Bernanke's Bluff

Dear Reader, At this very moment, well before sunrise, as part of a regimen to adjust my internal clock precedent to a whirlwind trip to four countries in eight days kicking off this weekend, I am attempting to more or less simultaneously (a) catch up on the pile of work I need to get done before said trip; (b) drink enough coffee to melt away the cobwebs that have built up in my brain overnight, and (c) put together coherent and at least mildly useful thoughts for this weekly missive.

Bernanke's Bluff

In April of 2011, writing in The Casey Report , I warned readers of a pending shift in the Fed's accommodative monetary policy. My view at the time was that the shift would result in a rebound in the dollar, which was in a state of near collapse at the time.

Should the Fed not end its quantitative easing on schedule in June, but rather roll straight into a new round of easing (QE3), it will send an unequivocal signal to the market that the dollar is to be sacrificed for political expediency. At which point the waterfall collapse in the world's reserve currency could very well occur and any potential Treasury bond buyers - outside of the Fed, that is - will begin demanding higher interest rates. Those demands will have to be met, because the day that the Fed is effectively the sole buyer of Treasury debt will be the day the dollar dies.

Should the Fed step away from the auctions starting in June (and maybe, for propaganda points, in May), then the interest rate picture becomes a bit less clear. Will non-Fed buyers step into the $50 billion or so monthly gap left by the Fed's exit? Or will they demand higher interest rates, setting off the death spiral in the process?

While it can only be conjecture at this point, I think the end of the Fed's monetization will not cause an immediate spike in rates. For four reasons:

1. The dollar's precipitous slide will suggest to traders and institutional market participants that it's overdue for a rebound. A perfectly logical conclusion, given that should the dollar continue on its current steep downward trajectory, its days will be quickly numbered. As that is the sort of monumental event that happens only every few generations, most big money players will discount the demise of the dollar as a credible scenario, and so many will come back to Treasuries to play the bounce.

2. There are few alternatives to the U.S. Treasury market when it comes to parking big money. Even the relatively small amount of money now flowing into gold has sent it to nominal record highs - can you imagine what would (and ultimately, will) happen to the price if $500 billion tried to flow quickly into precious metals?

3. By exiting its quantitative easing, the Fed will be formally announcing a shift from a loose monetary policy to what might be called a "neutral" policy. Not too loose, not too tight, but just right (they hope). That will give potential buyers some degree of confidence that it's okay to go back into the Treasury waters.

4. Last but not least, institutional equity managers are fully aware of the importance that free-flowing money has played in the recent rally. A tightening by the Fed could almost certainly be the pin that breaks the equities balloon. In the case of Japan's first experiment of QE, following the collapse of its own housing and stock bubbles, during the quantitative easing the stock market rallied about halfway back to the bubble top. But almost immediately on stopping the easing, the stock market crashed back to earth, giving up about 50%. And what would happen in an equity market crash? If history is any guide, money would flee the equities in favor of the "safe harbor" of Treasuries. You can bet that this is also part of the Fed's calculations.

As far as the Fed is concerned, it has done exactly what Chairman Ben Bernanke has said it would do - shower the economy with dollars. By stepping away from the quantitativ e easing, Bernanke begins to act on part two of his monetary hypothesis; that the Fed can mop things up before the dollar dies and inflation runs out of control.

At this point, seeing that the dollar is crashing and inflation and interest rates are already on the rise, the Fed's hand is being forced. It really has no option but to step aside and hope for the best.

For awhile (two months? three? six?) the Fed's gambit may pay off as a sufficient number of fools rush in to take the Fed's seat at the Treasury auctions. So maybe rates remain flat or don't rise overly much. But in the absence of the government making substantive cuts to current spending - there is, after all, an election to be bought - it is only a matter of time, and not very much time, before the Treasury's borrowing needs will outstrip available buyers and interest rates will have to rise.

At that point, the endgame begins, leading to massive wealth destruction for the unprepared.

April 2011

Likewise, in my article, Forlorn Hope, in April of this service, I repeated the warning about a turnaround in the dollar, especially as it related to the commodities in general, and the smaller resource exploration companies in particular.

If I am right, then the way to play it is to expect a near-term rally in the dollar. While the U.S. dollar is toilet paper, it is of a better quality than the euro or the yen. Which is not to say that it doesn't deserve its ultimate fate - the fate of all fiat currencies - but rather that, as long as the Fed shows some restraint here, it may be able to stave off that fate a bit longer.

