Wednesday, March 27, 2019

Gold and Cryptocurrencies

The CHICAGO BOARD OPTIONS EXCHANGE was the first exchange (in December 2017) to provide futures trading in bitcoin. When a few days ago it announced it was terminating this service with the expiration of the June contract, severe selling of those still holding positions was expected to drive prices lower. That didn't happen. Trading was orderly with little changes in prices, which hovered just below the $1400 level that the market had been unable to surmount for several weeks. The next day the price sailed through $1400 and added another $29 before settling back below $1400. The fear of a debacle had vanished with optimism of higher prices, with $1500 cited by some as the next price target. That target was quickly hit on April 3, when the price shot up $1,000 in one hour and reached $1525 before settling back.

What happened? Attention was focused on the CBOE, but across town the Chicago Mercantile Exchange, which also had been dealing in bitcoin futures since December 2017, presented a different picture. On March 14, the day before CBOE announcement, almost $90 million worth of CME's bitcoin trading changed hands, compared to only around $8 million of CBOE's trading. But the CBOE story made the headlines, not the CME with more than ten times the trading volume and no problem.

Large swings in price are characteristics of not only Bitcoin but other cryptocurrencies. During part of 2011, the Bitcoin price dropped about 95%. It also dropped 85% between December 2013 and January 2015. The total market value of all cryptos is down about 85% from its peak in January2018. But Bitcoin has always bounced back from these huge declines and risen to new highs.

Despite discontinuing Bitcoin futures next June, CBOE expects to be involved in cryptos in some way. A spokesman said it is “assessing its approach with respect to how it plans to continue to offer digital asset derivatives for trading.” CBOE is owned by Intercontinental Exchange (ICE), which envisioned its participation here in crypto futures as a building block in a broader platform for trading and storing digital currencies and delivering metallic coins in the settlement of accounts. CBOE owns 18 existing exchanges, including the New York Stock Exchange. It planned to offer its crypto—called Bakkt—on the same exchange where it lists natural gas, cotton and coffee futures. The delay in launching Bakkt arose from disagreement with the regulator (CFTC) over how Bakkt should be regulated. Negotiations are continuing, including “warehousing” discussions related to Bakkt's responsibility for customer funds. But at least a dozen other companies are working on plans to launch futures trading backed by gold. So gold appears in the process of establishing an increasing presence in the cryptocurrencies.

If Bakkt or any other crypto is backed by gold, an interesting parallel arises with what happened on the Shanghai Gold Exchange. When the Shanghai exchange opened some years ago, it provided an opportunity for central banks to acquire gold without upsetting trading on the gold exchanges in New York and London, which deal mainly in trading futures contracts rather than physical gold. The banks didn't want to buy gold by dumping large amounts of dollars on the market since that would diminish the value of their remaining dollars. The SGE made it easy for banks to trade dollars for physical gold. If a gold-backed crypto can be bought with dollars, that will make it easy for millions of people to move dollars into gold. And in the long run, that could create pressure for making the dollar once again officially convertible into gold. In that case we will have come full circle back to a gold-backed currency.

Thursday, February 28, 2019

Central Banks Buying Gold

Gold buying rose spectacularly in 2018 led by the world's central banks, which increased their physical purchases by 651.5 tonnes. That's an astonishing 74 percent over 2017. This was the most gold these banks bought in more than a half century, since 1967. The world consumed 4,345.1 tonnes of gold in 2018, up from 4,159.9 tonnes in 2017. Jewelry demand was relatively unchanged at 2,200 tonnes. Retail investment in gold bars and coins grew 4 percent to 1,090.2 tonnes, which included a sharp 222-percent rise in demand in Iran for almost 62 tonnes.

