Friday Metals recap, 10/25/2013

Quick update. I still have no position in gold or silver. Gold is up over 5% since my bearish post 2 weeks ago, when I thought the charts looked awful. They've improved (the weekly head and shoulders in gold turned out to be a false alarm). But ... I'm still watching the 144-day MA (purple, at $1360). If that's cleared on a daily close I'll move in, looking to sell half at the important dotted blue line ($1400) and more at the 200-day MA (red, at $1432), where I expect at least some very strong short term resistance. But that's assuming the 144-day MA is cleared, which I give at best a 50/50 chance.

Alternately, the (similar) 20-30 week MA "ribbon", which ranges from $1323 to $1361:
I consider that $40 interval a no man's land. Let's see if it can be cleared on a weekly close, which would be a good first step for those of us who think gold can still break $2000 in the next year or two.

Friday metals recap, 10/11/2013

My proprietary weekly three-line break charts based on ratios with GDXJ (which indicate when to go long gold and silver, respectively) have reversed, as I predicted a few weeks ago. So, the short gold and silver bull cycle in the intermediate bear cycle would appear to be over. 

I still expect the top of the expanding wedge below (green, dotted) to be hit on my world-famous "yields in silver" chart before gold bottoms. Clearly, there's a ways to go (for example, at the current 10-year yield of 2.7, silver would have to fall to a 15-handle). 

Also, please note the obvious bull flag on the two year version of the ratio.  

Now, take a look at the 20-30 week MA-ribbon below (similar to my old stand-by 144-day MA). I've been emphasizing it for the past several weeks: gold never cracked it, and now we see an obvious (so obvious, could it possibly have been painted??) head and shoulders pattern, with the right shoulder smack at the lower bound of the ribbon.

One Currency Zone - Two Circuits

(New Gold Supra-Theory Salon des Refusés – Post 4)

We are delving into the workings of the Eurosystem’s TARGET2 system (T2) using circuit theory to separate it into discrete circuits in order to try to identify whether gold could improve this system. The Euro gets the job done in the household consumption circuit (discussed here).

Earlier we referred to the other components of T2 as the 'non-consumption circuit' to differentiate it from the circuit we were exploring. Now we are trying to determine if gold has any potential role in correcting TARGET2 imbalances through some other circuit involving goods that aren't consumed.

Monetary circuit theory is a way of looking at endogenous money creation by a banking system. Individual banks generally borrow first and then lend. So it’s difficult to detect this endogenous money circuit by looking at the books of a single bank. Banking systems lend money into existence in the form of deposits. The money created by one bank’s lending surfaces as a deposit on the books of another bank.

A key point to remember as we look at this T2 system is that by trying to separate it into two circuits we are creating a simplified conceptual model in order to try to understand a few specific issues. The reasons for the current TARGET2 imbalances and to determine if gold could have helped to prevent them or correct the imbalances if it played a different role in the system today aside from being the primary ECB reserve asset.

Before we press on here’s a recap on the household consumption circuit theory. The fathers of the Euro used a modified version of the price>specie>flow mechanism in the design of the Eurosystem. I’ll style this here as prices+>Euro>flow. The phrase ‘prices+’ is used to indicate that there are more factors involved than prices alone. Under a free trade regime the money flows in this mechanism automatically correct imbalances in the availability and diversity of the most-demanded consumption goods and services across the Eurozone.
In this post I’m going to draw on one of the BIS Working Papers (No. 393) titled “Interpreting TARGET2 balances”. (Hat tip to Piripi Peterson for the original link to it.) Even if you don’t have time to read the whole paper take a look at the graph on Page 1 titled “The TARGET2 claims of the Deutsche Bundesbank”. The range of fluctuations in the DB's T2 balance was reasonably consistent from 2000 to 2007. Then it took off between 2007 and 2012. I think we can summarise the conclusions of the authors of this BIS paper as follows:

1. The German banks were pulling loans and repatriating funds from the Club Med countries.

2. Money from international banks was positioning itself in Germany for a breakup of the Euro single currency zone. Hedging “redenomination risk” (or speculating on it) with the aim of being redenominated into a new Deutsche Mark if the breakup happened.

3. The Eurozone inter-bank credit market seized up.

Issues 1 and 2 offer the best explanation for the bulk of the T2 imbalance but I think item three is the one that we should focus on. Under normal circumstances the existence of the Eurozone inter-bank lending market can’t be detected by looking at T2 because clearing occurs between banks before any net balances flow through the TARGET2 payments system. (In that BIS paper the authors explain this using simplified balance sheet entries.)

