The date was August 9^th, 1974 when Richard Nixon resigned the Office of the President of the United States. Some people today might take the opportunity to argue over how Nixon abused the powers of the Oval Office, or how the Supreme Court began a judicial process in which they investigated the executive branch of United States government. The significance of this was this was the first time the high court went after a president, and many questioned whether the action was overreaching their mandate. However, since we are on the topic of Nixon (and because the lack of action in the markets last week very much exhibits the doldrums of summer) it is also important to discuss his role, during his presidency, in ending a gold exchange standard (known as Bretton Woods) and the transition to this current period of floating exchange rate regimes.

Towards the end World War II, the United States and other participating nations established a monetary regime known as a gold exchange standard. Different from a gold standard where an individual country’s currency or fraction of their currency is backed to their own gold reserves, a gold exchange standard had member nations exchange rates pegged to the US dollar, and the US dollar in turn was partially backed by gold. This began the US dollars reign as the world’s reserve currency as every other countries currency was relative to the US dollar. And from the setup of the regime, the idea was that US dollars were as good as gold, and vice versa.

Particularly in the postwar period, stability in exchange rates was pivotal to a period of sustained and stable economic growth in order to avoid a repeat of events following the First World War. During that period, countries had individual control over their exchange rates, which led to competitive devaluations and erection of trade barriers in order to direct domestic demand for home grown (or provided) goods (and services). David Ricardo’s 1817 On the Principles of Political Economy and Taxation written around a century earlier would reveal why this was a bad idea.

Amongst the many flaws surrounding the system of international finance during Bretton Woods, one key example was that pegged exchange rates were more suitable during times of slow and steady economic growth. As the world’s economies began to pick up speed, the gold exchange standard came into question. The US needed to continuously run deficits in order to ensure liquidity in global finance; however, US deficits undermined the value of their dollar relative to the price of gold. This was known as Triffin’s Dilemma, named after the economist Robert Triffin.

In addition to this, the US overburdened themselves with heavy social spending, and the expense of the Vietnam War. The Treasury was in desperate need of more money, which led to congress decreasing the fraction of gold backed to a US dollar. It’s no question this continued to shake the confidence of participants of this global monetary system, and thus led to French President, Charles de Gaulle along with others to begin calling on the US to exchange the dollars held in their foreign exchange reserves for gold.

It was Nixon’s executive order to close the gold window in 1971 as faith in the Bretton Woods Regime had dissipated. Ultimately, the perception of the US dollar being overvalued collapsed the link between the dollar and gold. And so begins the paradigm of the dollar and gold’s inverse relationship. Some forty-two years later, the result of a preponderance of fiat currency gives gold the standing of being a store of value rather than cash.

“Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough.”

‒ Mario Draghi

Those were the now famous words of European Central Bank (ECB) President Mario Draghi this time last year as he pledged to do whatever it takes to save the Euro currency. And the markets believed him, thus far at least. It is only his words that have had to stand behind the recovery of the Eurozone as their central bank is yet to participate in the Outright Monetary Transactions (OMT) where they would act as a buyer in the debt markets to support struggling European nations. But as Europe proceeds’ forward, some analysts seem to forecast the worst is soon behind them in terms of growth as they attempt to escape a triple dip recession. The caveat, however, is the employment scene despite improving marginally is still dire.

The most pertinent part of a recovery in Europe is that it is sustained, and in order to attempt to bring their public finances back into balance it becomes necessary. Their states and governments require revenue, and that is achieved from a broader tax base of an economy that has reached full employment. Jobs have been the long term problem to any of the economic recovery’s around the globe. The United States is witnessing devastating effects to the long term unemployed members of their labour force, but particular to Europe are the stories of little prospects for the youth either graduating high school or university.

There is still a massive divide between the North and South Eurozone. It is no secret the German’s have benefitted from a strong export sector that has learnt to rely on a weak Euro. And for that reason, the German economy has a strong labour force. Michael Steen in the Financial Times writes, “if you are out of work in Germany and apply for a job, there is, statistically, just one other person vying for that position, but in Portugal there are 89, in Spain 71 and in Ireland 31.” That tells us that labour is immobile across the Eurozone, and either before or after Chancellor Merkel attempts to get re-elected this fall, Germany has decide what real part they will play in supporting the peripheral nations.

