There has been an unprecedented attack on gold and mining shares over the past three years emanating from financial institutions in order to support the government’s supposed success in bringing the economy back to health. And even though gold-mining shares are down 85% during this period, the case for owning gold-related investments has never been more compelling.
The reason to own gold is the same today as it has been for thousands of years: it is the perfect store of wealth. Gold is portable, divisible without losing its value, beautiful, extremely scarce and virtually indestructible. It is simply the best form of money known to mankind.
Negative Rates
The case for keeping your wealth in gold only becomes more obvious when real interest rates are negative, faith in fiat currencies is crumbling and nation states are insolvent. The massive and unprecedented Quantitative Easing programs and Zero Interest Rate Policies among the Bank of Japan, Peoples Bank of China, European Central Bank and Federal Reserve clearly show that Central Banks have no escape from manipulation of their bond market, currencies, equities and economies. Ms. Yellen’s recent tacit admission that the Fed Funds Rate must remain at zero percent for at least a full seven years was a clear validation of this premise.
For example, if the BOJ were to stop buying every Japanese Government Bond issued, interest rates would skyrocket, the stock market would crash and the economy would melt down in a matter of days. That's because any nation that has a debt-to-GDP ratio of 250%, over a quadrillion yen in debt, and is in a perpetual recession should never be blessed with a 0.3% 10-year note yield.
Turning back to the Fed’s recent decision to hold rates at zero, its inaction should lift the veil on its omnipotence. As Clark Kent can attest, being “Superman” is easy; returning to normal can be awkward.
With $44 trillion in total non-financial debt, which is up $12 trillion in the last 10 years alone, we have also become a highly indebted nation that has become completely addicted to lower rates. The U.S. high-yield bond market, which was the catalyst of the 2008 financial crisis, has grown to $2 trillion in size -- a full $1 trillion of which has been added since 2009.
And They're Back
But high yield isn’t the only lesson unlearned since the 2008 crisis. According to CNBC, nearly two-thirds of the high risk Ginnie Mae guaranteed securities are issued by independent mortgage banks, affectionately referred to as part of the “shadow banking system”. And those independent mortgage bankers are deploying some of the most sophisticated financial engineering that this industry has ever seen. Sound familiar? With credit scores of 520 and down payments of just 3.5%, indeed it is clear that subprime mortgages are back with a vengeance.
Therefore, a rise in rates would further cool the already lukewarm housing market. According to the National Association of Realtors, sales of existing homes dropped 4.8% in August month over month to a seasonally adjusted annual rate of 5.31 million. Home ownership rates at 63.4% are already at the lowest level since 1967. Rising interest rates would not cause renters to become homeowners. Instead, it would likely send the home price to income ratio, which is currently at 4.4, crashing back to its long-term average of 2.6.
Turning to the interest paid on U.S. bonds, it is clear that mean reversion of the 10-year note would bankrupt the Treasury. That's because that average rate is north of 7%. If the Treasury was forced to service the existing $13.2 trillion of publicly traded sovereign debt at that rate it would take about 30% of all Federal tax revenue. Just imagine what will occur when rising rates cause the economy and revenue to decline, as deficits explode. Remember that annual deficits soared to $1.5 trillion during the Great Recession -- and that was with interest rates plummeting toward 2%.
The EMs
And then we have emerging markets, where a rise in US interest rates will reveal one of the great instabilities in the global economic system today. A total of $9.6 trillion in U.S. dollar-denominated debt is owned by non-U.S. borrowers. When the U.S. dollar strengthens, the cost to those foreign borrowers rises…a lot. Emerging-market economies’ debt is now 167% of their gross domestic product, which is up 50 percentage points since the end of 2007, according to figures from the Bank for International Settlements.
Which brings us to Brazil -- already suffering the effects of a slowdown in China, which announced austerity measures totaling $17 billion to bridge the gap in its budget after Standard & Poor’s Ratings Services downgraded the country’s rating to below investment grade.
Turing back to the U.S. stock market, low interest rates have fueled a whopping $2.5 trillion stock-buyback binge since the end of March of 2009. Higher interest rates would see the end of this corporate buyback scheme that provides an artificial boost to EPS and share prices.
And don't forget the several hundred trillion dollars’ worth of interest-rate-sensitive derivatives, including credit-default and interest-rate swaps underwritten by institutions, which will have to once again crawl back to the government for another bailout once their bets become insolvent.
Finally, seven years of ZIRP has forced pension plans far out along the risk curve in search of higher returns, vastly increasing the amount of equity exposure in their portfolios in an attempt to generate the necessary 9% average annual returns. However, the Dow Jones Industrial Average has already dropped to a two-year low without one single basis point rate hike in the last nine years. Ms. Yellen and company must be aware that if a cycle of rate hikes was to take place now it would not only bring increased competition for stocks, but also help push the anemic global economy into a recession. The result being that there wouldn’t be a solvent public or private pension plan in the entire nation.
The Fed is beginning to wake up to the fact that there is no easy escape from its artificial zero interest-rate policy. The Fed will not be able to move very far off of the zero-bound range before the yield curve inverts and the US, and indeed the entire global economy, melts down. This means real yields will become more negative, the US dollar will lose more of its purchasing power and economic instability will intensify over time -- the perfect fundamental backdrop for rising gold prices.
Inverse Relationship
As the credibility and effectiveness of central banks comes more into question, investors will seek comfort in gold because it is the sole monetary solution that has stood the test of time. This is why there is a direct inverse correlation between the faith in fiat currencies and the price of gold. Every few decades, a reminder is needed that all fiat currencies throughout history have lost all of their value.
Therefore, if you are among those who own gold and gold mining shares, consider yourself a part of a small and very fortunate club -- a cadre of investors that will be able to maintain its purchasing power and standard of living, while those with complete faith in fiat currencies get summarily remanded to the lower class.
Michael Pento produces the weekly podcast “The Mid-week Reality Check”, is the President and Founder of Pento Portfolio Strategies and Author of the book “The Coming Bond Market Collapse.”