Market Shocks Ahead Should be Positive for Gold, Negative for the US Dollar

Market Shocks Ahead Should be Positive for Gold,

Negative for the US Dollar

By John Williams, Founder,

Nothing is normal: not the economy, not the financial system, not the financial

markets and not the political system. The financial system still remains in the throes

and aftershocks of the 2008 panic. A number of underlying problems of that time,

tied to the risks of a near-systemic collapse and the related, extreme economic

downturn, were pushed into the future—not resolved—by the extraordinary liquidity

and systemic-intervention actions taken by the Federal Reserve and federal

government. Further panic is possible, and severe US dollar debasement and

inflation remain inevitable.

Nonetheless, several major misperceptions appear to have developed in the last

month or two concerning an end to the Federal Reserve's quantitative easing, the

level of crisis posed by US fiscal imbalances, and an unfolding recovery in the US


Contrary to currently hyped expectations in the popular financial media, chances are

negligible for any serious, near-term reduction in the Federal Reserve's purchases of

US Treasury securities. The Fed has locked itself into ongoing quantitative easing,

with fair prospects of expanded, not reduced accommodation in the year ahead.

Separately, the long-term solvency issues of the United States should return to the

center of attention for the global financial markets by early September 2013. At

present, prospects of the US government meaningfully addressing its extreme fiscal

imbalances are nonexistent.

Exacerbating financial-system solvency concerns for the Fed and intensifying US

fiscal instabilities, the US economy never recovered from its 2008 plunge, and now it

is slowing anew. Increasing recognition of these factors, complicated by the potential

of a domestic political scandal taking on Watergate-style status, promise difficult

times ahead for the US dollar, with resulting domestic inflation problems and

significant upside pressure on the prices of gold and silver.

Federal Reserve's Primary Function Is to Preserve Banking-System Solvency

Despite a Congressional mandate that the Federal Reserve pursue policies to foster

sustainable US economic growth in an environment of contained inflation, those

issues are secondary to the Federal Reserve's primary mission, which is to preserve

the stability of the banking system. While Fed Chairman Ben Bernanke has

acknowledged that there is little the Fed can do at present to boost economic

activity, the weak economy remains the foil for banking-system difficulties, serving as

justification for more easing by the Fed.

Accordingly, since the breaking of 2008 crisis, the Fed's accommodation, liquidity

actions, and direct systemic interventions have been aimed at maintaining the

stability and liquidity of the banking and financial-market systems. As bank bailouts

became politically unpopular, the Fed increasingly used the weakness in the

economy as political cover for its systemic-liquidity actions.

In response to critics of excessive accommodation, the US central bank recently put

forth several rounds of jawboning on exiting quantitative easing, in an effort to quell

inflation fears. Those efforts have been a factor in recent gold selling.

Comments from the June 19 Federal Open Market Committee meeting and Mr.

Bernanke's subsequent press conference were clear but largely ignored by the

markets. The shutdown of quantitative easing—specifically the bond buying of

QE3—would not happen until such time as the economy had recovered in line with

the relatively rosy economic projections of the Fed. As the stock market began to sell

off in response to the Fed chairman's initial press-conference comments, he

sputtered something along the lines of, "No, you don't understand me. If the

economy is weaker, we'll have to increase the easing." The economy is going to be

weaker; banking problems will persist, and the Fed will continue to ease.

Nonetheless, the consensus perception appears to be that QE3 will be gone by the

middle of 2014, despite the stated economic preconditions. As will be discussed,

though, intensifying economic deterioration should become obvious to the markets in

the next several months, and that should help to shift perceptions. The harsh reality

remains that the Fed is locked into its extraordinary easing by ongoing solvency

issues in the banking system (only hinted at in Bernanke's post-FOMC press

conference), and by the political cover provided by a weakening economy.

In the latest version of quantitative easing (QE3), the Fed has been buying US

Treasury securities at a pace that is suggestive of fears that the US government

otherwise might have some trouble in selling its debt. Through July 3, 2013 and

since the expansion of QE3 at the beginning of 2013, the Fed's net purchases of

Treasury securities has absorbed 90.5% of the coincident net issuance of gross

federal debt. That circumstance is exacerbated somewhat by gross federal debt

currently being contained at its official debt ceiling.

Still, in the pre-crisis environment of 2008, the St. Louis Fed's measure of the

monetary base (bank reserves plus cash in circulation) was holding around $850

billion, with roughly $40 billion in bank reserves. As a result of intervening Fed

actions, today's monetary base is around $3.2 trillion, with more than $2.0 trillion in

bank reserves (primarily excess reserves). Under normal conditions, the money

supply would expand based on the increase in bank reserves, but banks have not

been lending normally into the regular flow of commerce, due largely to their

impaired balance sheets.

