Gold Rehypothecation Is Not What You Think It Is

Those who hold gold and want it to go up, have claimed for years that the Federal Reserve is part of a gold “rehypothecation” scheme where the gold has been pledged as collateral to another.

Some perma-bear/gold and silver blogs like to publish fantastic stories about how all the gold held by the Federal Reserve was tied up backing the U.S. dollar, but when the dollar was taken off the gold standard in the 1970s, now all that gold was sitting there doing nothing and that’s when the Fed created this rehypothecation of gold scheme.

Folks, that’s a big bunch of crab-cakes. There is no such thing as a grand conspiracy of gold rehypothecation. What there is, is the fractional reserves system. The fractional reserves system was created by gold producers and gold traders themselves hundreds of years ago, long before the U.S. dollar was taken off the gold standard! To believe that the Fed is executing on some evil gold rehypothecation scheme in the wake of the dollar being taken off the gold standard in the 70s, you would have to not know the history of gold and how it became money, and you would have to have a very poor education in macroeconomics.

I have said this a dozen times before, and I will say it again. Be very careful where you get your education in economics from because your stock trading business just might depend on it.

You are about to learn that there is no such thing as a gold rehypothecation conspiracy. There is only the fractional reserves system. The same fractional reserves system that has its origins from the gold industry itself.

The Goldsmiths Create The First Form of Paper Money

The best way to think about this is to go back several hundred years to England when commodity money such as gold, was the prevailing medium of exchange and goldsmiths emerged as the first commercial bankers.

In this earlier era, people didn’t like to carry around all their gold or leave it sitting around the house because it was cumbersome and might even get stolen, so people asked their goldsmiths to store it. The Goldsmiths’ intern would give the gold depositors a paper receipt, and when a depositor needed to get some gold to make a purchase, he or she would use that receipt to redeem the gold.

The First Paper Money

Now, over time, three important things happened with this system.

The First Bank Interest

#1 – Gold depositors figured out that they could trade their gold receipts for goods rather than go back to the goldsmith to redeem the paper every time they needed to make a transaction. These receipts functioned in effect as the first paper money.

#2 – The gold depositors soon figured out that they didn’t have to leave their gold with the goldsmith for free. In fact, it wasn’t long before goldsmiths began competing for depositors’ gold. In those good old days, they didn’t offer fun entertainment passes and rebates to open an account. They did offer people interest on their gold deposits.

The First “Fractional Reserves”

#3 – Finally, the goldsmiths figured out that they could operate under what is today called a system of fractional reserves. For example, they might take in $1,000 of gold deposits and issue receipts for that amount to the depositors. However, they then might turn around and also issue another $1,000 in gold receipts as loans to other people, even though they didn’t have enough gold deposits to redeem all the receipts that they issued. The goldsmiths could operate this way because it was highly unlikely that everybody who held the $2,000 of receipts would all come in at once to demand their gold.

There is your origin of “gold rehypothecation”. There is no such thing as gold rehypothecation. There is only the fractional reserves system that was created by gold producers and gold traders hundreds of years ago, and that practice continues today. This is basic macroeconomics folks.

In the example of the goldsmith above, the implicit fractional reserve is 50%, or 0.5.

At this level, the goldsmiths would issue twice as many receipts as they had gold deposits for, and such a system allowed the goldsmiths to expand the supply of money over and above the amount of gold reserves they held in their vaults.

The Modern Banking System

Today’s modern banks function much like the goldsmiths of old, and you can see now how such banks can create money.

How Banks Create Money

Suppose, for example, a person deposits $1000 in Bank 1. This table shows the balance sheet for Bank 1 in this initial position, where both reserves and deposits are $1000:

Now suppose further that the bank’s Board of Directors decides that they are going to maintain a fractional reserve, or reserve requirement, of 10%. This means that the board of directors is betting that no more than 10% of their depositors will come in and demand their money at any one time. This in turn means they can lend out at least $900 of the new $1,000 demand deposit. This table shows Bank 1’s balance sheet after making such a loan:

Deposits remain at $1,000, but reserves fall to $100, while loans and investments go to $900.

