The Confidence Game

By James J Puplava CFP, November 18, 2003

The dollar is plunging, stock indexes are falling, and interest rates look like they are ready to rise. As the value of paper declines, the value of gold and silver is soaring. Commodity prices from copper to cattle are climbing as the CRB breaks out into record territory. On the economic front the economy is improving, but most of the benefit is going to foreign producers with the U.S. trade deficit at record levels. In addition to record trade deficits, the government is running record budget deficits. On Monday the government reported that the federal budget deficit widened to $69.5 billion in October, an annualized rate of over $800 billion. It is only the first month of the 2004 fiscal year. The deficit was much larger than anticipated. Fiscal 2004 now looks like it will become another year of record budget deficits.

Trade and budget deficits in the U.S. are now at levels that would normally trigger a currency crisis in any other country. The dollar is falling, but its fall isn't critical at this point. The record trade and budget deficits are producing a surfeit of dollars around the globe. With supply greater than demand for dollars, the price of the dollar is sinking. For the first time in decades, the Fed faces a credibility crisis: how to finance America's growing twin deficits and maintain the value of the dollar. It has become a game of confidence with the financial markets. How do you continue to run gargantuan deficits and convince foreigners to continuously lend you money? No one wants to own a currency that is headed for a fall. With nothing backing it, owning the dollar has become a confidence game.

The only thing that holds the dollar up is the strength of the U.S. military and faith in the U.S. economy. Currently there is a lot banking on the U.S. economic recovery. It is faith in that recovery that is keeping the dollar from collapsing. Everything rests on the strength of the U.S. economy and its financial markets. If problems surface in either area, the confidence game is over and the dollar is toast. The Fed now has its hands full with holes in the dike everywhere it looks.

Too Many Holes in the Dike

The stock market is extremely overvalued and back in bubble territory. The bubble in housing and in mortgages is tied to cheap and abundant credit. The strength in the economy, in particular consumer spending, is also dependent on the strength of the housing market and the ability of consumers to extract equity out of their homes. Mortgage refinancing is what stands behind the American consumers' ability to spend and consume. Housing's strength still remains the major bright spot of the economic recovery. It has been the chief beneficiary of the Fed's inflation policies. This is the key sector to watch in determining the strength and durability of the economic recovery. The Fed is hoping that business spending will pick up by the time the housing market and the consumer spending roll over.

The housing market is driven by low interest rates. What happens to this sector if interest rates suddenly jump as they did back in June of this year? If interest rates rise and choke off the housing market before the labor markets improve, then the economy runs into trouble. The housing market has become far too important to the health of the U.S. recovery. This is because of the role that housing plays as an important source of credit to the economy. Real estate loans now account for over 50% of all bank loans and represent over 70% of household debt. The mortgage backed security markets are now bigger than the Treasury market. If anything goes wrong in housing, it could send tremors throughout the whole financial system, i.e. the banking system.

What keeps the housing markets propped up is the bond market. What keeps the bond markets propped up? It is a game of confidence. The Fed is playing a high wire act of trying to talk down and manipulate interest rates. Its old nemesis is the bond market. In the past, bond investors have acted as vigilantes of Fed policy. In the 1990s the Fed tamed the bond markets through disinformation and pacification. The Fed must convince bond investors that there is no need for interest rates to head higher. So far the Fed has managed to convince the bond market that it intends to keep rates low for the foreseeable future, but for how long? It will not be an easy job with budget and trade deficits growing at an accelerating rate. Furthermore, there are signs that symptoms of inflation are starting to surface everywhere from rising commodity prices to a jump in gold prices. Precious metals--gold and silver--are the ultimate arbiter of Fed policy. If gold prices continue to rise and move beyond $400 and $500 an ounce, it will become a signal that the Fed is losing its grip over the financial markets and ultimately the confidence game.

End Game Approaching

The Fed's job is to keep investors in paper, in particular the dollar. It must keep investors corralled so that only paper options are considered. What the Fed does not want to see happen is the price of gold and silver soar. When precious metals start flying, as they are doing now, it is telegraphing in advance that the confidence game is coming down to its end game. Greenspan must continue at all costs keeping investors corralled and preventing them from escaping and getting out of paper. Greenspan knows better than anyone else of the danger of a collapse of confidence in paper. To quote the maestro himself from a paper he wrote on gold back in 1966,

In the absence of the gold standard, there is no way to protect savings from confiscation through inflation. There is no safe store of value. If there were, the government would have to make its holding illegal, as was done in the case of gold. If everyone decided, for example, to convert all his bank deposits to silver or copper or any other good, and thereafter declined to accept checks as payment for goods, bank deposits would lose their purchasing power and government-created bank credit would be worthless as a claim on goods. The financial policy of the welfare state requires that there be no way for the owners of wealth to protect themselves.

This is the shabby secret of the welfare statists' tirades against gold. Deficit spending is simply a scheme for the confiscation of wealth. Gold stands in the way of this insidious process. It stands as a protector of property rights. If one grasps this, one has no difficulty in understanding the statists' antagonism toward the gold standard.