Under no circumstances will the Eurozone be able to move forward without greater integration between member nations, both fiscally and economically. And this is not a call for bigger government; moreover, there is a need, like elsewhere in the world, to systematically restructure their system of government. To make headway though and move forward, this recovery needs legs, and the recovery is dependent on jobs.

Continual improvement in the labour force will be the only way for Europe to move forward. It’s very similar to the US where indeed their employment situation is not perfect, but modest gains have continually been made to give their recovery traction. Everything in Europe is good news at the moment. Business surveys have turned positive for the first time in over a year and a half, and employment data in countries like Spain have shown improvement in the right direction. For things to continue to get better though, ‘sustained recovery’ is the key word.

Investors who have been salivating for reassurance regarding the outlook for more monetary stimulus from Federal Reserve Chairman Ben Bernanke got their wish this last week. It truly is phenomenal that we can flip flop so many times on a consensus for the US Fed in terms of their direction for policy, but as Bernanke seized the opportunity to differentiate between asset purchases versus record low interest rates – the market rallied higher. And that was the key difference that the US central bank governor touched on this week. Winding down asset purchases is entirely different from the prospects of the Fed’s funds rate, their key interest rate, and since it has been record low interest rates that initiated this run of mispriced and cheap credit the story will play on.

In hind sight though, it’s almost as if the volatility and the uncertainty introduced by the Fed at the end of June was all for nothing. The first time around, the thought of tapering or easing back of monthly asset purchases pulled the carpet out from underneath the markets. It started a firestorm in the bond market and sent everything else except the US dollar tanking. As the apparent revelation came to be that asset purchases carried no implications for interest rates, risk assets came into play again. Assets ranging from equities to commodities to currencies all moved higher. And that is why it is important to differentiate between the two policies the Fed currently has in place. One is the extraordinary stimulus known as quantitative easing, and the second is control over the fed funds rate, which has been held at record low levels.

The Fed Funds Rate is akin to the overnight interest rate maintained by the Bank of Canada, and it very much gives the respective monetary authority power over the shorter end of the yield curve. QE was such a phenomenon when first introduced because it stepped beyond conventional monetary policy. It allowed the central bank to alter the prices of long term debt instruments, which carries extreme implications for the amount of control over financial markets. Never has the term free market been so distant since we have seen these policies in place, and now that central bankers have realized this ability to influence the markets in this manner, these policies have become almost common place.

With the world renowned Mark Carney now at the bank of England, awaiting their economy to achieve “escape velocity,” the developed world looks open for more and more easy money. Between the Bank of England, the European Central Bank, the Bank of Japan, and the instigating US Federal Reserve, a new norm has been rewritten in terms of coping with economic crises and let alone any slowdown in the economy. The belief still is that the Fed is likely to start tapering their asset purchases by September of this year. However, just to sit back and watch the markets react to random dialogue from the US fed (when nothing has changed fundamentally) indicates that the amount of uncertainty around how asset prices will fare when this day comes is still unknown.

My bet has always been that when the time comes, moving forward from QE and emergency level interest rates will not be as seamless as anticipated. Particularly because the underlying US economy is not as strong as many perceive it to be, and the outlook over the long term is weak due to the structural changes that have failed to be made.

Gold reacts to rumours, not news. This was witnessed since the onset of quantitative easing. Speculation on the consequences of expansive monetary policy contributed to a safe haven status for the metal. People went into gold to protect their wealth or hold onto the purchasing power of their money. The biggest rumour or perception though that QE created was that it would lead to rampant inflation. Such expansive monetary policy would lead to the demise of the US dollar, and one of few assets able to hold value was gold.

This theory seems to be facing some headwinds.

The rumour, belief, perception, or whatever we want to call investors take on Bernanke’s press conference following the FOMC meeting last Wednesday is that the game is over. The Fed is removing the metaphorical punchbowl from the party, and the source or backstop of liquidity for financial markets is soon to be no more. It seems to be a bit of an irony that what should be such good news prompts the kind of reaction from the markets we had Thursday of this week; however, it seems there is a lack of confidence among market participants that the real economy is able to take over from this artificial one.

