturn. When a capital loss leads to a loss of collateral the leverage of these collateral products shrinks even harder. This is really important and you had better pour yourself another stiff shot right now and think about this point - whatleverage gives on the way up it takes away ten times faster on the way down.

This is where it starts to get weird. The Chinese credit impulse is collapsing into negative territory and the Chinese economy is shrinking. One of their most critical problems is an impending shortage of US Dollars in the emerging economies in Latin America, Africa and Asia and this especially includes China. As the credit impulse wanes business in China is beginning to contract and bond defaults are immanent (Evergrande is on the brink of insolvency as I write this and Evergrande owes US$300 Billion to Chinese buyers of real estate, investors and construction workers and at about 6.44 Yuan to the US Dollar that makes it about 1.3 Trillion Yuan that is owing). Beijing is making it look as though they are cracking down in segments of its economy but that may be Beijing covering up the economic contraction. The contraction will be relieved by selling US Treasury bonds from the national foreign exchange reserve to raise the funds for a stimulus package to paper over the cracks in the domestic credit market and to boost the economy.

In the normal course of events the bonds sold by Chinaand other emerging economy nations will be pristine collateral – unleveragedcollateral - that can be used to pump the shadow money derivatives markets,loaned at high interest rates to hedge funds that need them and a lot of otherprofitable uses when these bonds are in the hands of the big trading banks. Part of the profits from this act of economic piracy will be invested into the bonds sold to fund the US Infrastructure spending bill. Thus, this will leverage US stimulus from the infrastructure spending program in multiples of US$1 trillion perhaps by multiples of up to 8 times because the stimulus bill will be paid for by issuing more bonds that also can be repledged multiple times. Everything is looking rosy right? Pour yourself another stiff drink and get ready for the next step.

Interest rate compression – the difference between thepresent high rate for the best grade bonds and the zero bound – means that weare likely on the final iteration of this strategy to manage the economy. Thirty year mortgages in the US are at 3.27% or a little less. They can come down to 1.00% but no further because when long term interest rates are at the 1.00% level shorter duration interest rates will be effectively be at the zero bound. The next reflation will be the last reflation under this system because in order for bond leverage to work it must be accompanied by falling interest rates and there will be no room left for interest rates to fall as negative interest rates are not an option.

So what does all of this have to do with gold – bothmetallic gold and the shares of the gold miners? I am, after all, posting this in a gold forum. The word picture that I have painted above should serve to illustrate the fragile nature of the system as it now exists. It stumbles from one crisis to the next and those in charge of it are reactionary by nature, never working proactively to avert any crisis and the next crisis is upon us.

We are about to experience a private debt crisis. The covid lockdowns have set in motion a wave of yet to realised delinquencies and defaults on loans of all sorts. As these delinquencies and defaults move through the system securitised investment products such as mortgage backed securities based upon mortgages taken out by workers who were unable to work during a lockdown and mortgages secured by businesses that were unable to trade during the lockdown or collateralised debt obligations made up of credit card loans, auto loans and personal loans that were securitised into investment products and sold to investors are all going to enter delinquency or default. These products have been sold to institutional investors seeking yield in order to pay annuities and pensions and they, in turn, may fail if they are too heavily exposed to products of this nature. Worse still, many of these products have been pledged as collateral for leveraged loans and as the security goes bad the loans will be called in by the lender, necessitating the unwinding of the positions secured by that collateral. This is going to be ugly.

By its very nature a private sector insolvency event isextremely deflationary. When markets decline in an unruly manner deleveraging amplifies the contraction by an estimated ten times. This makes it impossible for central banks to actually achieve stability. The chronic contraction of the GFC was relieved when the accounting standard that required unlisted securities to be marked to market was suspended. We have no such circuit breaker this time. The velocity of money will contract, money will be hoarded and assets will decline in value as there will be less money available to buy those assets.

Thisis the problem with debt – debt always gets paid. The question is who will pay for the debt. The rich and powerful are shifting assets to try to avoid paying for the debt. Institutions could be wiped out if they hold the wrong sort of debt. Those who are receiving government benefits are worried that their benefits will be cut. Taxpayers are getting nervous that it may be they who are going to pay for it through government bail outs of insolvent banks. The latter course – government bailouts of insolvent banks – will lead to inevitable sovereign defaults because nobody understands just how insolvent the banks will be when the collateral multiplier moves into reverse. According to the most recent data from the Bank for International Settlements (BIS), for the first half of 2019, the total notional amounts outstanding for contracts in the derivatives market was an estimated $640 TRILLION. The BIS is at pains to say that this is a gross value of all contracts and that they need to be netted off to a mere US$12 Trillion. This estimate is based upon the assumption that all players in the derivatives market are solvent. When counterparties enter insolvency then netting off of the positions is not possible and this could – and probably would – set off another cascade of insolvencies that will affect the banks. And this is how a taxpayer funded bailout of the insolvent banks will lead to a sovereign debt crisis.

A sovereign debt crisis will be delayed becausegovernments have coercive powers that can delay their insolvency although thesesame powers cannot prevent it. This gives us a short window of opportunity to act if we are prepared to do so. In a private sector debt crisis the price of gold will go down hard because there will be a mad scramble for US Dollars and even more so for US Treasury paper for reasons explained above. As one observer put it, for a period of time there will be a currency even harder than gold because the supply of that currency will be contracting faster than the market has the ability to absorb the available gold on sale. Non US holders of gold will feel some pain but as gold is priced in US Dollars it will outperform local currencies. Not so for the people in the US where the price of gold will be falling in absolute terms against a rapidly contracting supply of US Treasury bills, notes and bonds. It is important to note here that a fall in the price of gold willcause the share price for gold miners and gold explorers to fall.

Is the timing coincidental? The rent and debt moratoria are now ending in time for an October panic as the defaults roll through. The major decline in Asian stocks suggests that a crisis is coming and this is confirmed by the actions of Blackrock (the world’s biggest fund manager) which has reportedly sold 90% of its Standard and Poors Stock Index position. Big funds cannot change their position overnight. They have a lot of stock to sell and they have had to do it slowly over many months. BlackRock's assets under management total US$6.84 trillion across equity, fixed income, cash management and alternative investments.

So, the long and the short of it is that this is why the share price of DEG is declining slowly despite good news being released by the company. DEG still has the funds to continue the exploration and drilling of the finds at Hemi and the related ore bodies which is good news. The company will emerge from the economic contraction in a sound position and still be a very desirable asset to own. But for a period of time the shares of the company are going to be buffeted by the gales of an economic cyclone in the financial markets.

Cash is going to be king and the best form of cash will be US Dollars. I have sold 20% of my gold shares and I am holding it as cash ready to acquire more shares if my analysis is correct. I am still deeply exposed to the shares of gold miners and I am holding on tight as I expect a strong rebound in the price of gold once the collateral contraction has ended. But to make the most of the adverse circumstances one needs to have cash.

Thereare 11,000 cryptocurrencies. There are 164 official national currencies. Thereare 118 elements. There are only 8 noble metals. Remember this.