Given these statements, it is understandable why the Fed and central banks in the west have been hostile towards gold. They have made extraordinary efforts to keep its price down even as they expanded money and credit to levels never seen before in history. Gold acts as a check on the schemes of government to create money out of nothing. It exposes the hollowness of paper money. That is why all efforts will be taken to keep the price down, from selling off reserves, increasing the size of paper gold shorts in the derivatives markets, to talking it down or obfuscating the inflation picture. The Fed--at all costs--must keep investors fooled that there is no inflation when in fact it is all around us. Inflation originates and begins when central banks inflate the supply of money and credit in the financial system.

Doublespeak

There is no way to disguise the consequences of these actions, so obfuscation is used to keep investors confused. If the price of raw materials goes up, it isn't inflationary; it is only temporarily reflecting demand from a robust economy. If housing prices go up to absurd levels, it isn't inflation; it is a new bull market in housing. If the NASDAQ rises 40% this year and sells at 170 times forward earnings, it isn't inflation; it is a new bull market in stocks. If gold has gone up 56% in the last two years and is up 15% this year, well Houston, we have a problem. The rise in gold signals a lack in confidence in paper and the primary paper of the world is the U.S. dollar.

So the confidence game continues to be played with great aplomb. It has become a high stakes game that the Fed can not afford to lose. At the moment the bond markets remain pacified. The Fed knows that it faces a horrendous challenge ahead. The U.S. economy and financial markets are extremely levered, so any rise in interest rates will have to be deftly managed. How does it raise rates without doing major damage to the economy and the financial markets? The last time it attempted to execute a change was in 1994. That year was full of financial mishaps from currencies to derivatives. The derivative markets are more highly levered today approaching $170 trillion.

The futures markets are already forecasting a rate hike of 50 basis points by next summer. The monetary aggregates are also starting to contract without the added stimulus of tax cuts and a slowdown in mortgage financing. Bank lending has also weakened. The rise in gold recently and its confirmation by silver are signaling that trouble lies ahead for the financial markets. How do you raise rates without causing major disruptions to the bond carry trade, the mortgage markets and the housing markets, and an overvalued equities market? The Fed may not want to raise interest rates, especially in an election year, but it may have no choice if it needs to defend the dollar. The U.S. needs to finance over $1 trillion a year to balance its trade and budget deficits. In the end, the bond markets may force its hand. The remainder of this year and next year are sure to be full of surprises. The key will be to keep your eyes on the dollar, interest rates, and the price of gold. That will tell how well the Fed is playing the game. It must at all costs keep investors from leaving the corral and heading for safety into tangible assets.

Once confidence is lost, it is gone and not easily regained. The lessons of history tell us that once confidence is lost in paper, a central bank can no longer control the supply of money. As to where we are headed and when, keep your eyes on the money supply and velocity, the dollar, the bond markets and gold. The bond market is headed for trouble, and if that trouble becomes big enough the stock market will quickly follow. It is time to get out of all long-term bonds, hedge against dollar problems, and for safety, buy silver and gold.

Today's Markets

Today's decline in stocks was the fourth consecutive decline for the major indexes. The decline in stocks was triggered by a new record low for the dollar against the euro. The recent fall in the dollar is raising questions as to whether foreign investors are dumping dollars or at the very least simply avoiding new purchases. Authorities are worried that a plunge in the dollar could set off a daisy chain of events from the bond markets to a sudden plunge in the equities market.

The day's news didn't help matters any with several tech companies reporting disappointing earnings, while federal regulators said they are investigating more Wall Street firms for allowing Freddie Mac to break accounting rules. Today's drop in the dollar against major currencies follows yesterday's report of record budget deficits for the month of October. Government reports also showed that foreign purchases of Treasury securities fell sharply in September to the lowest level in five years. Foreign purchase of Treasury securities in September was only $4.19 billion, down from $49.9 billion in August. Without foreign buying of U.S. Treasuries the dollar has no support.

There were other worries for the Fed and the government today as the price of gold made another run at $400 an ounce. Silver prices rose along with gold. Silver looks like it is ready to jump over $5.50. It wasn't just precious metals that were making new highs today. The price of crude oil jumped 4.9 percent to $33.28 a barrel. Energy prices are starting to rise just as we head into the beginning of winter and the Christmas season. Rising energy prices are an added cost for consumers and businesses that the economy can ill afford.

In a report out on consumer confidence, investors believe that the market climate has improved, but indicated that they are unlikely to invest in stocks. The recent spate of scandals on Wall Street is taking its toll. The scandals seem to be nonstop and it is beginning to shake investor confidence.

Only a handful of stocks rose today outside of gold and silver. All three major indexes lost ground. Declining issues beat out winners by a 19-13 margin on the NYSE and by 20-12 on the Nasdaq. December gold futures rose $6.10 to close at $397.60 an ounce. December silver rose $0.14 to close out at $5.367 an ounce. Gold and silver equities rose to new record highs. Pan American silver jumped $1.04 to $12.26, a gain of over 9.27% and a new record high for the year. Silver Standard rose $0.71 to $8.97. It hit a new intra day high of $9.08. Silver Standard is up 68% for the year. Newmont Mining rose over 4% for the day to hit another record, closing out the session at $45.30.

Chart courtesy: www.stockcharts.com

James Puplava

© 2003 James Puplava

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