I think we can also see an inter-bank credit circuit exposed by the T2 imbalances that complements our household consumption circuit. A circuit that mainly funds transactions involving assets as opposed to household consumption goods and services. Exploring the Eurozone monetary system with this perspective could be an interesting exercise but our focus here is on the question of whether gold has a role to play in this circuit and in correcting T2 imbalances.

When the Eurozone inter-bank market froze this circuit became visible on the central bank balance sheets because a central bank is the lender of last resort. It’s only in times of crisis that the lending which normally occurs in the inter-bank market moves onto the balance sheets of central banks. If the cause of a banking system crisis is merely a lack of liquidity the solution is to supply Euro - not gold. If the problem is insolvency the solutions are an orderly bankruptcy, merger with a stronger bank or recapitalisation of the insolvent Eurozone bank with Euro.

One of the major challenges for a central bank is that a liquidity crisis and a solvency crisis are identical in appearance. (Being able to view these net inter-bank flows via T2 doesn’t tell the ECB Eurosystem what is on a commercial bank’s books.) In a crisis the CB must act and carry out a forensic investigation later. In my opinion the right solution to this problem is the banking union and making the ECB the chief regulator of Eurozone banks (with a mandate to deal with the underlying causes of crises pre-emptively).

Highly-rated sovereign debt forms part of this inter-bank credit circuit because it is classified as a risk-free asset for banks under BIS rules. That BIS paper identifes sovereign debt as one of the underlying factors in the current T2 imbalances. Normally the sovereign debt held by banks is imbedded in the inter-bank credit circuit. In an ongoing crisis like the present one it erupts onto central bank balance sheets as collateral for emergency funding.

It doesn't seem likely that gold could address any of the problems in this inter-bank credit circuit of the Eurozone monetary system. To identify gold’s role in this new international monetary and financial system I think we need to turn our attention to currencies and the concept of a risk-free asset. Then we can restart the discussion about gold and international trade settlement (after we deal with a couple of the issues that hindered the first attempt).

New Note Circulation Tuesday 8th October

On Tuesday, the new redesigned $100 note will start circulating, at least according to the press release from last April, which I presume is not affected by the shutdown.


The ECB Targets 1752 (Part 3)

(New Gold Supra-Theory Salon des Refusés – Post 3)
In the discussion thread of this post I think we clarified some important issues around the theory about the adjustment mechanism for household consumption-driven imbalances in the Eurozone. In the course of the discussion it became obvious that gold had no role to play in the operation of this mechanism in the Euro currency zone. The Euro can and does get the job done.

This isn't the end of the story. My view hasn’t changed that the probability of gold being a key part of a new international monetary and financial system has such a high probability that it approaches inevitability. Determining the limits of the role of gold in this new system is a valid line of enquiry too. If gold is making a comeback let’s not be right for the wrong reasons.

Kudos (in alphabetical order) to DP, Piripi Peterson and Victor The Cleaner for engaging in the discussion and presenting their perspectives. We clarified some issues about the composition of the HICP Eurostat inflation index that I want to share with you here in the Salon des Refusés. This is where theories that don’t make the cut for the New Gold Supra-Theory will reside. We also discussed a circuit theory approach to understanding the TARGET2 balances that has identified one of the potential roles for gold in the Eurosystem.

Let’s briefly recap on the theory about the consumption circuit and incorporate some of the input from the discussion about the first two parts of this post. I presented the theory that the fathers of the Euro incorporated a modified version of the classical economists “price>specie>flow” mechanism into the design of the Eurosystem. I style this mechanism as prices+>money>flow for a currency zone but it should be rendered as prices+>Euro>flow in the EMU single currency zone.

The adjustment mechanism in the consumption circuit allows the ECB to target it’s two (2) per cent average annual inflation rate with feedback from the Eurostat HICP consumer price index (CPI). On their web pages discussing the HICP the ECB says here: “Key priorities for the coming years are the treatment of owner-occupied housing (currently excluded)....”

If they are including new housing consumption in their index and excluding land already then we will argue that they should Stop right there! The HICP is already capturing the only useful data on owner-occupied housing (OOH) that a consumption index can utilize. If Eurostat isn’t including any part of the consumption associated with new OOH then we propose an approach that will solve three statistical analysis problems associated with OOH that bedevil other CPIs around the world. These problems are: volatile land prices, resales of existing homes and rent (housing services).

If data on house prices that separates land prices is gathered in your region it should be clear that the replacement cost of a house closely tracks increases in the general price level.  Armed with this data it also becomes obvious that it’s the land component of housing that experiences these boom-bust cycles. (One bonus in excluding land from your CPI is that you reduce the volatility in your index.) It is self-evident that houses deteriorate over time unless they are maintained. This is the consumption component of OOH. (There are question marks over the correct treatment of depreciation, repairs and maintenance so I’m going to put these issues aside for now. It's not a deal breaker however you treat them!)

