The Fed purchase of bonds is supposed to bolster the economy and increase employment. However, much of the money printed by the Fed has been used in a levered carry trade by banks and hedge funds. Speculative bets on bonds have been made with borrowed money at almost zero interest costs, with a large interest income spread of 2 to 3%. A 2% spread times 10 is a 20% guaranteed return.
However, as interest rates recently spiked up, investors have been exiting their bond investments with unexpected ferocity. Retail investors sold a record $48 billion worth of shares in bond mutual funds so far in June, according to Trim Tabs. Hans Humes, a hedge fund executive, said, “people are selling first and asking questions later.” The levered carry trade can make huge profits when bond prices are going up, but unwinding leveraged trades can cause large loses when prices are falling.
The threat of reduced bond buying by the Fed caused the $10.5 trillion Treasuries market to lose 2 percent in May, the worst month since December 2009. It fell another 1.3 percent in June, according to Bank of America Merrill Lynch index. Major U.S. banks and hedge funds involved in the bond carry trade have purportedly hedge their speculation with derivatives contracts. However, if everyone exits at the same time, history has proven derivative hedges don’t work if counter parties blow up.
While bond prices have dropped gold prices have increased. Gold prices are being supported by continued diversification from the dollar by central banks. Foreign gold buying has been countering outflows of ETF holdings. Fed Chairman Bernanke acknowledges he is illiterate when it comes to gold, and the history of fiat money. He believes the depression was caused by the gold standard and by the Fed not printing enough soft money. In reality soft money destroyed the Greek, and Roman Empires, and several Chinese dynasties. Ancient Empires debased currencies with metallic coins, various Chinese dynasties, such as the Yuan and the Ming, used paper money. Bernanke is the first soft money advocate to create fiat money with a computer entry.
As bond prices fall, and the West trades in paper gold derivatives, the Asians are taking delivery of physical gold and silver. Many in the West believe gold and silver are just commodities which go up and down. However, Chinese and India cultures see silver and gold as money, and a store of savings free of government debasement.
Texas oilman Bunker Hunt and Saudi Prince Abdullah attempted to corner the silver market in the 1970s with a few billion dollars, and drove the price of silver to $50. However, China’s foreign currency reserves have surged 700% since 2004. The combined total foreign reserves among Brazil, Russia, and India haven risen 400% since 2004, and now exceed $1.1 trillion. These reserves are primarily held in U.S. dollar denominated assets. If China sold U.S. dollars and bought gold, they have enough currency to buy every central bank’s official gold supply twice.
Chinese demand for gold is on the verge of eclipsing that of India, currently the world’s largest consumer. Financial expert, Jim Rickards, believes China is buying gold to diversify its reserves and to make the Yuan more attractive, with the end result of being included in a basket of currencies, referred to as the Special drawing Rate (SDR). He added there is a move to make the SDR the new global reserve currency. “Everybody knows the U.S. dollar’s days are numbered, but there is no currency to take its place except for the SDR”, he said.
The demand for physical gold is exploding all over the world, and bullion banks are now experiencing a supply crunch that is unprecedented. At some point the lack of physical gold may break the back of the paper gold market, and the spot price of gold and silver will spike.
Today hedge funds are short more than 10% of the entire open interest in the gold market of 667,000 contracts. Short sellers could become trapped in a dangerous short squeeze because foreign investors are buying gold and silver futures contracts and taking delivery. If just 10% of the buyers of expiring gold contracts legally claim delivery, Comex does not have enough gold in its warehouses to deliver.
Oil futures are all currently in a backwardation inverted curve, which indicates a tight physical market. Backwardation occurs when the front month futures contract commands a price premium to the subsequent months. Normally, futures contracts are in contango positive curve where the future months are higher than the front months. Gold and silver futures are almost flat but have flirted with a backwardation curve.
A sharp backwardation curve in precious metals will show a short squeeze. If hot money rotates out of equities and bonds into commodities, the Fed will eventually have to tighten monetary policy, causing interest rates to move into an inverted yield curve, which would result in a market crash. Many believe several Wall Street institutions will blow up again. Easy money encourages risky leveraged speculation. Many financial experts believe the five largest U.S. banks have become gambling casinos risking tax payers money with proprietary trading. Only God knows the future, but Proverbs 22:7 says, “The barrower is a servant of the lender.” And Proverbs 10:16 says, “Wisdom is better than silver or gold”.
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