And that could put some serious pressure on commodity-related investments, especially the more thinly traded junior exploration stocks. The chart here shows the relative performance of the Toronto Stock Exchange Venture Index - the index offering the best proxy for the micro-cap resource stocks favored by so many dear readers - against the price of gold.

As you can see, there can be quite a divergence in the performance of these small stocks over the price of bullion. While gold's rise has been remarkably orderly, the rise in the stocks has occurred in fits and starts, with some breathtaking setbacks along the way. Of late, the stocks have had a substantial run-up, which again gives me pause. I think it is a fairly safe bet, therefore, that if gold were to correct 15% or so, the juniors would again go on sale.

In time, however, because interest rates are so low, and the sovereign debt problems so acute, the worst-case scenario - of rates spiking - followed by the Fed quickly reversing course, is a certainty.

Which is to say that, in the now foreseeable future, all things tangible will do the equivalent of a moon shot.

Again, you have to make your own decision as to which scenario we are most likely to see. In my view, from a risk/reward perspective, as long as you have a core portfolio in precious metals and other tangibles (including energy), then selling some of your more speculative positions (you know the ones) to raise cash can make a lot of sense. That way you'd have the ready funds available to snap up the bargains that will be created during the Fed's brief attempt at slowing the dollar's current fall.

With apologies for being something of a stick in the mud for raising these concerns again, the way I figure it, at this point you can find all manner of analysis that will tell you it's all blue sky from here for the commodities. Thus, a cautionary note seems justified.

Casey's Daily Dispatch, April 22, 2011

So, what has happened in the year and a bit since those articles? Well, for starters, the Fed did, in fact, pause in its quantitative easing in June 2011. Triggering the following...

1. As you can see in the chart here of the Dollar Index (the dollar against a basket of major currencies), the dollar reversed its sharp downward trajectory. For context, I ran the chart showing April 22 2010 through the present, with the arrow marking the approximate date when the above articles appeared.

2. In response to the policy shift, the US stock market fell sharply in July 2011. It subsequently bounced around at lower levels until early October 2011 following the Fed's decision to swap short-term Treasury holdings for those of longer duration as part of its "Operation Twist." It undertook this operation to keep interest rates low - and succeeded.

The net result has been that, between April 2011 and today, the US stock market has been essentially flat and interest rates have fallen to new historic (and unsustainable) lows.

3. The commodities sector, as evidenced in the chart here of the CRB Index, did what we expected it to and has taken what is technically known as a "good thumping," losing 23% since April 22, 2011.

4. Given the smack-down of the broader commodities sector, it is rather encouraging that gold not only managed to hold steady as the dollar rally kicked off, but broke out to new highs before falling back to where it is today, slightly ahead of where it was back in April of 2011.

5. Unfortunately, my concerns about the gold stocks proved warranted, with large-cap precious metals stocks, as measured by the GDX, falling more or less in sync with the broader commodities, off about 26% over the period. Meanwhile, the juniors, as measured by the GDXJ Index shown in the chart here, have been properly mugged, taking a 50% kicking.

To recap, then, in April 2011 the US dollar was in a death spiral, and Bernanke did pretty much the only thing he could do - which was shift Fed policy from the wholesale dropping of dollars from helicopters to a neutral stance.

As the dollar began to rally and the stock market began to fall apart, Bernanke & Co. came up with a new scheme, the aforementioned Operation Twist, a bit of baling wire that managed to keep the wobbling wheels from falling off for a bit longer.

Today, however, the economy is in no better shape. In fact, per the dismal jobs report last week, it is showing every sign of following an increasing number of countries in the European Union back into an officially designated recession. That would be a serious body blow to the president's reelection bid, and so must be avoided at all costs.

Concerned about the continued lack of steam in the economy's boilers, earlier this week members of Congress asked Bernanke to comment on his next move. In response, Ben opted for the mantle of inscrutability, saying only, "As always, the Federal Reserve remains prepared to take action as needed to protect the US financial system and economy in the event that financial stresses escalate."

When Ben was then pressed on the matter of further monetary accommodations, he maintained his composure. According to Bloomberg...

