These are confusing times to say the least. On one hand we are being told the United States of America economy has been recovering. On the other hand, the Federal Reserve is still adding $200 Billion a month and the government is proposing trillion-dollar stimulus packages.
Why is the Federal Reserve increasing its balance sheet if the economy is growing again? The following chart shows the increase of total assets at the Federal Reserve. Source https://www.federalreserve.gov/monetarypolicy/bst_recenttrends.htm
Why has the US Treasury been spending its cash (held at the Federal Reserve) to buy back Treasury Bills? There has been more than $480 Billion spent. Was the intention to have investors buy longer dated Treasury debt to help keep rates from rising? And why were rates rising so fast on a percentage basis? This rise in rates equates to Treasury Bonds dropping almost 20% in price from the peak last August.
The answers have little to do with the economy and more to do with the leverage in the monetary system.
With chronic US Budget deficits as far as the eye can see, the Federal Reserve was buying nearly all the issuance of new US Treasury Securities up until July of 2020. Then the Federal Reserve decided to reduce the Treasury securities they would be purchasing from their Primary dealers. That is where the turn begins. Without the Federal Reserve, Primary Dealers had to hold a larger supply of debt using leverage from their balance sheet. As US Treasury securities began to turn down in price, these Primary Dealers’ balance sheets began to haemorrhage losses. This crescendo continued through March of 2021. As the losses mounted, the US Treasury decided to start paying down Treasury Bills in February which attempted to liquify and deleverage these Primary Dealer’s balance sheets. By the end of March 2021, of the $480 Billion in Treasury Bill paydowns, $370 Billion had increased Bank Deposits while $110 Billion went to reducing Bank Repurchase Agreements Outstanding. Essentially, the $110 Billion disappeared as fast as it was created. What remained were the ashes from trading losses as bond prices declined.
THE FED EXPANDS ITS BALANCE SHEET
To understand the system and why the Federal Reserve must continue to expand its balance sheet, regardless of the economy, one needs to simply understand the idea that the Federal Reserve’s Primary Dealers do not have the capacity to buy endless amounts of US Treasury Securities. They rely on the Federal Reserve to periodically cash them out. This is where the drawdowns in the US Treasury account at the Federal Reserve (the rubber) meets the upcoming waves of new US Treasury supply (the road). Without the Federal Reserve to absorb and fund this new supply, prices for US Treasury securities will begin to fall again. This will have tremendous repercussions not only in the financial markets, but for real estate as well.
However, before the law of gravity takes over, the Federal Reserve has their last and greatest tool in the toolbox. This is called Yield Curve Control (YCC). Basically, this is an unlimited amount of money creation buying a fixed price of securities. Essentially it is a peg where yields become artificially suppressed. The Federal Reserve goes from a lender of last resort, to a buyer of last resort. This activity is where inflation will begin to fester. We have not seen the toxic side of inflation for more than 40 years. To make matters worse, inflation is not as much as a monetary phenomenon as it is a psychological phenomenon. The entire financial system is simply a complex confidence game. Inflation may come from too much demand chasing too few goods, tightening or shortages in supply chains, or lastly, confidence in the currency itself.
Fiat currencies do not last forever. At some point, debts become too large and the power to inflate them away becomes the path of least resistance. Central Bank balance sheet expansion could be interpreted as a form of inflating away the debt. What makes this environment more interesting is that Central banks have not just been buying government securities, but other financial assets to stimulate or support asset prices in general. This creates ever-increasing asset prices and widens wealth inequality. Essentially, we are trapped and addicted to Central Bank intervention.
DECENTRALISED AND UNDERVALUED
To put this insanity into perspective, after the Great Financial Crash (GFC) in 2008, the USA weekly initial jobless claims peaked at 665,000 claims per week. Since March of 2020, US initial jobless claims have stayed above the GFC peak of 665k for a year now. Below is the chart with the yellow horizontal line at 665,000 claims.
I believe governments and central banks cannot allow yields to rise much past 2% since that may choke off asset prices. To prevent higher interest rates, Yield Curve Control measures may drive inflationary pressures and commodity prices higher.
Germany was in a similar situation in 1931 with large deficits. The US has the same three options that Germany had:
1. Discover a extraordinary productivity-enhancing technology and deploy it in record time.
2. Massively slash government spending (austerity). Politically and economically unsupportable since US Government spending is greater than 20% of US GDP.
3. Federal Reserve finances the US Government with increasingly larger amounts of new money. Ideal path of least resistance.
If the USA decides to print its way out, the next chart provides a great example of just how much commodities are undervalued to paper assets.
To put into perspective silver’s cheap relative valuation, the following chart above is the Dow to Silver Ratio - 100 Year Historical Chart.
This chart tracks the ratio of the Dow Jones Industrial Average to the price of silver. The number tells you how many ounces of silver it would take to buy the Dow Jones Industrial Average on any given month. Currently, it takes 1,321 silver ounces to buy the Dow Jones Avg. In 1980, at silver’s peak of $50, it took only 24.50 ounces. At current Dow Jones Industrial Average levels, silver could go to $1,375 an ounce to equate to the 1980 peak of 24.5 to 1 ratio. The risk/reward is very favourable for silver here.
This is where the recent global silver movement takes hold. Many are recognising the value in silver, relative to other assets. Silver is one of the few commodities that is still at 1970’s prices. Investors have bought nearly 20% more silver American Eagle 1 OZ Coins during the first 3 months of 2021, than same period in 2020. And 32% more silver American Eagle 1 oz Coins during the first 3 months of 2020, than the same period in 2019.
During the first quarter of 2021, over 30 million silver ounces have been delivered off the Comex (Commodity Futures Exchange). This unprecedented demand is being felt around the world as physical silver investment products continue to be in tight supply. The recognition for gold and silver began over 3 years ago, as higher net worth investors began increasing precious metals allocations to their portfolio. One very important note, the gold and silver markets began to be deleveraged in 2020. This is one of the most important events in this sector. What this means is that the paper metal contracts and unallocated positions in London used to influences the price via leverage is greatly being diminished due to Basel III regulation regarding the Net Stable Funding Ratio where unallocated metal is not treated the same as allocated metal on a bank’s balance sheet.
Investors are not just buying gold and silver as a hedge against inflation or negative real rates, but rather for systemic and counterparty risk concerns. As the overall system becomes more leveraged, more risk enters the equation. Whether it be situations like GameStop, Archegos Fund, overcrowded passive strategies, or simply pure momentum driven frenzies, PHYSICAL precious metals offer something no other asset can, 5000 years of history. Physical metal is the ultimate decentralized asset which provides safety in times of uncertainty. The ultimate safety—no counter party risk!
EDUCATION, BEFORE DIVERSIFICATION
I own one of the largest private depositories in the USA (www.goldsilvervault.com), manage a physical gold and silver fund, provide transaction services which offer some of the lowest premiums on physical products globally for high net worth investors, and have been an Investment Advisor since 1992. For individual or institutional investors buying precious metals, please carefully read any user or storage agreement before investing. Education is key and buying metals does contain risk beyond the price alone. Understand the advantages of owning the metal directly whether within arm’s reach or held segregated in a professional vault. Precious metals can be a wonderful addition to a portfolio when owned correctly. EG