At this point, the borrower from Bank 1 deposits the money in Bank 2, and this is reflected in Bank 2’s initial balance sheet in this table:

Now Bank 2 also has a 10% reserve requirement and so it can lend out funds, $810 to be precise, as indicated by Bank 2’s final balance sheet in this table:

By now you get the picture. When $810 is deposited in Bank 3, Bank 3 lends out $729. Bank 4 lends out $656, and so on. From this table, you can see how the actions of all the banks together produce what is called the multiple expansion of money:

The final equilibrium is reached when every new dollar of original bank reserves supports $10 of demand deposits. Through this expansion, the original $1,000 demand deposit creates an additional $9,000 of new loans and investments, and a total of $10,000 in new deposits.

The Money-Supply Multiplier

The money supply multiplier is simply one divided by the banks required reserve ratio:

In the example above, if the reserve is 0.10 or 10% then the money multiplier is ten (1 / 0.10), and ten times the original $1,000 increase in demand deposits is $10,000.

Let’s do one more example. Suppose the reserve requirement is instead 50%. What’s the money multiplier (MM)? (1 / .50 = 2) That’s right, it’s two. So, if Bank 1 receives a new demand deposit of $1,000, it can lend out $500 ($1,000 x 50% = $500). Bank 2 can lend out $250 and so on, until a total of $2,000 (2 times the original $1,000) of new money is in circulation.

The bigger the reserve requirement, the smaller the money multiplier and the less money that is created by a new dollar of demand deposits.

You might want to know where in the example above the $1000 of paper money that was deposited in Bank 1 originally came from. In the U.S., the answer is the Federal Reserve, the nation’s central bank. Through its control of bank reserve requirements, the Federal Reserve sets the level of interest rates and has a major impact on output and employment.

Fed Speak Jackson Hole Increase Risk of Deflation

Fed Conference Paper for Jackson Hole Economic Symposium shows that Fed sees a growing risk of deflation. The risk of the U.S. experiencing deflation over the next 5 years increases from zero in short term, to about 15%. For Japan, the risk remains around 50%. For the Eurozone, “in the short-run the risk of deflation is about 5% and it increases to about 20% over the next five years.”

Deflation is when both prices and demand (and GDP) fall at the same time. Employers all but stop giving raises. Deflation occurs when the inflation rate falls below 0% (a negative inflation rate).

Currently, the U.S. economy is experiencing disinflation which is a slow-down in the inflation rate where inflation declines to lower levels.

The best predictor of every inflation and disinflation cycle since 1967 is the CRB index. I wrote about the threat of deflation, the CRB index, and the crash of oil back in January of 2015 here: CRB Index.

Notice that the Fed is fighting the biggest disinflation cycle since the Great Recession.

Also out of Jackson Hole this weekend were comments from Fed Vice Chair Fischer who said that the Fed will not wait for 2% inflation to raise interest rates. Fischer said he is watching the China economy extra closely but that he’s skeptical of a link between volatility and U.S. monetary policy. Folks, that’s silly. The Fed began talking up rates over a year ago. That is why the U.S. dollar has gone up. The U.S. dollar rising has crashed the price of oil and other commodities, in addition to dropping U.S. export sales which has lowered earnings of many U.S. international corporations, which has made their stocks sell-off. That’s the direct link to monetary policy and volatility. I understand that Mr. Fischer does not want to be blamed for increased volatility but let’s not stick our head in the sand and pretend something else.

Mr. Fischer said, “We should not wait until inflation is back to two percent to begin tightening”. He said he is confident the economy is on track to achieve the inflation target. He said that the PCE inflation data “have recently been only above zero” due to temporary factors like declining oil prices. Mr. Fischer believes that energy price declines should be a one-off event for inflation. A one-off event? The U.S. dollar has been going up for a year now, and oil down along with it. What is Mr. Fischer’s definition of a “temporary factor”? All the evidence to date says that this is not something that is temporary. The 17% increase in the U.S. dollar since last summer has lowered exports and thus GDP.

