Loonie Loses it’s Luster?

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The Canadian dollar against its US counterpart had one of the narrowest trading ranges of most major currency crosses in the last few months and had not closed below par since November of 2012. That all changed this week as we saw the loonie fall over a cent and a half and finished trading at close to 99 cents. There were a number of announcements and releases this week that triggered the downward trend in the Canadian dollar and it was led by both the IMF and Bank of Canada revising down their forecasts for economic growth and inflation, and further the Banks more dovish tone towards interest rates. Moreover, currency markets have once again become a little more interesting as the perception of “currency wars” is again explored by investors and the media.

Many of the economics departments of Canada’s financial institutions were pointing out that the loonie had been overvalued since last fall. With trade numbers, growth projections, and fundamental indicators all pointing to an overvalued currency, it was the stability in our government compared to the rest of the western world that was driving investors to park funds here in Canada. That being said, the recent realization that the United States is expected to experience more robust growth in 2013 and the stagnation of prices has seen our dollar return to under parity. As the Canadian dollar was exhibiting this status of a safe haven currency, it had even led the IMF to recommend its inclusion in a central banks basket of foreign exchange reserves. Despite the loonie falling off this week, the reality is the Canadian economy has not drastically changed course from where we were five months ago.

Jim Flaherty, speaking in Davos, Switzerland at the World Economic Forum summarized our growth path compared to the US quite well. To summarize, we are in a period of quite moderate economic growth, and in 2008 we experienced a little dip. The US, however, went a lot lower than us and is bound to accelerate and make their way back at a bit of faster pace. So it really raises the question of why financial markets continue to tell a different story then where the world sits from an economic standpoint.

US equity markets are at their highest levels in the last five years. They have come back from the lows of the Sub-prime crises of 2008 and ’09 and the confidence of investors is driving them higher and higher. The VIX, which tracks the implied volatility of the S&P, and for this reason is referred to as the fear index, is at its lowest levels on record.

So keeping the mindset of a student, questions arise surrounding why equity markets carry such optimism in this moderate growth environment. And this leads to the discussion and motivation of currency wars. Two central bodies can directly influence a country’s price level, and thus the exchange rate. One is the federal government through fiscal policy, and the other is a central bank via monetary policy. Either can do so, but this idea of devaluing a currency to give a competitive trade advantage so that a countries good are priced cheaper in foreign markets has been directly influenced by the actions of central bankers in initiating bond buying programs such as quantitative easing and keeping interest rates at record lows since 2006.

It’s hard to rationalize why in a period when government looks to be more and more anemic, and central bankers are relied on to engage in a competition of currency devaluation to stimulate economic activity, that the market place would be so optimistic. That being said, lets enjoy the ride of this rally and look for warning signs of it coming to an end.

Germany wants its gold back—should we worry?

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News surfaced this week that the Bundesbank, Germany’s central bank, was recalling some 674 tonnes of gold that they hold outside of the country. This came as quite a surprise as this particular gold has been stored with the New York Federal Reserve and Bank de France for decades. But many were asking the question, why does it matter where Germany stores their gold?

Following World War II and the beginning of the Cold War, the majority of Germany’s gold was moved to the safekeeping of western central banks as a threat of Soviet invasion loomed; however, not until the end of the war did Germany start bringing their gold home. Germany is the world’s second largest holder of gold, and they held as little as three percent of their entire holdings domestically during the wars. Currently, that number is around 31%, and their plan is to hold about 50% of their gold in Frankfurt by 2020 by repatriating these 674 tonnes from New York and Paris.

Various commentators have tried to provide rationale for why Germany would have the incentive to do this with reasons ranging from the US Fed and central banks lack of proper auditing practices to the gold actually not being there. Giving conspiracy theories only so much credibility, I think Germany’s motivation is deeper and stems from the geopolitical risk of a breakup of the European Union.

Economic growth across the Eurozone is stagnant at best as they look to start off 2013 in a double dip recession. The Euro Zone sees almost a quarter (24.7%) of their labor force under the age of 25 unemployed and seeking work. And rates are higher in peripheral Eurozone countries like Greece, Spain, and Italy, who saw youth unemployment increase to 57.6%, 56.5%, and 37.1% respectively. The social unrest in these countries stems from the inability to find and/or keep work, and this ongoing problem that bares no present solution is what threatens the single currency zones present stability.

Through these times of economic uncertainty it is gold’s role in international finance that safeguards a number of these European nations from extreme currency instability. It’s interesting to note that while Germany looks to repatriate a large portion of their gold holdings, that these countries are still largely dependent on the precious metal. As the German’s are the second largest holder of physical gold, not far behind are Italy, France, and the rest of the EU to make up over 10,000 tonnes and almost a third of the World’s Central Banks’ Foreign Exchange Reserves. The very asset that backs their currency, unlike a lot of Asia, which post Bretton Woods opted to hold US dollars, is predominantly made up of gold. In essence, that is why Europe’s central banks are bound by an agreement referred to as CBGA3 which limits them flooding the market with large quantities of physical gold.

This preamble circles back to the importance of Germany bringing home their gold to store domestically, and I believe their reason for doing so is not unlike the typical retail investor who holds gold. Gold is the hedge or the insurance against debasement of currencies and geopolitical risk. I hope for the sake of the Nobel Price-winning Canadian Economist, Robert Mundell, that the Eurozone does not dissipate, but this move by Germany may be hedging against just that.