Bernanke ducked direct questions on whether the Fed would initiate more quantitative easing, what the Fed would buy if it did (Treasuries or mortgage-backed securities), and if he would take QE off the table. He reassured his audience that the Fed has "tools that would allow us to get further accommodation into the economy" - and tools to exit as well, without allowing inflation to flare.

So, what tools does the Fed actually have left to it? In a world where governments have lost anything remotely resembling a moral compass, as well as any sense of how functioning economies actually work, it is impossible to know what rabbit Bernanke might be able to pull out of his hat. Yet, we can step back just far enough to identify some general policy options left to the Fed.

1. Do nothing. Given that the US politicians in all their wisdom have not only run themselves into a box canyon but set the brush behind them on fire with the troubling trifecta of (a) an approaching debt ceiling (which is more like an automatic moonroof if you ask me, and who says all debt ceilings must be hit?); (b) the mandated spending cuts caused by the last failure to avoid the debt ceiling; and (c) the scheduled hard stop of the Bush tax cuts. Should the Fed sit on its hands over the rest of the year, the economy will collapse.

This is, in my strongly held view, the best possible outcome as it would finally reveal the real value of everything to everyone. For example, the actual worth of all the toxic mortgage paper now sitting on the books of banks, governments and central bankers alike. From the smoking ruins, recovery could begin anew and surprisingly quickly.

But do any of you dear readers think that even though the Fed should let the market work its miracles, it will? Especially in an election year? The odds are zero to none, and none is quietly slinking toward the door.

2. More Quantitative Easing. While this is what the extend-and-pretend crowd most fervently desire (along with gold investors, it must be confessed), for the Fed to step back up to the plate and take the sort of big monetary swing required to get anyone's attention at this point ($2 trillion?) would have immediate and dramatic repercussions on the dollar, on Bernanke's career, and on Obama's election prospects.

The odds of this happening are, I believe, 100%... but just not yet. Not until after the election, and not until the Fed is left with no other form of artifice and chicanery.

3. Artifice and Chicanery. The Fed could, for example, relaunch Operation Twist, although almost certainly under a different name. No matter what you call it, however, it is the Fed meddling in the bond market. In my view, this is also a 100% certainty, and sooner rather than later, with the Fed's deploying the tattered remains of its bloated balance sheet to buy CMBS (which stands for Crappy Mortgage Bull Sh#%... er, I mean Commercial Mortgage-Backed Securities) from other government agencies (Fannie and Freddie) as well as the banks the Fed is sworn to protect. If it is needed, it will be unhesitant to once again roll short-term paper over into longer-dated Treasuries.

Just how crappy are the CMBS? While the chart here, showing delinquency rates on the CMBS cobbled together out of the pre-crash loans, is a touch out of date, it will give you a clear idea of the trend in motion.

And the government, the Fed and the world's banks are stuffed to the gills with this stuff. Ergo the pressure on the Fed to continue the bailouts by swapping what remaining "good" assets it has on its balance sheets, for the CMBS on the balance sheets of others.

The point is fairly simple. The world's largest ships of state, and the underlying financial systems, have the equivalent of magnetic explosive mines stuck all over their hulls. At this point, at least as far as the US is concerned, the Fed is the last hope of prying these mines off before the timers tick down to an explosion. (Truth be told, all the world's central banks are now reliant on the Fed as the fixer of last resort.)

Tomorrow it may be the escalating defaults in the CMBS market; the day after, trouble in the trillion-dollar student loan market. The next day, it's the final unwinding of the EU as we know it; the day after, it's a collapse in Japan; the day after, a revolution in China... etc., etc., with Bernanke called on to respond with the right fix to keep the status quo in America (and the world) intact.

But all this meddling, no matter how clever, is highly problematic. For one thing, properly operating markets serve a utilitarian function. Whether it's a Treasury market or a market selling vegetables, the function is the same: it's where sellers go to sell at a price they want to sell at, and buyers go to buy at a price they are willing to pay. When the interests of both parties align, a transaction occurs and money moves through the economy.

That utilitarian function is degraded and eventually completely disabled by meddling in the free exchange between buyer and seller. Thus, when the Treasury acts as a seller, but the Fed, a de facto arm of the same government, acts as a buyer, the core functionality is put at risk because it skews the market and, in time, scares off other buyers. And when a market is not free and honest, it stops being a market and starts becoming something entirely different... it becomes a con game.