While there has been no significant flow-through to the broad money supply from the

expanded monetary base, there still appears to have been impact. As shown in the

accompanying graph, there is some correlation between annual growth in the St.

Louis Fed's monetary base estimate and annual growth in M3, as measured by the

ShadowStats-Ongoing M3 Estimate. The correlations between the growth rates are

58.1% for M3, 39.9% for M2, and 36.7% for M1, all on a coincident basis versus

growth in the monetary base. The June 2013 annual growth estimates are based on

four weeks of data.

The ShadowStats contention, again, remains that the Fed's easing activity has been

aimed primarily at supporting banking-system solvency and liquidity, not at propping

the economy. When the Fed boosts its easing but money growth slows, as seen at

present, there is a suggestion of mounting financial stress within the banking system.

Further, underlying US economic reality is weak enough to challenge domestic

banking stress tests. In this environment, the Fed most likely will have to continue to

provide banking-system liquidity, while again, still taking political cover for its

accommodation activity from the weakening economy.

Renewed Fiscal Crisis by Early September

At present, the US Treasury is playing daily accounting games in order keep its

borrowings—subject to the debt ceiling—from exceeding the ceiling. The July 3,

2013 Daily Treasury Statement showed those borrowings to be just $25 million shy

of the roughly $16,999.421 billion ceiling. The US Treasury estimates that the ability

to play games will end, and the debt limit will have to be raised, sometime early in

September 2013.

The long-postponed and unresolved budget-deficit conflicts within the Congress and

with the White House are likely to surface anew at that time. What is being played

out here is still part of the fiscal-crisis confrontation of July and August 2011, which

almost collapsed the US dollar and brought about a downgrade in the sovereign

credit rating of the United States. The issues never were resolved. They were put off

until after the 2012 election, and other than for minimal sequestration, they remain in

play, going into a post-Labor Day 2013 showdown.

The global markets, which broke into brief but extreme turmoil with the unresolved

crisis in 2011, await a resolution. The markets have been patient with the US dollar

through the ensuing sequestration, and continued postponements of serious

negotiations that have accompanied successive displays of the political inability of

the US government to address its long-range solvency issues. Further efforts at

delay and/or obfuscation not only should invite an intensifying crisis of global

confidence in the US dollar, but also will invite a further downgrade to the sovereign

credit rating of the United States.

The crux of the dollar-debasement and ultimate, severe-inflation/hyperinflation

issues indeed is this political inability of the United States to cover its long-range

obligations, other than by printing the money it needs. Based on the US Treasury's

financial accounting of the federal government using generally accepted accounting

principles (GAAP), the GAAP-based federal budget deficit was $6.6 trillion in fiscalyear

2012 (year ended September 30). Well beyond the simple cash-based deficit of

$1.1 trillion in fiscal 2012, the GAAP-based annual deficits have been in the range of

$4 to $5 trillion for the six years leading up to 2012. The largest difference here is

that the GAAP numbers include annual deterioration in the net present value of

unfunded liabilities for programs such as Social Security and Medicare.

Those GAAP levels are not sustainable or containable. Beyond the likelihood that

the economy is at the tipping point on taxes, where higher taxes actually would

increase the deficit due to resulting slower economic growth, the government cannot

raise taxes enough to cover the actual deficit in any given year. The annual shortfalls

also are so large that every penny of government spending (including defense) could

be cut to zero except for the social programs, and the fiscal circumstance still would

be in deficit.

The options open to those running the government are limited in terms of new taxes

and have to include significant spending cuts and restructurings of Social Security,

Medicare, etc., so that those programs are solvent over the long haul. Such actions

are a political impossibility at the moment. Given continued political contentiousness

and the use of overly optimistic economic assumptions to help ten-year budget

projections along, little but gimmicked numbers and further smoke and mirrors are

likely to come out of pending negotiations or confrontations.

Economic Plunge and Recovery versus Plunge and Stagnation

The official version of recent economy activity is that a deep recession began in

December 2007, hit bottom in June 2009, and that business activity has been in

recovery since. That pattern is reflected in the accompany graph of headline, real

(inflation-adjusted) gross domestic product (GDP). The economy regained its prerecession

high in fourth-quarter 2011 and has been expanding ever since.

Unfortunately, no other major economic series has shown the full and expanded

recovery suggested by GDP reporting. Those "errant" series include payroll

employment, industrial production, consumer confidence, and housing starts, among


Closer to common experience, there never was a recovery following the economic

downturn that began in 2006 and collapsed into 2008 and 2009. What followed was

a protracted period of business stagnation that began to turn down anew in secondand

third-quarter 2012. The "recovery" seen in headline GDP reporting was a

statistical illusion generated by the use of understated inflation in calculating the

inflation-adjusted series.