Mr. Fischer said, “[We will] consider the overall state of the US economy as well as the influence of foreign economies on the US economy as we reach our judgment on whether and how to change monetary policy… At this moment, we are following developments in the Chinese economy and their actual and potential effects on other economies even more closely than usual.” He reiterated that the Fed will proceed cautiously in normalizing policy and that the Fed can remove accommodation at a very gradual pace.

Q2 GDP Revised Up to 3.7%

Q2 GDP was revised up to 3.7%. This was a positive surprise and just above the consensus range of 2.7% to 3.6% growth.

Consumer demand was strong with personal consumption expenditures at a 3.1 percent rate led by an 8.2 percent rate for durables, a gain that was tied to vehicle spending.

The economy’s acceleration is now much more respectable from the first quarter when growth, at only 0.6 percent, was depressed by heavy weather and special factors.

The S&P 500 exploded higher on the news:

Stock traders track the GDP report because GDP is the all-inclusive measure of economic activity. Traders like to see healthy economic growth because more business activity translates to higher corporate profits.

Durable Goods Orders Up 2%

The mainstream financial media is hyping the Durable Goods Orders report which came in at 2%. New orders rose 2% in July which beat out the pathetic expectation for a 1.2% gain.

Orders for vehicles were up 4% in July, following June’s 0.8% gain. Vehicle shipments are up 3.9% following a 0.9% gain last month.

Here are some of the headlines in the mainstream financial media today regarding the Durable Goods Orders report:

“Durable goods orders crush expectations” (Business Insider)
“Durable Goods Orders Unexpectedly Rise in July” (Fox Business)
“Dow implied open +400 again amid durable goods orders” (CNBC)
“Stocks Rebound at Open After Durable Goods Surprise” (TheStreet)
“US Durable, Capital Goods Orders Climb in July” (Bloomberg)

So what does the Durable Goods Orders, new orders sub-component chart really look like?

Pfff… LOL. New orders actually fell from the previous month! You would think the chart would show a huge move up with all those sensational headlines. That chart looks absolutely pathetic. It’s vacillating around zero. Don’t get me wrong, at least it’s above zero so it does show very weak growth but let’s not kid ourselves that this is some kind of shocking, unexpected, rebounding and climbing number, LOL.

Traders track this report because orders for durable goods show how busy factories are. The data includes refrigerators, cars, industrial machinery, electrical machinery, and computers.

Former Treasury Secretary Says Rate Hike Serious Error

The Former US Treasury Secretary Lawrence Summers said that the Federal Reserve raising rates in the near future would be a serious error. FT News reports that Mr. Summers said, “A hike now would threaten all three of the Fed’s major objectives, price stability, full employment, and financial stability.”

Mr. Summers went on to support his statement, “More than half the components of the consumer price index have declined in the past six months, the first time this has happened in more than a decade. CPI inflation, which excludes volatile energy and food prices and difficult-to-measure housing, is less than 1%. Market-based measures of expectations suggest that, over the next 10 years, inflation will be well under 2%. If the currencies of China and other emerging markets depreciate further, US inflation will be even more subdued.”

Is Mr. Summers motivated by politics to come out and make such a statement? We know that Democrats are pressuring the Federal Reserve to not raise rates before the next Presidential election as if the economy crashes, Democrats will have practically zero chance of re-taking the White House.

In 1993, Mr. Summers was appointed Undersecretary for International Affairs of the US Department of the Treasury under the Clinton Administration. Mr. Summers was appointed by the partisan Obama administration, serving as the Director of the White House United States National Economic Council for President Barack Obama from January 2009 until November 2010, where he emerged as a key economic decision-maker in the Obama administration’s response to the Great Recession.

We know Mr. Summers is a long time Democrat and so it is possible that he is being motivated, at least in part, by a political agenda. Nevertheless, I happen to agree with every point Mr. Summers made even if he was politically motivated to make such comments about Federal Reserve monetary policy.