There is a reason auction houses enforce the simple rule that sellers can't sit in the audience during an auction of their own items and bid up the price. Should this rule not be enforced, how long would others show up for the auctions?

In the case of the Fed, its interjection as the most significant player - by a wide margin - in the Treasury auctions is an abomination. In small doses, simply to grease the wheels of the banking system, its role as an actor in the auctions is not of any serious consequence.

But when the entire funding of the government and its many obligations depends on the Fed's actions, you have a real problem. Correction, we have a real problem.

The bottom line is that US government, and by extension its quislings at the Fed, has to keep its interest costs low, or the whole con job gets revealed and collapses. For now, the con job is still functioning, but it cannot go on forever.

As for who is being conned by the Fed's steady manipulations, look no further than the mirror. Or into the face of your aging relatives and friends who rely on interest income to pay the daily bills. And then look down into the face of the children, because they, too, are being conned - their futures mortgaged by the transfer of private wealth into the public coffers... then incinerated in the most wasteful spending spree in history.

This morning, after the sun had risen and the morning progressed to a respectable hour, I called a good friend who labors under the hood at the highest level, poking around in the deepest bowels, of one of the country's biggest banks.

I asked for his assessment of what the Fed is likely to do next, and down the road as it is forced to it, and found he and I are completely on the same page.

As for the outlook on the dollar, we agree on that as well. Namely that until the next big QE is announced (3 months? 6 months?), the dollar remains the prettiest pig in the poke and so is likely to hang in about where it is, with the usual fluctuations, of course.

Gold? He's a steady buyer at these prices (and, mind you, this friend is a very institutional type, not a dedicated gold bug). When I asked him where he would invest $100,000 if he were forced to it, he first said he'd be on the sidelines, but when pressed said what we have been saying of late - that the producing gold stocks are looking very cheap.

So, what's the conclusion?

It is that Bernanke is bluffing. He's got very few cards left to play, and after he is finished with the next round of meddling and forced to it by circumstances, the Fed will have to launch a QE3 for the record books. The problem, of course, is that the net impact of additional money printing is becoming less and less effective. In time, no matter how high they turn on the taps, all that's going to come out is inflation with no real net gain in the economy, but quite the opposite.

In short, and I know that I sound like a broken record, this crisis cannot drag on forever. And it cannot end with a quiet sigh of relief. The only way that could happen is if the world were to enter a period of protracted robust growth on a scale that hasn't been seen since just after WWII. That scale of growth would allow the world's sovereign deadbeats to generate enough tax revenue to reverse the deficits and, in conjunction with spending cuts, start chipping away at their debts and obligations. It would take time, but conceptually could be done.

Maybe you can see where that level of growth is going to emanate from; I sure can't. Not with the typhoon-like headwinds coming from demographics, from the debt deleveraging, from the overstocked housing inventories and from the systematic unemployment that is highly unlikely to improve by any great degree as millions of jobs are lost to machines.

There is so much more to the situation, including the entrenched bureaucracies that are going to take every conceivable measure to protect their jobs and their pensions... starting by kicking off a class war. But at this point, I am starting to depress even myself, so I will leave off.

Pushed to predict what's coming next, I would sum up by saying:

· More Fed manipulation, leading to full capitulation in an orgy of QE.

· Within the normal range of volatility, gold will do just fine as a wealth preservation asset for the duration of this crisis, which almost certainly has another few years left (frankly, I don't see how things can hold together much longer than that).

As the crisis reaches its crescendo, gold will easily trade above $3,000. Unless, of course, one of the government's extreme actions includes gold confiscation, always a possibility. If you have 20 to 30% of your portfolio allocated to gold and gold stocks, that should be enough to offset much of the risk to your net worth, but because of the political uncertainties, more than that is a threat to your net worth.

It was noteworthy that George Soros, the world's most successful currency speculator, was revealed this week to have tripled his position in gold in the first quarter of this year. That he is a man who knows his currencies is without question. That he chooses gold speaks volumes.

· The gold stocks are very definitely worth your attention at this point. If you have a contrarian bone in your body, and you don't already have a corner of your portfolio dedicated to that sector, then now is the time to start building (ideally over time, on the inevitable down days).

