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Gold, the Fed and the Looming Stock Market Correction Q&A

Stock-Markets / Financial Markets 2014 Sep 23, 2014 - 09:49 AM GMT

By: Money_Morning


Shah Gilani writes: My mailbox is still bulging with all your questions about everything I’ve been writing about recently. So I’m delving back in today to answer a few more.

Last week, I took on your “looming catastrophes” and “what-if” scenarios and told you what I would do – and what I hope our leaders in Washington and Wall Street will do. (Don’t hold your breath…)

Today, you’ve got questions about the Federal Reserve’s inflationary policies, the price of gold and the eventual stock-market correction.

Let’s go…

Q: The Federal Reserve has printed up trillions of new dollars to provide liquidity and prop up the economy. How does it plan to take that money out of the economy at the right time in order to not create runaway inflation? It can’t mop that money up by selling bonds – there are already too many out there. What options are at the Fed’s disposal? Thanks. -David T.

A: The Fed historically mops up excess liquidity by selling bonds. It sells bonds to the “primary dealers” who have to buy them from the Fed and into the open market through the federal funds market.

In this process, the Fed goes into the open market and executes repurchase agreements. A repurchase agreement is when a party – the Fed for our purposes – sells collateral (usually government bills notes and bonds) to banks and simultaneously agrees to repurchase that collateral at a future date. (The banks take money out of the system because the Fed is selling bonds and banks are paying for them with cash and credit.)

Repos can be overnight or can be “term” repos for any amount of time or term that both parties agree to. There’s nothing stopping the Fed from doing that if it wants to soak up credit. The central bank can also pay banks interest to park additional reserves at the regional Federal Reserve banks.

The theory is that if the Fed sells bonds into the marketplace, interest rates would start rising and rising rates would slow the velocity of money. The problem the Fed has is that rates can rise without central bankers “managing” them rising at some reasonable pace. If rates rise quickly because the Fed can’t soak up excess funds fast enough, prices could start rising (inflation) as producers try to offset the higher cost of manufacturing and production because their financing costs are rising.

The global worry over inflation is that central banks in the United States, in Europe – everywhere – have flooded the world with money. And all that money can’t be soaked up fast enough to offset coming inflation. However, because global growth is so slow, inflation hasn’t been a problem. That could change, and it could change quickly.

We’ll see if that happens and how adept the Fed will be at doing repos and paying banks to just park their money.

Q: I would like to know your opinion of the repo market’s recent and dramatic increase in “fails” (as reported by the Financial Times last month). What will the impact be on all financial markets? -Stan R.

A: The problem with the high level of “fails” is that they represent a liquidity problem in the making, and possibly a really big one. It is worrisome. First of all, a “fail” is shorthand for “fail to deliver.” When banks do repurchase agreements, meaning they lend each other money overnight or on a term basis, the party borrowing the money sells collateral (almost always government treasuries) to the party lending them money.

The repo is an agreement to later repurchase that collateral. The collateral has to be “delivered” by settlement date. Settlement date is the day the collateral is due to be delivered.

A fail to deliver, or “fail,” happens when the collateral isn’t delivered. Fails also happen in stock transactions. The problem with fails in the Treasury collateral marketplace is that the Fed has soaked up so many Treasury bills, notes and bonds that banks aren’t flush with them. Banks have to keep “reserves” at all times, and those reserves are usually stockpiles of Treasuries.

Because the Fed has taken inventory offline and banks still have to maintain reserves, the fact that they don’t deliver the collateral they promise (hence the “fail to deliver”) in a repo is because they can’t part with the Treasuries they have on account of the fact that they need them to count toward their “reserves.” It’s not a problem as long as counterparties believe the collateral is there and forthcoming. Or if they don’t get in and the money they lend is returned, it’s all well and good.

However, if fails mount, reserves get really tight and another panic ensues, meaning banks don’t trust each other’s solvency or that they will ever give over collateral they’ve promised, they could stop lending to each other. That happened in 2008. Banks just stopped lending to each other after overnight repo interest rates went through the roof. Banks figured it didn’t matter how much interest they were charging each other. If they weren’t going to get their collateral back, no amount of interest was worth it, so they stopped lending to each other.

Banks rely on short-term funding to survive. That’s why the increasing number of fails is worrisome. If the problem gets big enough, we could experience a bank liquidity crisis.

Q: You and others have made a case for rapidly rising gold prices. Yet gold has slowly been falling for more than a year. Do you have any idea why it’s been falling? -Stan S.

A: As the dollar rises, the price of gold generally falls. The same is true of oil and other commodities priced in dollars. Money watchers expect the dollar to continue to strengthen, and that’s one reason gold has fallen in price.

But investors seem to be thinking that there won’t be any currency wars, or major devaluations, or runaway inflation, or general debasement of fiat sovereign obligations. And so they may be selling gold, which they bought to hedge against all of those things.

They are wrong. All of those things are coming to pass, and maybe sooner rather than later.

That said, a lot of hedge funds stockpiled gold and are now selling it on account of it not having gone to $1,500 where they (me, too) expected it to get to. I believe gold is a “buy” here and would add to my position if it goes lower.

Q: Here’s my favorite head scratcher: “What legal or technological issue prevents a debit card denominated in precious metal from being issued in the United States?” I don’t mind Federal Reserve notes being the medium of exchange in our country – I just don’t want to store value in them. If I can use my dollar-denominated debit card overseas to buy something in euros, yen or whatever, surely we should be able to figure this out. -John B.

A: There are no legal or technological reasons, but there is a mechanical reason. We can’t figure that out because it’s not feasible. No private credit company or bank is ever going to back its customers or itself with gold or any precious metal. Precious metals prices are too easy to manipulate, and their fluctuating value (unless they are pegged) would make transacting in any medium based on them impossible to manage or hedge.

Q: Volume of derivatives has reached $710 trillion. How is it possible to generate that amount of money out of a world gross domestic product of only $72.5 trillion? -Bernard P.

A: It’s all about contracts. Derivatives have nothing to do with GDP. They’re agreed-to bets. You and I make up a bilateral contract, and it is real. We’ve added to the notional value of outstanding derivatives. They are based on nothing more than “reference” indexes, other securities, differences in spreads or whatever we as parties to a derivative contract agree to bet on.

They can be weapons of mass destruction because of how banks use them to “hedge” (change the accounted for value of what’s on a bank’s balance sheet or off the balance sheet) and due to how much exposure counterparties are subject to.

Q: Many experts are saying that stock markets are in for a correction. What is your opinion? -John M.

A: Oh, it’s coming. I wish I knew the date, but I don’t. I just know if it looks like a duck, walks like a duck and quacks like a duck, we’re ducked.

Thanks for all your questions, folks. I enjoyed answering them.

I’ll be back with a regular column on Thursday. See you then.

Source :

Money Morning/The Money Map Report

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