Yield Curve Flattens on Institutional Trader Selling On TICK

The yield curve has been flattening over the last 3 months at a rate that appears to be beyond just the normal ebb and flow and “heart beat” of the yield curve.

Check out what short term yields (3 month) have done for the last 3 months:

Short term yields are impacted by the Fed’s discount rate adjustment and so for the most part, short term yields are flat for the last 3 months. The big run up in short term yields in early August was bond traders timing a September rate lift-off by the Fed. As the economy has continued to weaken and countries around the world continue to devalue their currencies which hurts U.S. exports (rising U.S. dollar), the FOMC Minutes released on 8/19/15 made more traders believe that a rate hike will not happen in September. In fact, some think the economy is too weak to raise rates and the Fed will ultimately need to devalue the U.S. dollar in order to defend the U.S. dollar in the global currency wars. That’s why gold is surging higher.

Check out what long term yields (30 year) have done for the last 3 months:

Long term (30 year) yields are down almost -10% over the last 3 months, while short term (3 month) yields are flat. In other words if we were to graph out all the yields on a single chart, we would get the yield curve chart (published on stockcharts.com):

I have turned on the “Trail” setting so you can see a short history of where rates have moved from. Clearly you can see that the yield curve is flattening as long term yields are coming down, while short term yields are fixed at near zero percent.

Banks make big money off a normal to steep yield curve. They borrow money short term, loan it out long term, and make a profit off the spread. When the yield curve flattens, there’s less profits to be made by banks. That’s why bank stocks have been hit hard over the last few weeks. Check out the SPDR Bank S&P ETF:

The SPDR Bank ETF is down -7% over the last 2 months as the yield curve has been flattening at a quick pace.

As yields come down with the flattening yield curve, the big winners are stocks that trade in the Utilities sector because of dividends. Utility stocks dividends are more attractive as bond yields come down. This is why over the last 53 days, utility stocks are leading all other sectors:

Institutional Trader Selling on the TICK

The TICK detected institutional trader selling on Thursday, August 20, 2015:

The institutional selling was broad based but notice what happened with the offensive consumer discretionary/cyclical sector versus the defensive consumer staples sector:

Consumer discretionary/cyclicals fell -2.81%, while consumer staples fell just -0.91%.

Existing Home Sales Honey Badger Don’t Care

The Existing Home Sales report showed existing home sales up a stronger-than-expected 2.0 percent in July to a 5.59 million annual rate. Sales are up 10.3 percent year-on-year, with the median price rising 5.6 percent to $234,000.

Check out this strong uptrending chart in existing home sales:

The market should get some type of bounce on the Existing Home Sales report, right?

Honey badger bear, don’t care, about the existing home sales report.

Stock traders track existing home sales because of the multiplier effect through the economy. People have to be feeling pretty comfortable and confident in their own financial position to buy a house. Once an existing home is sold, it generates revenues for the realtor. Home buyers often purchase refrigerators, washers, dryers and furniture. The economic “ripple effect” can be substantial.

Philadelphia Fed Business Outlook Survey Very Weak

The Philadelphia Fed Business Outlook Survey came in at 8.3 for August. That’s a tiny little move up from the 5.7 reading in July and shows a weak business environment. This index has plunged since the beginning of 2015, far below the highs of 2014. The demand for manufactured goods, as measured by the survey’s current new orders index, remains low as well, falling slightly more than 1 point to 5.8 in August.

Price pressures for inputs are subdued with more firms reporting price decreases for their products than reported price increases.

The S&P 500 plunged on the Philadelphia Fed Business Outlook Survey:

Stock traders track the Philly Fed survey because the stock market likes to see healthy economic growth because that translates to higher corporate profits. The bond market prefers more moderate growth so that it won’t lead to inflation. The Philly Fed survey gives a detailed look at the manufacturing sector, how busy it is and where things are headed. Since manufacturing is a major sector of the economy, this report has a big influence on market behavior.

