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The Conundrum
by David Coffin
01/03/08

A few years back, Alan Greenspan did a lot of talking about “the conundrum”. This occurred when Greenspan was still head of the Fed, before he retired and dumped the mess he had made on Ben Bernanke. At that time the “conundrum” was the stickiness of long term interest rates. The Fed was busy raising rates after holding the Fed Fund Rate at 1% long enough to ensure the credit bubble we’re living with now would materialize. Long bond rates were refusing to rise; giving the yield curve the sort of nasty downward slope that usually spells trouble. The problem back then was (surprise, surprise) excess liquidity. So much money was chasing yields that demand for longer term treasuries drove up prices and brought down the yields.

This period created a lot of consternation among analysts and economists. Inverted (down sloping) yield curves have historically been a reliable indicator that a recession was on the way. We were not that concerned about it at the time. We saw the inverted curve for what it was; an indication of high demand and liquidity, not a reflection of a market where interest rates had been pushed too far.

Unfortunately, Ben Bernanke has a much tougher situation on his hands than Greenspan had to deal with 3-4 years ago. Life will be very, very tricky for central bankers over the next few months and things could get nasty if they get things wrong.. The good news is that the only rational course of action we can see the Fed and other central banks taking would be positive for gold.

What’s all this have to do with the gold price? Plenty. As you know, the value of the US Dollar is one of the main drivers of the gold price. A virtual collapse of the Dollar since September is a major part of the reason gold prices zoomed above $800 and other precious metals followed suit. Through November and early December the gold price has stalled. Some of this is due to selling on days when everything was on sale. Some of it is due to recent strength in the Dollar. For reasons we detail below that strength is likely to be short lived.

The bounce in the Dollar ocured when oil prices stabilized (sort of), the Fed disappointed the market with a smaller than expected 25 basis point rate cut in December, and inflation again reared its head. Both wholesale are consumer inflation gauges in the US turned up sharply, moving well above most central bank’s comfort zone. Inflationary times are usually good for gold and other commodities. So why the sell off in precious metals?

Traders moved out of gold because they feared the Fed would do an about face and start raising rates. That would inevitably increase the value of the dollar. Even though a higher inflation environment would be positive for gold in the longer term, rising rates would give the Dollar a bounce that would hurt gold traders in the short run.

We are bullish about gold long term view but, more importantly, we are pretty bullish short term as well because we think the chances of any rate increase are very small indeed. The world is being gripped by a crisis of confidence and a break down of trust in the credit markets. Bernanke and other central bankers are now dealing with a much nastier conundrum than the one Greenspan faced.

Central banks in the US, Canada and the UK all cut interest rates in December. These cuts had almost no effect in the going rates for inter-bank lending, commonly known as the London Inter Bank Offering Rate (LIBOR) These rates send a strong message; banks and other credit market counterparties do not trust one another. They are not lending to each other or to businesses and consumers. In short, the credit markets are freezing up. Understand that these inter bank lending rates – NOT the official discount rates – set many of the interest rates for things like mortgages, consumer and commercial lending.

Credit contractions are, by definition, deflationary events. As lending diminishes in a fractional banking system the money supply shrinks with it. Central banks are pledged with the duty of maintaining price stability, but this is a minor issue compared to the credit market troubles. Rising inflation is simple if not painless to deal with. Keep raising rates and you will ultimately choke it off, though you might get a recession to the bargain.

Deflationary monetary events like a credit crunch are far more dangerous to a central banker. They simply do not have the weapons in their arsenal to deal with it. When and if a deflationary event gets out of hand it quickly gets to the point where central bank intervention is useless. Think of Japan circa 1990-2005. The Bank of Japan cut rates to 0% but waited too long to do it. Once confidence evaporated the central bank rate cuts were “pushing on a string”

We can’t read the minds of the world’s central bankers. We do know this however. The lessons of the Depression and the Japanese credit implosion are well known to all of them. A credit deflation is so serious compared to an increase in inflation that even if the balance of probabilities greatly favours inflation it’s simply not worth it to risk credit contraction.

Until a few days ago it really didn’t look like the central bankers “got it”. That changed when the Fed offered $80 billion in repos no questions asked (their version of sub prime lending) and the ECP flooded the LIBOR and EURIBOR markets with $500 billion in credit injections. This was finally enough to start dropping LIBOR rates but we’re not out of the woods yet. We fully expect enough sub prime debt bombs to go off over the next few months to keep central bankers squarely on message. We think they will cut rates, even in the face of increasing inflation. They may well cut several times. If they don’t go that far you can be sure they will continue to pump massive amounts of liquidity into the markets to keep them stable. They will always err on the side of increased liquidity in the hopes of avoiding a recession. Higher inflation later is simply the lesser evil in this case and they would be fools to worry about it while a credit contraction was gathering steam.

Traders are starting to accept this which has capped the Dollar rally and sent gold prices back to their all time highs. Against that backdrop gold and other precious metals will do well in 2008. Well structured precious metals producers and discovery stocks that are rapidly increasing their asset value through exploration will be your best defence against an attack by “the conundrum”. If the credit contraction worsens the market could be rocky and it will be important to lock in profits regularly but precious metals producers and explorers are the place to be.



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