A very important Digest...
A very important Digest... A chart that doesn't lie... An interesting development in Nicaragua... Goldsmith's performance...
I've been writing for a few years now that the most important trend in finance is the relative performance of gold and U.S. "long" bonds. In this week's Friday Digest, I'd like to explain in plain language why I still believe it's "the only trend that matters" and what all the economic jargon really means.
The chart below displays the trend I'm talking about. Over the last year, gold has gone up roughly 25% more than U.S. Treasury bonds…
As longtime readers know, I write the Friday Digests personally, and do my best to teach you core investment strategies that everyone should know about (but that most people have never even heard of). Believe me, I understand most subscribers aren't interested in learning and the rest probably view these "lessons" as condescending. Nevertheless, I carry on. It is what I would want from you, were our roles reversed.
Let's start with the basics. On that chart above, the green line represents the price of one ounce of gold (GLD), measured in U.S. dollars. The blue line represents the price of long-dated U.S. Treasury bonds (TLT), which are also denominated in U.S. dollars. In terms of dollars, gold went up about 25% over the last year. Treasury bonds were flat. But what do these lines really mean?
The spot price of gold is set every day in London in what's known as the "gold fix." This is the price at which members of the London Bullion Market Association will readily sell gold. The five firms who set the price twice each day are Scotia-Mocatta, Barclays, Deutsche Bank, HSBC, and Societe Generale. This isn't a conspiracy. It's simply a tradition that developed in the early 1900s to facilitate a fair price for gold among all the members of the bullion association.
Today, the price is "fixed" in three currencies: dollars, euros, and pounds. When you ask what the price of gold is, more often than not, you'll get that day's "PM gold fix" price. The gold fix price is set at 3 p.m. London time to coincide with the market open in the U.S.
The price of gold can also be measured by trading in the futures markets. Here, market participants can buy and sell 100 ounces of gold for delivery in the future. So today, for example, you could buy gold on the COMEX futures market for near delivery (June 2011) at $1,535.90. And there's an almost continual bid for gold at various spot markets around the world. You can follow the up-to-the minute price of gold at Kitco's website.
Given that the supply of gold is essentially fixed (gold isn't typically consumed by industry and relatively little is produced each year), the only real factor influencing its price is demand. That's one of the main reasons why gold is seen by most experienced investors as an alternative currency, not an industrial metal.
People demand gold when their local currency becomes unreliable. People demand gold for savings during periods of global uncertainty. But most importantly of all, people demand gold when they no longer trust their government… which explains the antipathy between government-backed central banks and gold.
The "long bond" is the common term for U.S. Treasury obligations that mature in 20-30 years. The prices of these bonds are first set when the U.S. Treasury sells them at weekly auctions through primary dealers (20 large banks and brokers). But because long-duration bonds aren't sold in each auction, current prices for long bonds are determined via trading on the futures markets.
The largest market for Treasury bonds is the CME Group, which resulted from the 2007 merger of the Chicago Mercantile Exchange and the Chicago Board of Trade. Most of the other interest rates in the world are set from the price of the 10-year U.S. Treasury bond.
The prices of U.S. Treasury certificates (especially the long-dated variety) are heavily influenced by inflation expectations. To understand why, you have to remember the coupon payment on bonds is fixed. So if the Treasury issued a new 30-year, $1,000 bond today, at current interest rates, an investor would be paid a coupon of roughly $17.50 every six months. That represents a 3.5% annual interest rate. The bond would be said to trade at "par" at this yield.
In 2041, the investor would be repaid his $1,000 in principal. Over the life of the bond he would have received a total of 60 coupons, totaling $1,050 in income. Thus, the offer from the U.S. Treasury is: Allow us to borrow $1,000 now, and we will pay you $1,050 over the next 30 years and then we'll repay your principal.
But... if inflation were to go up over the next 30 years – pushing interest rates up in the process – then today's investor would have a problem. Higher interest rates will make his 30-year bond less attractive to investors than newly issued bonds, which would carry higher coupon payments. Say for example, interest rates go up to 6% annually. New Treasury bonds issued at this interest rate would pay an investor two coupons per year of $30 each. Over the life of a 30-year bond, that's $1,800 in coupon payments.
Which bond would you rather own? The bond that will pay you $1,050 over 30 years or the one that will pay you $1,800 over 30 years? Investors will prefer the bond that's paying more. As a result, the market price of the lower-paying bond will fall, until the yields are roughly equal. To reach a 6% yield, the price of the former bond would have decline from par ($1,000) all the way down to around $580. That's a huge loss for the bond investor.
