Tuesday, November 10, 2009

Keeping an Eye on Inflation Expectations?


William Rees-Mogg of the London Times asks which will come out on top: paper or gold?:

Last week the price of gold rose to $1,100, the highest ever recorded. Gold is still an important measure of the world economy. The theory of the 19th-century gold standard was that gold was “real money” in the same way as landed property was “real estate”. All types of paper money are capable of being created by banks or governments, so the supply is potentially unlimited. It was observed that gold holds its purchasing power over centuries, whereas paper money tends to depreciate towards the value of zero.

Of course, the rise in the gold price reflects the weakness of the dollar as well the strength of gold. I have been writing about the significance of the gold price since the early 1970s. The latest rise in price reflects the significance of gold as part of the world’s monetary reserves.

The immediate cause of the rise was a purchase of 200 tonnes of gold bullion by the Reserve Bank of India from the International Monetary Fund. The Indian purchase is quite large in terms of the gold market, but not particularly large in terms of the Indian reserves. India’s reserves now amount to $277 billion, of which this new purchase of gold amounts to only $6.7 billion.

The significance of the purchase is that it may be the start of a new phase in the struggle between gold and paper. Since 1971, when President Nixon ended the convertibility of the dollar into gold under the Bretton Woods Agreement, the world’s central banks have tended to be net sellers of gold and net buyers of dollars. Now the Indians have decided that they have more dollars than they want.

Already Sri Lanka has followed the Indian lead, with a purchase of five tonnes of gold. If the new fashion spreads, and particularly if it is joined by China, then Asia would have decided that it is better to have gold which is rising in value than an unlimited supply of dollars which are falling in value.

In the 19th century, bankers trusted gold precisely because they did not trust other bankers, or the paper that other bankers issued. They could hold gold in their own vaults; it would not be dependent on other people’s debts or on the printing of paper money. Most central bankers still believe that the purchasing power of money is ultimately determined by the quantity that is created.

Asian bankers know that the West, and particularly the US, has been creating new money in huge and unprecedented quantities. They must assume that this increase in the creation of dollars will result in a fall in the purchasing power of the dollar itself. China may or may not join in the movement to buy gold, but the logic of the market would justify it doing so. Why should China go on losing in dollars when the gold price is rising?

This new logic extends outside gold and outside currencies. The real struggle between gold and paper is a struggle for power. If paper money is the dominant form of currency, as it is at present, then the ultimate governors of the world economic system are the bankers who have the power to create money.

If, however, gold is regarded as the ultimate standard, as “real money”, then the market decides the valuation. The floating rate system which emerged after 1971 depends on relatively stable relationships between different currencies. If countries develop a preference for gold over paper, then paper currencies will have to demonstrate that they have a stable value in gold, as they did in the years before 1971.

This may help to explain the strange events that occurred in the G20 finance meeting at St Andrews. In the 1970s, an American economist, James Tobin saw very clearly the speculation that would arise after Nixon ended the convertibility of the dollar into gold. Tobin, who later won a Nobel Prize, knew that gold had been the standard by which other currencies were valued. Once that was removed, he feared a growth of excessive speculation, such as the inflation of the 1970s, or the successive bubbles of recent years. He thought that this speculation could be controlled if it were taxed. He advocated a new transaction tax.

At St Andrews, Gordon Brown unexpectedly advocated the adoption of a global Tobin tax. He was immediately repudiated by Timothy Geithner, the US Treasury Secretary, and by Dominique Strauss-Kahn, the head of the IMF. The proposed global Tobin tax has the support of Oxfam and of some left-wing economists, but without American support, it does not have the least chance of being adopted.

The Swedes experimented with a national transaction tax in the 1980s. It did not work because bankers avoided paying tax by transferring transactions to markets in which it was not imposed. The tax had to be abandoned in the early 1990s. This negative history must have been known to Mr Brown; perhaps the clumsiness of his diplomacy reflects the pressure he is feeling.

In Britain, there is an urgent need for a new tax base. One can take almost any very large figure as the sum needed to balance the budget. At some point, Britain will have to raise taxes and cut expenditure. It is hard to see where this additional revenue can be found.