The Trillion Dollar Coin

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The idea that the US treasury will mint a one trillion dollar platinum coin in order to avoid the debt ceiling seems somewhat absurd, but faced with a government threatened with deadlock and inaction it is being entertained. The premise behind this coin is that it avoids entering a debate scenario similar to August of 2011 where “Tea Party” Republicans toyed with the idea of the US government defaulting on their debt payments and liabilities. That being said, not raising the debt ceiling, which has been done on 78 separate occasions since 1960, and pursuing alternative measures to avoid exhausting the US Treasury’s coffers will ultimately shock both creditors and rating agencies.

The glutinous spending of the US government is no secret by now. And it is known that there is a very serious debate to be had in the US about the structure of their entitlement programs and their continuing problems with their deficit financed spending. It seems the approach, however, of the current administration is to simply leave addressing these issues to someone else as politically palatable actions seem to be the more favoured course of action. And just like passing a budget deal without addressing entitlement programs, the idea around issuing a one trillion dollar coin is exactly that; putting off the job of addressing the structural issues of their deficit for someone else.

Despite all the structural issues in the US, there has been a serious shift of optimism in equities, and thus moving away from fixed income, as investors start to hope this global recovery continues to takes place. And the speed bump to a rallying stock market, as many have predicted will rally in the beginning of 2013, will be debt ceiling talks in the US. The media exemplifies polarized views, either extremely left or right wing when discussing the idea of the treasury issuing this coin, but the implications of it are not political and in fact quite simple.

US lawmakers along with the over glorified president are too dysfunctional to sit down and debate spending such that the Treasury has to take its own course of action. Such a vote of non-confidence by minting this coin will not only disrupt their currency and the price of the US dollar, but also their credit rating. This will be a signal to international lenders that when it comes to finances, parties involved can only travel to the extremes to achieve this charade. It is almost unbelievable. The US government is losing any shred of creditability they have left.

And that is really what the problem is. When Obama got re-elected for a second term he must have truly believed that he had a mandate to do whatever he wanted. John Boehner, who is a moderate Republican, is under pressure from the fringe of his party to get some compromise in terms of spending cuts, and the president, to use a baseball metaphor, will not even come to bat.

To paraphrase PIMCO Bond King, Bill Gross, the US Treasury is in essence writing cheques for free. They issue bonds to be bought by the Fed, and then receive back the interest that the bonds have paid. His claim is that there must be a cost for this as, simply put, cheques cannot be written for free. Ultimately, the cost will be inflation.

Some think inflation is palatable. I am on the other side of that bet and that is why I believe in real assets like gold and land. But the message is that every action has its costs. If the US opts for minting a trillion dollar coin, the costs will be insurmountable.

Calling the Fed’s Bluff

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The US Federal Reserve revealed from their December meeting that several of their voting members would opt to end their extensive bond purchasing program, known as Quantitative Easing, by the end of 2013. It was back in November of 2008 when the US Fed initiated this monetary stimulus effort, and just for reference the price of gold closed that month at 811.30 USD/oz. It’s no secret the price of gold has moved up significantly in response to the US central bank’s issuance of cheap credit at the cost of their dollar, but the question then becomes what happens to the price of gold when the Fed takes the punch bowl away?

Well, that is a scenario that I do not think we need to worry about just yet.

There is no set in stone timeline for when this stimulus program will end, but it is up to the Federal Reserve’s Policy setting committee. The structure of the Fed’s policy setting committee (known as the Federal Open Market Committee, or FOMC) has it so that the majority rules. Of the twelve voting members, there are seven Federal Reserve board governors, including chairman Bernanke, which traditionally vote in unison. The remaining five positions rotate between the 12 Federal Reserve District Bank presidents, and that is there there can be dissent from the consensus. This structure, however, ensures the governors have their majority in all decision making.

The renowned Bond Fund investor Bill Gross of PIMCO stated on CNBC following the release of the FOMC December minutes that it’s too early to put an end date on this monetary policy experiment. The incoming voting members of the FOMC are more dovish and will support a more accommodative policy going into 2013. For this reason alone, it’s too soon to anticipate these bond purchases will be wound down.

In fact, James Bullard, the St. Louis Fed’s district president promptly told media following the release of the December minutes that it will take a significant improvement in the economy to end the program instead of setting some tentative date. This was his effort to make clear that the Fed’s expectation is for the economy to improve by the end of this year, such that they will no longer need to supply such a supportive policy; moreover, cutting back bond purchases is very conditional on an improvement in output and labour markets.

In an introductory course to macroeconomics we learn how central banks may utilize the media to affect consumer and business confidence. If business’s all truly believe that the economy will improve by the end of 2013 maybe that will prompt them to go out and hire more employee’s and increase capital expenditure and investment. But then, how much of the Fed’s forecast for the improvement in the economy is based on the fact that business and consumers will react in this way?

My view is that the US economy will continue to advance at a mediocre pace in 2013. Friday’s job’s report helped illustrate that the labour market is only moving in accordance as job creation remains quite weak and only slightly outpaces the growth of their labour force.

The US Federal Reserve will have no choice but to continue their experiment known as Quantitative Easing due to how reliant this fragile American economy truly is. With a stalemate in Washington that only looks to get worse, the next bump in the road will be negotiations on the budget ceiling and the imposition of spending cuts that the federal government keeps delaying. This will lead to very cautious levels of investment and consumption akin to 2012. With a market potentially expecting an end to this program by 2013 year-end, any extension will be very bullish for gold.