You can also record the purchase of a new house (minus the land component) as a single consumption event in the year in which it occurs. Here’s why: let’s say this new house has a life of 40 years. The first owner has purchased 40 years of house consumption. Even if the house is sold every 10 years each of the 4 owners only “consumes” one quarter of that initial consumption item over the ‘working’ life of that house. So you can exclude resales from your CPI as well.

In the comment thread here Victor The Cleaner offered the analogy of a new car purchase to explain this principal: “If you purchase a new car and then sell it after a year, the value added that you have consumed is only the difference of the prices. Same for the next owner in line after you, and so on, until the car is eventually scrapped. So in effect, the purchase price of a single new car needs to be counted once.” This analogy also deals neatly with the depreciation issue.

You solve the rent/housing services problem by not treating OOH as a form of quasi-income. Occupying a house may be a cost saving if it’s owned outright but an avoided cost isn’t income. If you want to test this out wander past a Ferrari showroom and decide not to buy one and then check your bank balance to see if you are any wealthier. If one of our 4 owner-occupiers in the example above is replaced by a tenant for 10 of those 40 years it’s still part of the consumption life cycle of the house that began with the original purchase.

Rent on a house can be equated to an interest-only private loan. The landlord has invested in an asset. The tenants have an overhead that reduces their disposable income – the income available for consumption. The rent paid by the tenant could result in an increase in the disposable income and consumption of the landlord's household which would be detected by the HICP anyway. This is a transfer of purchasing power rather than a type consumption.

Kudos to Eurostat for not using a “typical household” approach to gauge consumption spending and thereby resolving the classical economists reservations about indexes. They seek to gather statistics on actual household consumption spending across the Eurozone. It appears that Eurostat have finally created an accurate inflation indicator based on prices.

The TARGET2 system also discussed in this series provides a very low friction ‘plumbing’ system allowing the prices+>Euro>flow mechanism to correct imbalances across the Eurozone. In the process optimizing the benefits of free trade and a single currency zone as the classical economists Hume, Ricardo et al said it would.

Next we’ll explore a circuit theory approach to understanding the TARGET2 balances in order to determine if gold has a role to play in correcting imbalances in this part of the Eurosystem.

Dread Pirate Roberts to be keel hauled

Silk Road hit the news wires again but this time it's because the authorities caught
up with the Dread Pirate. I was talking with a friend of mine today and mentioned
this to him and he was completely lost as to what I was talking about.
He didn't know the "Silk Road" was a place where you could order illicit drugs and all manner of illicit other stuff and have it delivered to your door. He hadn't heard of the "Dread Pirate Roberts" and didn't get the movie reference.  For those who prefer the convenience of mail order Cocaine this is going to be a problem.  For those who used the service it's going to be a huge problem.

What is interesting is the DEA, FBI etc have been trying to crack this case for years now and suddenly they got lucky because apparently the Dread Pirate was foolish enough to order nine fake ID's on his own website. Somehow these ID's were intercepted (it could be the fake ID's were part of larger sting ).
They interviewed him and decided to watch him. They also obtained his Comcast account ISP records.
Using Underwear Gnome sleuthing techniques they gum shoed their way to the Silk Road server and commandeered it.
Hmmm, there appears to be large holes in the narrative but the narrative isn't complete yet.
Keep in mind though one of the things Snowden revealed in his leaks is the documents show that the NSA goes to considerable effort to reveal data gathered through its advanced capabilities only when it is possible to come up with a more innocent possible source (a “parallel construction”).

What I am saying is there is no way in hell a guy running a Billion dollar illegal business, who understands crypto currencies, encryption and encryption gotchas (if you don't know what you are doing) is going to use his home computer and his own internet connection to administer a website like Silk Road. He was smart enough to be able to hide the Millions of Dollars he made on the site in the form of bitcoins offline presumably. He was able to convert some of those coins to dollars to pay his rent. He obviously wasn't smart enough to get out of the USA though.

To get an idea of just how big the operation was:

The criminal complaint revealed that the site had collected revenues of some 9.5 million bitcoin since 2011, the equivalent today of $1.2 billion in sales and $80 million in commissions for Ross Ulbricht, who allegedly ran the site under the moniker “Dread Pirate Roberts.”
There are only about 11.75 million bitcoin in circulation. There were even fewer when Silk Road first began—the supply of bitcoin will steadily increase until there are 21 million in existence.
If you want to know more about the Silk Road then load up TOR or downlod something like TAILS and start searching around or just go here for this brilliant analysis