To me, it raises the question as to whether the Fed actually wants to start pairing back their record bond purchases, or if they have just reached some sort of inflexion point where they are more forced to act. Perhaps the benefits of their efforts no longer exceed the consequences. As many have argued, it’s the lack of fiscal policy that has stalled the global economy over the last few years as monetary policy is an imperfect tool for correcting the market failures. Even so, it was anticipated by investors that because of the rise in yields witnessed over the last few weeks, Bernanke would seize the opportunity to try and calm markets and talk down yields. That definitely wasn’t the case as he expressed confidence in the US recovery. It is now evident that the Fed is keen on economic growth and tapering is soon to begin.

With the key focus being on the labour market, it’s the Fed’s expectation that the employment rate should fall to 7 percent by early 2014. At this point, stimulus to the markets would come to an end, and interests rates would stay low until the US economy achieves what they refer to as full employment at 6.5 percent. There is only one problem though with talks of withdrawal and raising interest rates, and that is the fact there is no inflation.

It is almost as if we have forgotten the role of a central bank. Through this extraordinary period of all different types of policy to spur economic growth, we have forgotten that one of the banks mandate is for low and stable inflation around the level of 2 percent. The lack of inflation not only slows any advancement in the labour market, but also hinders the Fed from raising interest rates without creating a hindrance to economic growth.

Many gold investors see the potential for inflation. The vast reserves created by the US Fed just sit idle in the US financial sector, but the lack of velocity or volume of that money changing hands keeps inflation levels quite tepid. This is what will keep interest rates low for the next two years, and until there is the threat or “rumour” of inflation—gold will continue to be on the defensive.

The US economic recovery is really at a crossroads in terms of which direction it will head next. With asset prices so artificially skewed from their fundamental values, every pullback in the markets has investor’s questioning whether we are witnessing that inevitable correction, or this bull market in equities just continues. The uncertainty plaguing investors is whether the real economy is able to catch up with this frankly unbelievable run on which these stock markets have gone. And job numbers in the US were once again stable and mediocre. They weren’t amazing, but they weren’t that bad either.

Of course the employment situation in the US really is the foremost important economic indicator, and for the numbers not to be negative, as many were cautiously expecting, has given markets reason to trade higher to finish the week. But the inevitable question remains, can the real economy take over from how spectacular equities are priced in this one that’s artificial.

After continued buying into the month of May, stocks suddenly appear to be indecisive. US equity indices altered between positive and negative trading sessions over the past week and a half. US Treasuries on the other hand, have had their worst month in May since December of 2010. As of late, there has been a shift in the sentiment of the markets that does raise some caution for investors. The problem is that investors have not been paid enough for the risk they incur in other areas of the market. And that is absolutely the paramount concern of the effects of the record stimulus that has been added to these markets.

Central bankers all over the world are aware that mispricing credit jeopardizes the longevity of this economic recovery. But as we see bond yields starting to once again creep higher or equities doing a seesaw, the markets have stepped away from reality and how they will come back into balance is the greatest question of this period in time. Many analysts stand ready to criticize the world’s central bankers before this experiment is even finished. The truth of the matter, as I cannot restate enough, is we do not know how it will finish. But it is simply too early to judge the efforts of Bernanke and the Fed because macroeconomic policy is intended for the long term.

Very much like Paul Volcker in the 1980’s, the central of bankers of today as well risk their creditability in the policy they opt to implement. There were just as many naysayers of the US central bank when Paul Volcker went to war against rising prices and correspondingly raised interest rates in order to tackle rampant inflation. Same too with what we see with the US Fed and this massive expansion of the monetary base in order to ensure the liquidity of the world’s financial markets.

Never has a central banker really been as exciting as markets are so keen to move so decisively off of the latest policy announcement or testimony before a central government. The problem is that these movements have become so erratic that the investor does not know which direction in this current cycle the market is going to take.

Stay tuned.