Overview:
There’s been a lot in the news and on Fin-X lately about Japan, record gold prices, and skyrocketing silver. Here’s a quick summary of the situation(s).
Japan:
I was going to write a long explanation, and then realized I’ve covered this in detail in the past. The short version is Japan ran up a massive national debt of about 240% of GDP. They were able to do that because they kept real interest rates negative for a long time and for years, had negative nominal rates. If the cost of borrowing is free or negative, there’s no disincentive to overspend.
That was fine until the yen started plummeting against the dollar a few years ago. Japan is an economic powerhouse, but is also a small island nation that has to import a lot. A falling yen means an inflation problem, especially in energy which is usually priced in dollars. This left the Bank of Japan with a tough choice; either continue with existing policy and see the yen continue to fall and inflation continue to rise, or raise interest rates to protect the yen and in doing so, create a bigger budget deficit. That budget deficit can only be paid by cutting spending or printing more yen which leads back to the same inflation problem. Japan now is seeing record-high interest rates on its long-term debt.
There are trillions of dollars invested in the carry trade where investors shorted the yen at a low yield and bought US Treasuries with a higher yield. Some even bought US tech stocks which had huge returns. Hedge funds and institutions used leverage to increase their “carry trade” positions. As the yield on the Japanese government bonds increases, there is an incentive to unwind the carry trade. This would lead to selling of US Treasuries and equities. Japan has a problem that can easily become our problem.
I started talking and writing about this issue in 2022. For those of you who want more detail, here are a few helpful DKI links:
November 1, 2022: Mark Rossano and me talking on OpenExchange TV about the same thing: https://www.openexchange.tv/pro-insights/what-does-sovereign-debt-default-mean
October 26th, 2022: Explaining to DKI subscribers on this blog the coming Japanese sovereign debt default: https://deepknowledgeinvesting.com/sovereign-debt-defaults-japan-vs-the-bond-vigilantes-part-i/
October 27th, 2022: More detail on Japan vs the Bond Vigilantes: https://deepknowledgeinvesting.com/sovereign-debt-defaults-japan-vs-the-bond-vigilantes-part-ii/
November 24, 2022: Interviewed by Michael Gayed of the LeadLag Report on “The Japan Default Looms”: https://www.youtube.com/watch?v=Q9oq_G7iXDk
Gold:
There’s been a lot of attention on gold’s incredible run. DKI started buying gold in 2020 around $1,500. A couple of years later, it hit all-time highs around $2k. Since then, the chart has gone parabolic with gold currently trading above $4,500. There are two related things happening here.
First, the US Congress has continued to overspend by trillions of dollars a year. This has been and will continue to be the case regardless of whether team red or team blue is in charge. The historical and correct definition of inflation is an expansion of the money supply. That’s what we have now and we’re all experiencing it as higher prices (or a reduction in the purchasing power of the dollar).
The government has chosen to fund its overspending through inflation. In the past, spending was financed through taxes which caused people to have hard conversations when sitting at their kitchen table to pay those taxes. A government that spent too much and delivered too little value would be voted out of office. Now, they just add more debt, increase the money supply, and blame everyone else like greedy corporations, Vladimir Putin, Covid supply line disruptions, and the boogeyman. (Should boogeyman be capitalized? Let me know if you have an opinion.) Americans experience a higher cost of living, but most don’t connect their growing financial discomfort with overspending out of Washington. Legislators act like money is free…because it is for them.
This practice of funding government spending through inflation and debt is dishonest and will continue until the bond market led by the bond vigilantes says “no” to the next trillion dollars of bond issuance from the Treasury Department. For those of you wondering what this looks like, please see the Japan section above. We’re starting to see some flexing by the bond vigilantes as the Fed has cut 175bp in the last five quarters and the yield on the 10-year Treasury has increased.
There is nothing the Fed can do to fix this; however, lowering the fed funds rate and restarting QE (quantitative easing) will only make things worse. Fed Chair, Jerome Powell, had done a poor job managing the one thing that’s the real responsibility of the Federal Reserve. The next Chairman will likely amplify Powell’s errors.
Second, foreign governments see the US abusing and debasing the world’s reserve currency and are increasingly rejecting it. Making this issue worse was the decision almost four years ago to impound Russian dollar assets. While the intention of defunding the war in Ukraine was admirable, the effect was to signal to the rest of the world that their dollar reserves were only secure as long as they stayed in the good graces of Washington DC, a place that changes leadership every 2-8 years.
China and India are stockpiling physical gold. China, in particular, is a price-insensitive buyer. They don’t want derivatives, promises, or paper “metal”. They want the hard asset in their own possession in their own vaults. Long-term this is bad for the dollar and great for the dollar price of gold.
I also think there’s value in shifting your perspective on this topic. Most people talk about the incredible increase in the price of gold. I’ll suggest taking a minute or two to think about gold as something that has held its value across thousands of years. It’s actually the dollar that’s falling and not the value of gold that’s increasing. If you start to think about inflation as a reduction in the purchasing power of your fiat currency, it makes the value of gold look much more stable.
Silver:
The dollar price of silver has gone parabolic, up more than 173% year-to-date. The silver market is strange with meaningful industrial use, jewelry, and store-of-value bars in vaults. Silver is primarily mined as a by-product of other metals mining so a higher silver price doesn’t necessarily result in increased mining activity as it would with gold. In addition, the silver market is highly-manipulated with the amount of paper silver far exceeding the supply of actual metal.
Paper silver is a derivative or other promise. Imagine I want to own exposure to silver, but don’t want to pay for insurance, guards, and a vault. I might go to a bank or institution and do a swap trade where if the price goes up, they give me dollars to reflect the change in value, and if the price falls, I would give them dollars. That alone doesn’t create a problem.
Right now, there are a lot of contracts maturing where people have the right to receive actual physical silver instead of settling in fiat. As you can imagine, most of those contracts are now deeply profitable and the holders are asking for delivery of physical silver which has to be delivered. (With paper silver, you might just receive fiat.) The problem for the sellers of that paper silver, is the physical supply in many markets is gone. You can’t buy what isn’t available and you can’t deliver what you can’t buy.
With the vaults empty, the silver markets have turned upside down. Normally, you’d pay something for storage, security, and insurance to take delivery in the future. Now, it’s cheaper to buy future silver than spot silver. (“Spot silver” is silver today). The reason is it’s hard to find the actual metal right now. What we have is the exact result the Hunt brothers tried to achieve in their attempt to corner the silver market decades ago.
To summarize:
- Multiple uses with technology demand increasing.
- All of the above issues with debased fiat and the declining value of the dollar (and the yen, euro, and pound).
- More promises to deliver than metal that can be delivered – the motherlode of all short squeezes.
Like gold, DKI first bought silver in 2020 in the mid $20s. I don’t know how long this supply crunch will last. At some point, the in-the-money demand from paper silver for physical will be exhausted, but the current backwards pricing where current silver is more expensive than future silver is saying we’re not there yet. I don’t have a short-term price target, but gold and silver are assets I want to hold as long as Congress keeps overspending. That’s a polite way of saying I want to own them for a long time.
Conclusion:
We’re looking at a massive overhaul in the realm of fiat currencies where the Japanese government is facing the biggest bond market collapse in decades, where the world’s reserve currency is losing share, and where precious metals are skyrocketing in value as price-insensitive central bank demand asserts itself. These are complicated issues so feel free to post questions in the comments or reach out to me at IR@DeepKnowledgeInvesting.com.
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