There is no way around it - other than being folded back into the mantle, that is - you and I are going to live in interesting times. The only real question is whether we observe what's coming in a cloud of chaos or more dispassionately from the sidelines, our portfolio safely tucked out of harm's way.

At this point, literally anything can happen at any time, including a black-swan event I didn't even touch on above. Be careful.

And now for something entirely different, though relevant to the topic of how the nation-states have brought us to this place. It is an excellent article by a new friend and fellow owner, Rex van Schalkwyk, a former Supreme Court judge from South Africa. Rex is married to Angela, a very talented participant in the La Estancia writers' group that swaps stories virtually each month.

As you will read in the following, Angela is not the only person in the family who is good at putting thoughts into words. In my view, what Rex has to say is essential for everyone to understand, because only then will they view the politicians and joined-at-the-hip perfect-worlders in the proper context... as parasites.

Here's Rex...

The Commoditization of Compassion

By Rex van Schalkwyk

In politics, it is the idea that counts. So also in philosophy, pop music, pedantry and philanthropy. The idea is everything. And between the idea and the reality, there lies that vast uncharted terrain of promises unfulfilled, of lies and deceit and of naked hypocrisy, all of which account for the failure of the public discourse and of public life. In short, this self-inflicted deception accounts for the failure of society.

Bertrand Russell, who is said by some to have been the greatest philosopher of the 20th century, and a notable socialist, proposed that in the one-world society he envisaged, the supply of food should be used as a lever to ensure social compliance. This is what he wrote on the need to prevent the increase of the world's population: "If this is to be done otherwise than by wars, pestilence and famines, it will demand a powerful international authority. This authority should deal out the world's food to the various nations in proportion to their population at the time of the establishment of the authority. If any nation should subsequently increase its population, it should not on that account receive more food..."

In this way, the philosopher would have contrived a one-world totalitarian dictatorship in a perpetual state of starvation. Russell did not even consider where the world's food, without which people were to be starved into submission, would realistically be produced. The most extraordinary thing of all is that he could suggest such an idea in pursuit of his ideal of the utopian life. Were it not for the fact that his work, The Impact of Science on Society, is no laughing matter, it might have been read as a malicious satire.

There is a conundrum here: why is it that so many of those who enthusiastically embrace a benign cause, conduct themselves with such malevolent intent? The answer in Russell's case, and many others besides, is that the real object of their concern is not the welfare of the individual, or of the collective, or the world, as the case may be. The real preoccupation is the idea, and close by the idea is the individual who will see self-interest as synonymous with the public good.

And so it is easy for Warren Buffett, Charlie Munger, George Soros and others, who have made their billions, to adopt neo-socialist causes and to plead the morality of higher taxation because, having made their pile, they can, with impunity, identify with the perceived interests of the disadvantaged. They can adopt the mantle of compassion because there is no real cost involved.

The worst crimes in human history were committed in the name of the communist ideology, whose central premise was the brotherhood of men. Everyone was a comrade, except when they were not, which was practically all the time. Never included in the common definition were the rulers, although they were routinely referred to by the same fraternal denomination.

George Bernard Shaw actually visited Russia in the company of a clutch of like-minded intellectuals, after the commencement of Stalin's infamous purges. When he returned to the safety of London, he proclaimed to have been well pleased by the progressive nature of Russian society.

How did this man of letters come to a conclusion so perverse? The answer is that he traded his integrity in exchange for the acknowledgement of the intellectual establishment of the time. It was believed then, particularly among the intellectual classes of Oxford and Cambridge, that communism was the way of the future. In Major Barbara, Shaw had excoriated the wealth derived from machines of death and destruction. What better trade for a playwright of his inclinations than to feign ignorance of the depravity of Stalin's Russia. In this way he would find favor with the masters of the intellectual universe.

In a letter written to The Manchester Guardian on March 2, 1933, Shaw and 20 other fellow travelers made this observation: "We desire to record that we saw nowhere evidence of such economic slavery, privation, unemployment and cynical despair of betterment as are accepted as inevitable and ignored by the [British] press... Everywhere we saw the hopeful and enthusiastic working-class, self-respecting and free up to the limits imposed on them by nature and a terrible inheritance from tyranny..."