During the last three decades, a number of methodological changes were made to

inflation-estimation techniques that have had the effect of artificially reducing annual

inflation rates. Of particular relevance to GDP estimation has been the introduction of

hedonic quality adjustments, which adjust inflation rates for the effects of nebulous

quality changes. These changes—ranging from new features with computers and

washing machines to the use of colored pictures in college textbooks—cannot be

measured directly, only estimated by econometric models, with the usual effect of

reducing related inflation.

The lower the inflation rate that is used in adjusting a series, such as GDP, for

inflation impact, the stronger will be the resulting inflation-adjusted growth. When the

US first used this process in its GDP reporting, countries such as Japan and

Germany did not follow. Hence, stronger relative US versus Japanese GDP growth

at the time reflected the difference of use in inflation gimmicks, more so than actual

differences in economic activity. The hedonic changes used in US GDP estimates

never have been applied consistently and do not reflect common experience.

The following graph of corrected real GDP is adjusted for the removal of roughly two

percentage points of aggregate, hedonically understated annual inflation. It shows a

pattern of economic plunge and stagnation, as opposed to the official pattern of

plunge and recovery.

Not only do a number of large, consumer-oriented companies find that the

"corrected" pattern of activity more closely resembles their business activity, but this

same pattern also is reflected in underlying fundamentals that drive broad activity,

such as household income.

The primary issues facing the economy are structural liquidity problems for the

consumer, who generates more than 70% of GDP activity. Without real income

growth, the consumer cannot sustain growth in real consumption, except for the

possible use of short-lived credit expansion. Yet, credit availability has been limited.

Without credit expansion (all growth in post-debt-crisis consumer credit outstanding

remains in federally owned student loans), the consumer is unable to borrow in order

to cover the shortfall in living standards.

The next graph shows median household income through May 2013, deflated by the

CPI-U (data courtesy of Sentier Research). Monthly median household income

plunged as the economy purportedly began its strong recovery in June 2009.

Further, in the last two years, income has been bottom-bouncing near its cycle low,

consistent with the "corrected" GDP series. The numbers here are based on monthly

surveying by the US Census Bureau.

So long as consumer liquidity remains constrained, the economy has not and cannot

recover. Accordingly, any near-term hype from an occasional "good" economic

statistic most likely is no more than hype. Economic reality will continue to surprise

on the downside, and that is a negative for the US dollar, as well as for budget-deficit

and Treasury-funding projections. The US economic weakness is long-term and

structural, and increasing global recognition of that in the months ahead will

contribute to eventual pummeling of the US dollar in the global markets.

Other Factors Impacting the US Dollar, Inflation, and Precious Metals

Highlighted here have been several issues where recent shifts in market sentiment

have neutralized or reversed the impact or otherwise had been significant, negative

elements for the outlook of the US dollar, and supportive elements of the outlook for

domestic inflation and the prices of gold and silver. Market sentiments should shift

again, both as the economy shows an intensifying downturn and as the clock runs

out on fiscal-crisis delaying tactics.

A new factor—not yet widely anticipated in the markets—is that still-developing

political scandals tied to the Obama administration could threaten global perceptions

of political stability in the United States, placing significant downside pressure on the

value of the US currency. The popular press generally has been highly sympathetic

to the political needs of the administration, so increasingly negative press in these

areas suggests that recognition of the "scandals" has gained some momentum.

In the event that a Watergate-type circumstance evolves from the current hubbub of

touted misdeeds, it could become a seriously negative factor for the US dollar. After

Nixon floated the US dollar in March 1973, the Watergate scandal began to break

open with Congressional hearings. Despite other turmoil of the time, including an

Arab-Israeli war and an Arab oil embargo, the day-to-day developments in the

Watergate scandal dominated day-to-day trading in the US currency.

When the US dollar again comes under heavy selling pressure, oil prices will spike

anew, separate from the effects of political crises in the Middle East. The inflation, so

driven, should reflect dollar weakness from Federal Reserve policies that Mr.

Bernanke will find he cannot escape, and from dollar weakness reflecting the inability

of the US government to address its long-term sovereign-solvency issues. Ongoing

economic weakness will exacerbate the dollar-negative circumstances, intensifying

the problems with Fed easing and US fiscal deterioration. The inflation will be driven

by US dollar weakness, not by strong domestic demand for goods and services.

As fundamental dollar selling kicks in, full-fledged dollar dumping along with heavy

sales of dollar-denominated paper assets are likely to unfold. Preceding, or

coincident with that, the global reserve status of the US dollar should be challenged.

As the rest of the world moves out of the dollar, domestic confidence in the US

currency will falter as well, eventually fueling severe domestic inflation, and setting

the early base of a likely hyperinflation. Such an environment is one for which

physical gold and silver would serve as primary hedges against the ultimate

debasement of, and loss of purchasing power in the US dollar.