Mid-Year Review

At the beginning of the year, I wrote: “The financial system has become so abnormal, the Fed has to keep inflating to prevent the system from literally going off the rails. But the irony is that eventually the financial system dies as a consequence of accumulated inflation.” I then went on to identify three things that everyone needs to watch in 2013.

Two of these events have already happened. I still expect the third to occur this year too. Here they are, with my current thoughts:

1) “The Federal Reserve balance sheet starts growing.”

The Federal Reserve began expanding its balance sheet soon after my article was published. It does this in a process called “quantitative easing”, or QE, in which the Fed creates money ‘out of thin air’ to buy debt instruments.

Its total assets on January 9, 2013 were $2.93 trillion. In the latest financial statement issued on June 19th, total assets are $3.47 trillion.

So in 23 weeks, the Federal Reserve’s balance sheet has grown by $540 billion, which is a 41.7% annual rate of growth. The inflationary implications are staggering. This monetized debt can be compared to a huge pile of tinder just waiting for a lit match. That spark will likely come from rising interest rates.

2) “The yield on the 10-year T-note climbs above 2%.”

I wrote in January: “This yield is probably the tipping point signaling that the Federal Reserve through its financial repression cannot keep interest rates artificially low any longer. In other words, market forces will finally overpower the Fed.”

After the Federal Reserve’s FOMC meeting in May, the yield on the 10-year T-note climbed above 2%. The FOMC met again last week, and yields soared in the “biggest weekly rise in 10 years”. The T-note ended the week at 2.53%, the highest yield since August 2011. The Fed is losing control.

As I explained on King World News after the FOMC meeting: “Since the announcement of QE1 in March 2009, dovish statements from the Fed were bullish for Treasury paper – meaning lower yields – because the Fed’s buying of paper was soaking up supply.  However, we are now in a situation where the Fed is buying nearly all of the Treasury’s new debt issuance, but interest rates are rising.” The significance of this observation cannot be overstated.

Despite buying $540 billion of debt instruments over the past 23 weeks, the Fed is unable to keep interest rates at artificially low levels. Market forces are overpowering the Fed for the first time since the beginning of QE.

What the Fed does next is not predictable, but if they follow the same crazy monetary theories, we know what to expect. In an attempt to keep interest rates from rising, the Fed will monetize even greater amounts of debt instruments.

Right now the Fed is buying Treasury debt instruments and mortgage backed securities, but they have the authority to monetize anything. Maybe they will start buying municipals to ‘help’ struggling cities, but in reality would be surreptitiously bailing out banks that own this paper, the prices of which are collapsing. Maybe they will buy corporate debt to keep banks from becoming even more highly leveraged. Then there is a mountain of sovereign debt on bank balance sheets just waiting for a buyer to which the bank can sell to avoid the mark-to-market losses that come with rising yields. Even though banks can move this paper from their trading portfolio to their investment portfolio to avoid recording any mark-to-market loss, everybody knows the banks are teetering on insolvency, so accounting gimmicks are of no help.

We can of course only speculate as to what the Fed might do, but one outcome appears certain. It will not do what Paul Volcker did when he was Fed chairman. He raised interest rates to save the dollar, which highlights the stark reality of the Fed’s policy under current chairman Ben Bernanke.

Mr Bernanke’s objective is not to save the dollar. He thinks artificially low interest rates from repeated market interventions by central planners will enable him to save an overleveraged financial system that perpetuates government power by giving central planners the authority to create money out of thin air. Mr Bernanke is trying to prove that central planning and fiat currency are good things. Of course they are not, which brings me to the third thing I said to watch.

3) “The gold/silver ratio falls below 50.”

So far this has not happened, but I still expect it to occur this year. When silver breaks below this key technical point, its outperformance to gold will signal that both gold and silver are ready to move higher, but will do so with silver rising faster than gold.

There are two other things from January that require comment. First, I said: “Gold and silver will probably break out of their 2-year trading soon.” They did, but obviously not in the direction I expected. Nevertheless, none of the underlying reasons to own physical gold and silver have been diminished in any way. Their drop in price this year just enables the purchase of physical metal at lower prices under the on-going cost-averaging purchase program that I have been recommending since launching GoldMoney in 2001. This year is an opportunity to buy metal cheap just like occurred in 2008.

The second important point is that the odds of a black-swan event like the one experienced in 2008 with the Lehman Brothers collapse remain high. The reasons are that the interrelated sovereign debt and bank solvency crises have not been solved, and there have been countless interventions that have distorted and all but destroyed the market process.

So the outlook for gold and silver remains very bullish, and will continue to be as long as central planners intervene in markets, instead of taking the prudent course which is to return to sound money based on precious metals.