Not only have central banks purchased more gold, but a number of new buyers have entered the market. Poland became the first European Union country to buy gold in the 21st century, adding 14 tonnes in the third quarter. The Hungarian central bank bought its first gold in 32 years, increasing its gold holding 10-fold. India added 21.8 tonnes, its first major increase since buying 200 tonnes off market from the International Monetary Fund in 2009. Mongolia bought 12 tonnes. Egypt bought gold for the first time since 1978, while India, Indonesia, Thailand and the Philippines re-entered the market after multi-year absences. The Russian central bank was by far the largest buyer of gold in 2018 adding an incredible 274 tonnes to its holdings. Since the beginning of 2017, Russia ranked first in gold purchases with 383.3 tonnes, followed by Turkey with 125.8 tonnes, and Kazakhstan ranked third with 68.4 tonnes.

Why has there been this large and growing interest by central banks all over the world in buying gold? The U.S. national debt is now $22 trillion, and that doesn't even include future obligations for Social Security, Medicare and Medicaid. Those will never be paid as promised, because the obligations are growing faster than government's income. Every dollar the federal government has borrowed in the last ten years, since 2008, has generated only 44 cents of economic output. The U.S. gross domestic product has increased 35% since 2008, but the national debt has increased 122%. So much for the Keynesian idea that government spending will promote economic growth.

As a candidate, Donald Trump promised to erase the entire national debt “over a period of eight years.” More recently he has shrugged off concern about the paying on the debt because “I won't be here” to take blame when the fiscal crisis blows up. That seems to be the attitude of a great many politicians. The fact that the dollar has lasted as long as it has as a fiat currency has perhaps led politicians to believe it can continue if not indefinitely then at least for their term of office. But a recent paper by two economic professors emeritus (Dennis W. Jansen and Thomas R. Saving) states: “The deficit and the cost of servicing the debt now take up more than half of all federal income tax revenue. The days of the Treasury counting on the Fed to help out with government finances are coming rapidly to a close, and the full bill for our fiscal policy choices is coming due”(italics added)not decades from now as many forecasts project, but far sooner.

The Fed creates money and uses it to purchase assets, such as mortgages and government bonds. These earn interest for the Fed. After paying its expenses, the Fed returns the remainder to the Treasury, which has been using it to service the federal debt. In 2006, for example, the Fed earned interest of $36.8 billion. And after paying operating expenses of $1.3 billion (plus the cost of rolling over a portion of maturing debt at current, higher interest rates), it returned $29.1 billion to the Treasury.

Following the Great Recession, the Fed greatly expanded its assets and liabilities, began to pay interest on bank reserves, and took other steps, the net effect of which was a large increase in Fed revenue and, therefore, in payments to the Treasury. In 2016 Fed transfers to the Treasury reached $100 billion and covered 48 percent of the debt servicing cost. The Congressional Budget Office projects that Fed transfers will cover only 11 percent of the debt servicing cost in 2019, and by 2020 the Fed will cover less than 10 percent of the debt service cost of $485 billion! That's $170 billion more than the $315 billion the government paid for interest on the debt in 2018!

President Trump on several occasions has said we need a “reset” of the dollar in the international monetary system. No indication of what this will consist of but it will necessarily be a devaluation of some sort for the dollar. The last two times the dollar was “reset” were FDR's reducing the value of the dollar to one thirty-fifth of an ounce of gold and President Nixon's 1971 eliminating any gold value to the dollar. The whole purpose of a “reset” is to try to avoid the consequences of years of fiscal and monetary extravagance, but it won't work. As the great economist Henry Hazlitt wrote many years ago: “If a government resorts to inflation, that is, creates money in order to cover its budget deficits or expands credit in order to stimulate business, then no power on earth, no gimmick, device, trick or even indexation can prevent its economic consequences." Not having learned that lesson from the past, we shall be forced to learn it under more painful circumstances in the future that is already at our doorstep.

There are trillions of dollars all over the world, not just in the central banks. In my view, the huge and growing gold purchases by the central banks result in large measure from fears the dollar will be “reset” in a way detrimental to the holders of dollars. So it's best to trade the dollars for gold before that happens. And that revaluation by the central banks will be followed and accelerated by dollar holders everywhere.