No doubt it would be helpful to Mr Brown if the other governments of the world would join him in policing a worldwide transaction tax on the banks. Britain would be a major beneficiary. Like the US, Britain has a combination of very large bank debts with a very large budget deficit. As a response to the recession, large sums of money have been injected into these economies. That has eroded global confidence in the pound and dollar.

If there is no Tobin tax, it will be difficult to rebuild confidence in these currencies, and the Tobin tax is not going to happen, if only because it would not work. Two factors emerge. Gold will be a stronger reserve currency than paper, and the market will increasingly decide national policies. “You can’t buck the market”, whether in taxes, in dollars or in gold.

I thought all you gold bugs would enjoy reading the article above. But there is another thing worth tracking in these markets. Matt Phillips of the WSJ writes as the rally rolls, keep an eye on inflation expectations:

For clues on inflation expectations in this carry-trade-crazed market, Tuesday’s auction of some $25 billion in 10-year treasury notes is something to pay attention to.

Last week’s Fed statement signaled all clear for the carry trade. And last weekend’s G-20 confab confirmed that the stimulus spigots at central banks will be open for the foreseeable future. But the Fed noted in its statement that it’s still going to be paying close attention to inflation expectations in the marketplace

An auction of some $40 billion in three year notes on Monday went well, and the equities market rally ratcheted up in response afterward, suggesting that some participants are keeping a close eye on the bond market. But the shorter end of the curve is anchored by the Fed’s near zero policy. Inflation worries are more likely to crop up in some of the longer-dated debt from Uncle Sam.

And there’s already some signs that worries about inflation are floating around out there. For one thing 10-year breakevens — that gap between the yield on 10-year Treasury Inflation Protected Securities (TIPS) and the yield on plain-vanilla 10-years — have been inching higher, a somewhat inflationary sign, although we’d need more evidence to confirm that inflation expectations are starting to break out.

“The tougher part for the Treasury will be selling (Tuesday’s) 10-year and Thursday’s 30-year auctions in light of the growing inflation expectations as measured by the TIPS, among other signs,” writes Peter Boockvar, of Miller Tabak.

If those auctions don’t go so well, and the yield on the longer end of the curve jumps, that might prompt more serious soul searching at the Fed. And uncertainty about how long the Fed will keep the spigots gushing liquidity could push some who’ve been betting on the weak dollar/rising risk trade to take a bit of money off the table.

Those auctions will go very well. In fact, on Monday, Treasuries prices moved steadily higher after solid 3-year note auction:

U.S. government debt prices rose on Monday after a record-sized Treasury note auction drew strong demand and investors bet other debt sales this week would get a similar reception.

The three-year note sale won a rousing bid as investors stood to gain an extra 0.50 percentage point yield over two-year notes for taking on slightly more interest rate risk.

"I would call the auction stunning," said William O'Donnell, head of U.S. Treasury Strategy at RBS Securities in Stamford, Connecticut.

"I like to focus on the bid-to-cover ratio and just looking at that it was the best bid-to-cover ratio for the 3-year Treasuries since November 1990."

The Three-year Treasury note US3YT=RR was trading 1/32 higher with the yield at 1.36 percent, down from 1.37 percent late on Friday.

Benchmark 10-year notes US10YT=RR were trading 10/32 higher in price to yield 3.46 percent, down from 3.51 percent late on Friday, while 30-year bonds US30YT=RR were 15/32 higher to yield 4.37 percent from 4.40 percent.

Following the three-year auction, the Treasury will sell $25 billion in benchmark 10-year notes on Tuesday and $16 billion in 30-year bonds on Thursday as part of this week's $81 billion quarterly refunding.

"Two-year notes are already through their resistance level, so I think the very steep slope of the curve is going to help the bond auctions tomorrow and Thursday," added O'Donnell.

Before Monday's note auction, Treasuries appetite was curbed by a pickup in stocks and other riskier assets in the wake of a Group of 20 pledge to stick with measures to bolster the global economy.

We'll see how the auctions go this week but my feeling is that Treasuries will be snapped up fast. Moreover, it will take a lot more of this liquidity rally to sustain a higher shift in inflation expectations. Given the slack in the global economy, inflation expectations will be capped for at least another year and possiby for a lot longer.

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