Tuesday, May 13, 2008

Paul Van Eeden's call on gold and bonds

Soaring interest rates

Paul van EedenPosted May 12, 2008

The following article was sent to subscribers to Paul van Eeden's Commentaries on April 18, 2008.

Five years ago I was certain that the gold price would double, or triple, from its then $300 an ounce price level. I bet large and it paid off. I am now becoming equally convinced that US interest rates are going to soar and I am going to bet big again. US dollar inflation, as measured by M3, is currently more than 17% per year, the highest level of inflation since M3 was created in 1959.

Other than now, the period of highest inflation was July 1971 when M3 increased by 16.12% year-over-year.The average inflation rate during the 1970s (from 1970 to 1980) was 11% and as a result the US dollar exchange rate fell 42% against an average of the currencies that now comprise the euro. A currency crisis ensued and the US Treasury was unable to issue sovereign debt denominated in US dollars, and was forced to issue its bonds denominated in German mark and Swiss franc instead.

Interest rates soared: the yield on 10-year US Treasury bonds peaked at over 15%. It took 15% interest rates to quell the fire of 11% average annual inflation rates. Today we have a 17% inflation rate and a 10-year interest rate of only 3.6%.

Shorting US Treasuries is a slam-dunk trade if ever there was one. It may not work immediately, but when it starts working it's going to be like having bought gold in 2001.Incidentally, interest rates also have to rise to thaw the credit markets.

Contrary to what the media reports, the markets are not experiencing a liquidity crisis; there is plenty of money around. It is a credit pricing problem. Credit was issued at interest rates that were too low to compensate for the credit risks lenders were taking. Credit default swaps and complex derivative trades did not eliminate the risk: the risk was merely passed from one entity to another and lenders will not come back to the market until interest rates rise to fully reflect inflation and credit risks.

The intense competition among banks to generate fees from creating loans, packaging them up and selling them to investors with "risk insurance" caused interest rates to fall to ridiculously low levels. Now interest rates must adjust upwards so that credit markets can function normally again.

SLM Corp. (Sally Mae) reported a first quarter loss and warned that it could not make profitable loans at this time. Nobody wants to lend Sally Mae money at current interest rates. What does that mean? Simply that interest rates have to rise to compensate lenders for the default risk they have to take. Remember, it's not a liquidity problem; there is lots of money out there. It's a pricing issue. Who in their right mind would underwrite student loans at 3.6% when inflation is running at 17%? At a 20% interest rate students will be able to get loans again and if you think interest rates of 20% are out of the question, remember that inflation is currently higher than it was at any time in the 1970s (or ever).

Earlier this week the British Bankers' Association (BBA) announced it was investigating banks' reporting of short term borrowing costs. The BBA oversees the London Inter-Bank Offered Rate (LIBOR), which is the interest rate banks are charged for short-term loans. LIBOR is used across the world to set interest rates and the assertion by the BBA that banks are understating their borrowing costs, implying that LIBOR has been under-estimated, has enormous impact on all borrowers and lenders. Since Wednesday, when the BBA announcement was made, LIBOR has been increasing.

Because global credit markets are now very much inter-linked, an increase in US interest rates will put upward pressure on almost all interest rates and any pressure that will be created by interest rates on currencies with vastly different inflation rates will be alleviated in the foreign exchange markets.

Simply put: the US dollar's extremely high inflation rate will continue to put upward pressure on global interest rates and downward pressure on the dollar's exchange rate.Yet in the short term, I am concerned that we could see a rally in the US dollar exchange rate that would cause a temporary decline in the gold price. Don't let this last sentence confuse you. In the short term I think the dollar could rally, but in the medium to long term it is going to keep falling until the US trade deficit comes under control and US monetary inflation is reduced.

The gold price increased more than 50% from August to March, when it breached $1,000 an ounce. Thereafter it briefly fell below $900, bounced up, and seems to be directionless at the moment. I don't think we're out of the woods yet, but don't know how to predict the gold price, so I remain neutral to bearish for the short-term. I would not be surprised to see the gold price drop $150 an ounce, taking it well below $800 again.


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