If Shaw were to be believed, he was well aware of the tyranny of the Tsar but blissfully ignorant of the savagery of Joseph Stalin, of the ubiquitous secret police, the extermination of the kulaks and the mass deportation and starvation of vast swaths of the Russian population. On his visit, he did not even notice the ever-present apparatus of Stalin's propaganda machine.

Joseph Schumpeter, who was both a sociologist and an economist, had the measure of human nature. In every democracy, votes are exchanged for favors. As the democracy matures, and as the prize of political office becomes ever more seductive, the promises become ever more extravagant. By this process the democratic bribe must, according to Schumpeter, result in government that becomes increasingly socialist. If practical proof of Schumpeter's thesis is required, it is to be found in the inexorable rise of socialism in Europe, Canada, Australia and in the United States.

Add to this the requirement of the bankers, and of the lesser financial institutions, to secure political advantage, and it becomes easy to follow the money. This also explains the paradox of capital making common cause with socialism. If there is hypocrisy in those who choose to ignore the contradictions of their actions, this hypocrisy is multiplied in those who regard such conduct as a promotion of the public good.

When, as Treasury secretary, Hank Paulson went down on his knees in his abject supplication before Nancy Pelosi, the high priestess of Congress, was it for the survival of the economy or his share-option scheme that he most fervently prayed? Whose interests was he guarding when he provided his banker friends and colleagues with insider information about the imminent collapse of Freddie Mac and Fannie Mae; a possibility that only weeks before he had publically and emphatically dismissed?

The "liberated" South Africa is governed by the African National Congress (ANC), which comprises an assortment of socialists, communists, trades unionists and a sprinkling of pragmatists. The one thing that this unruly crowd has in common is its conspicuous consumption. In the process, billions of rand are misspent, unaccounted for or simply stolen. The chief in the office of former president Thabo Mbeki, Smuts Ngonyama, once proclaimed that he had not engaged in the liberation struggle to be poor. Candor of this kind is, however, rare; far more likely, a critic of government corruption will be met with the accusation of racialism.

The poor and the dispossessed are routinely exploited for the social and political ambitions of their rulers. Winnie Mandela, the former wife of the idealized former president, was convicted of the common-law crimes of kidnapping and assault. Were it not for an opportunistic appeal court judgment, she might have spent many years in jail. Although she no longer goes by the moniker "Mother of the Nation," she still cuts a prominent and elegant figure on the many occasions she appears in public. Her kidnap victim was found dead, but her compassion is always on display: she never misses a photo shoot opportunity in the immediate presence of misery.

If the politicians and intellectuals are masters at the art of hypocrisy, Hollywood actors and pop stars have a sublime skill in the promotion of humbug. One such practitioner is Paul David Hewson, also known simply as Bono, the lead singer and lyricist of the accomplished Irish rock group, U2.

Bono has turned his talents, and his genius for publicity, to the international populist causes of the day. He has organized many benefit concerts, eagerly supported by the "me-too brigade" who make up much of the entertainment industry. The most woebegone victims invariably attract the greatest artistic support, which is always provided for free.

For his efforts, Bono has consorted with presidents and kings and accumulated an assortment of titles and awards. Formally granted an honorary knighthood in March 2007 and thrice nominated for the Nobel Peace Prize, the former Time Person of the Year has been described by Paul Theroux as a "mythomaniac"; a person who wishes "...to convince the world of (his) worth." The sociologist and political commentator Muhammad Idrees Ahmad has condemned Bono's conduct as "...a grand orgy of narcissistic philanthropy." So we have it on good authority: narcissism and philanthropy can co-exist.

If the hypocrisy of the pop stars is nauseating, the grandiloquent but meaningless oratory of the aspirant political "leaders," of which much will be seen and heard in the coming months, is almost certain to produce results, the very opposite of what is pledged.

Greece, Spain, Portugal and Italy, and others besides, have fallen into the trap of bribing their electorates with promises that become ever more unsustainable. In each of these states, expectations have been created that cannot be met and that cannot now be undone. This is surely a recipe for social unrest.

These will not be the only countries to succumb to failure. The national debt, the unaffordable long-term cost of social security, healthcare and a myriad other entitlements, the mounting evidence of the insolvent state, point to the same outcome for the UK and the US. Failure is ensured; the more pressing question is, what happens next?

Until next time...

David Galland
Managing Director
Casey Research