FOMC Minutes Tank Treasury Yields

The FOMC Minutes from the July 28-29 meeting cheat sheet:

– Several participants expressed concerns about China

– Most voting members say economy is not strong enough yet for a rate liftoff. Most members thought conditions were not yet appropriate for a rate liftoff, but we are “approaching” those conditions

– Further progress towards goals was seen but many officials felt more progress was needed towards lowering labor market slack

– The labor market was at or very close to maximum employment for this Bull/Bear cycle

– Downward pressure on inflation from energy and the USD was expected to abate

– Some members were concerned that by delaying a rate hike there could be inflation risks

– Considered some revisions to Summary of Economic Projections Members judged that information received since the FOMC met in June indicated that economic activity had been expanding moderately in recent months.

– The labor market had also continued to improve, with solid job gains and declining unemployment.

– A range of labor market indicators, on balance, suggested that underutilization of labor resources had diminished since early this year. Members generally viewed these developments, together with appropriate monetary policy accommodation, as supporting their expectations for moderate economic growth in the medium term and for further improvement in labor market conditions. They also continued to see the risks to the outlook for economic activity and the labor market as nearly balanced.

– Inflation had continued to run below the Committee’s longer-run objective, but members expected it to rise gradually toward 2 percent over the medium term as the labor market improved further and the transitory effects of earlier declines in energy and import prices dissipated.

– Some participants also discussed the risk that a possible divergence in interest rates in the United States and abroad might lead to further appreciation of the U.S. dollar, extending the downward pressure on commodity prices and the weakness in U.S. exports.

– The effect of financial stresses related to Greece and China on the largest U.S. financial firms was limited to date.

– Committee noted that, on balance, a range of labor market indicators suggested that underutilization of labor resources had diminished further. Most members saw room for some additional progress in reducing labor market slack, although several viewed current labor market conditions as at or very close to those consistent with maximum employment. Many members thought that labor market underutilization would be largely eliminated in the near term if economic activity evolved as they expected. However, several were concerned that labor market conditions consistent with maximum employment could take longer to achieve, noting, for example, the lack of convincing signs of accelerating wages, which might be signaling that the natural rate of unemployment could currently be lower than they previously thought.

– Most members viewed the incoming data as reinforcing their earlier assessment that, although inflation continued to run below the Committee’s objective, the downward pressure on inflation from the previous decreases in energy prices and the effects of past dollar appreciation would abate. However, core inflation on a year-over-year basis also was still below 2 percent. Moreover, some members continued to see downside risks to inflation from the possibility of further dollar appreciation and declines in commodity prices. In addition, several members noted that higher rates of resource utilization appeared to have had only very limited effects to date on wages and prices, and underscored the uncertainty surrounding the inflation process as well as the role and dynamics of inflation expectations. The Committee agreed to continue to monitor inflation developments closely, with almost all members indicating that they would need to see more evidence that economic growth was sufficiently strong and labor markets conditions had firmed enough for them to feel reasonably confident that inflation would return to the Committee’s longer-run objective over the medium term.

– The Committee concluded that, although it had seen further progress, the economic conditions warranting an increase in the target range for the federal funds rate had not yet been met. Members generally agreed that additional information on the outlook would be necessary before deciding to implement an increase in the target range.

Treasury yields plunged on the FOMC Minutes release today:

The drop in treasury yields suggests that most traders view the FOMC Minutes as pushing back the date for a rate increase as the U.S. economy continues to slow.

The complete collapse in oil prices puts disinflationary pressures on the U.S. economy. Also, the slowdown in China could pose risks to the U.S. economic outlook as a number of large U.S. corporations have exposure to China.

Most traders viewed the FOMC Minutes in a bearish light and bought more defensive bonds which pushes yields down.

You can view the complete FOMC Minutes from the July 28-29, 2015 meeting at:
http://www.federalreserve.gov/monetarypolicy/fomcminutes20150729.htm