That's why we pay so much attention to long bond prices: They are the market's early warning system for future problems with inflation. You can't buy a 30-year obligation with a fixed-coupon payment unless you have a lot of confidence in the government, currency, and the interest rate. Quite frankly, given our government's current policies, we can't imagine why anyone would own these securities at any price. And yet... interest rates remain low and bond prices remain firm. How do we explain that?
Two factors are distorting the market for Treasury bonds and warping interest rates around the world. First, China has produced a huge economic boom by recycling most of its foreign exchange reserves into the U.S. Treasury bond market. This lowers its currency's value. This cheap-currency policy inflates demand for its products around the world by allowing China to under-price its competitors. This, in turn, causes its trade surplus to grow ever larger and its foreign reserves to expand continuously.
This policy is unsustainable and dangerous. It will cause asset inflation in China's economy (which we've seen since 2004)… And if carried on long enough, it will lead to a big economic collapse. Almost the exact same cycle happened in Japan from the mid-1970s until 1989. We can't know exactly where we are in this cycle... But it is unsustainable.
The second factor warping the Treasury market is the Federal Reserve. In a misguided effort to sustain the American economy with negative real interest rates (which steal from savers and reward borrowers), the Fed has been purchasing roughly 70% of the total issuance of Treasury obligations. This buying is scheduled to stop on June 30.
I always believed that while the Fed (and the Chinese) could manipulate their currencies via unsustainable buying of Treasurys, it would always be evident in the market for gold. Think of it this way... the U.S. bond market is the ultimate barometer for the health of the global monetary system – a system based on the creditworthiness of the U.S. federal government. So while it's true world governments can manipulate the Treasury market, the efforts would eventually hurt the system's creditworthiness. And fears about the system would lead people to prefer gold to paper money.
That's why I believe the above chart comparing the prices of U.S. Treasury bonds to the price of gold is so important. It's a measure of the "system wide" health of the world's economy.
Here's the scary part. Look at the same chart over the last 10 years. The gap between gold and Treasurys has been widening since 2005…
This chart lays bare the false claims of our politicians, bankers, mainstream economists, and media that the economy is recovering, our debt levels are manageable, and the American way of life is safe and sound. As a newsletter publisher, it doesn't pay for me to be bearish. People won't pay for bad news. But this chart, unlike our leaders, doesn't lie. And the message is far too important to ignore. I hope you now have a better understanding of what it means.
I was at my partner's (Bill Bonner) ex-pat, beachfront community in Rancho Santana, Nicaragua last week. I hadn't visited for two or three years, and the progress they've made recently is stunning.
There are dozens of new luxury condos… at least a dozen new homes… a huge new clubhouse… and a new beach club. Several young families now live there full time. They've even started a community elementary school.
If you've never been there, you should see it for yourself. Or if you haven't been recently, you should go back – you'll be amazed.
Also, investors should note... There's a new development right next door, known as Gaucalito. The richest man in Nicaragua, Carlos Pellas, recently sold his bank for $1 billion (or maybe $2 billion) and is investing a huge sum – at least $100 million – in building the best resort in Central America. It will have a championship golf course, a luxury hotel, luxury homes, and Nicaragua's first real resort marina.
Many such developments have been promised over the last decade, without coming to fruition. But I stood on Gaucalito's new golf course last week. It's real. Once this resort opens in late 2012, the prices for land up and down the coast will go up.
If you're interested in a tour of the area, call my friend at Rancho Santana, Marc Brown. And just to be clear, while my friend Bill Bonner is the developer of Rancho Santana, I have zero stake in the development. I don't receive anything at all from lot sales there.
I pass along this information only because I think Rancho Santana is a special place... and I wouldn't be surprised if land values there double in five years. You can send Marc an e-mail at marcb@ranchosantana.com.
New 52-week highs (as of 6/2/11): Dreyfus High Yield Strategies Fund (DHF), Sprint (S).
Finally… a bit of humor for your weekend. To protect the innocent, I won't disclose where this video was filmed or the circumstances... But I can tell you the man in the middle is young Sean Goldsmith, who celebrated his 27th birthday this week. And apparently, is quite good with cowbells. Enjoy.
Good investing,
Porter Stansberry
Baltimore, Maryland
June 3, 2011