Thursday, I picked up my copy of the Wall Street Journal. On the front page was a photo of Federal Reserve Chairman Ben Bernanke, looking professorial. That, and he was smiling. The headline stated, ‘Markets Flinch as Fed Eyes Easy Money End.’
‘Why is that man smiling?’ I thought.
Then, on Friday, the WSJ headline did an about face, ‘Turmoil Exposes Global Risks.’ This refers to the selloff of pretty much everything that would attract a bid.
Well, which is it? ‘Markets Flinch,’ or market ‘Turmoil?’ How does it affect us? And is Ben Bernanke still smiling?
I’m only using the WSJ headlines to illustrate how, despite labels, markets are down hard across a spectrum. Stocks, bonds, gold, silver, energy, other commodities. Down, down, down. All of ‘em. It’s only a question of how far, how fast and where’s the landing point.
The scope of the selloff was vast, to the point of odd. That is, when one or two asset classes sell off, others usually rise while investors flee to so-called ‘safe havens’. It seems people want to go to cash – mostly dollars – and wait.
Of course, we don’t really know what’s coming next from the Federal Reserve. In fact, the Fed hasn’t done anything different versus previous, recent policy.
The so-called ‘news’ behind the headlines is that Federal Reserve gurus and economic witch doctors are talking about…y’know…maybe…eventually…changing policy from sort of ‘expansive’ monetary approach, to…something else…likely with higher interest rates.
That’s news? It’s not as if we haven’t heard something like that over many months. Indeed, media rumour mills have offered ample vibes that our Fed would eventually raise interest rates. It can’t keep interest rates negative, or at near-zero forever, right?
That, and the Federal Reserve needs to scale back its program of spending $85 billion per month to buy bonds and prop up the stock markets. The Fed can’t do that forever either, right?
Looking ahead, the Federal Reserve will likely scale back on its low-interest bond subsidy. The training wheels are coming off. Global markets will have to stand on their own. Thus markets ‘sold’ the news.
Shiny Stuff Down
Closer to our beat, the price of shiny stuff like precious metals – gold and silver – took it hard. Copper, too.
Why sell? Because nominal inflation is low. Gold prices have stagnated or declined in recent months – all that new Federal Reserve money supply notwithstanding. Meanwhile, many sectors of the investing space are hard-wired for relatively high return, and hard assets don’t seem to offer that just now.
Specifically, the price of gold is under $1,300 per ounce, down over 30% from its high above $1,900 in August 2011. Silver is under $20 per ounce, down a similar percentage from a recent excursion towards the $30 level. Copper is down from $3.30 per pound a few weeks ago to near $3.00.
You can call it a metal meltdown. Or at least a metal adulteration, as if the Fed is turning ‘precious’ metals back into lead. (Although in all fairness, lead has traded in a reasonably stable, $1 range per pound for most of nearly four years!)
Destroying Capital in the Mines?
It’s worrisome that, across the Big Gold industry, fully burdened costs of production are about $1,250 per ounce. That’s eerily close to the current selling price. So if this keeps up, say goodbye to profit margins. Over time, dividend payouts could be at risk too.
Plus, if low gold prices carry on, mining companies lose sustaining capital for expansion, and/or acquisitions. In a worst-case scenario, mining becomes capital destruction instead of wealth creation.
Look at one of South Africa’s largest players. Harmony Gold (HMY) is hard-down as well of late, with its shares trading in the $3.50 range.
In terms of ounces, Harmony has among the largest gold resource of any company, anywhere. But its shares have declined over the past six months as gold prices generally drifted down and mining costs generally crept up.
Yes, I understand the risk issues for South Africa. But right now, with Harmony, you can buy the outfit for a measly $1.5 billion. That’s simply bizarre!
Freeport McMoRan Copper & Gold (FCX), is down sharply, as well. Shares are trading in the $27.75 range. That’s quite a comedown, considering that within the past two weeks Freeport CEO James Flores bought a cool one million shares of his company’s stock at about $31.
On that last point, the Freeport shares were not a ‘grant’ to Flores. He wasn’t exercising options. This was a stand-up ‘buy’ order. Apparently Flores thought that his company’s stock was cheap.
What’s the Value of ‘Cheap?’
Let’s think about that last item. Here we have a company insider at Freeport, one of the world’s largest producers of key materials – copper, gold, silver and more. He knows as much about metal markets as anyone.
He knows all about his company’s business condition, to include those nettlesome government, labour and technical issues at its largest production facility at Grasberg, Indonesia – another story.
The Freeport guy walks up to the trading window and buys a million shares of his own firm, at $31 each. Then a few weeks later, the Fed guys mention that they might raise interest rates and make some other changes. Freeport shares tank by 10% or so.
Heck, if the guy who runs Freeport can’t make a lowball buy, what chance does anybody else have? Talk about not fighting the Fed!
Then again, the Federal Reserve has managed to warp the whole world economy for years at a time. And with smiling Ben Bernanke and his crew sailing the Seven Seas, is anything safe? Can we know the proper value of anything anymore?
The Federal Reserve’s zero-interest rate policy has undermined incentive of people to save. Constant inflation – even at nominally ‘low’ annual rates – has destroyed capital.
Direct Fed intervention has distorted price levels, such that it’s hard to affix a long-term value to most things anymore, such as housing, stocks, bonds, commodities, precious metal or energy. Even the guy who runs Freeport doesn’t know when to buy cheap.
Thank the Oil Patch
Which takes me back to a theme I’ve addressed before. The ‘fracking’ revolution in the North American oil patch has created immense monetary flexibility for the Fed.
That is, at the wellhead level, fracking has freed up otherwise tight oil and gas resources. At the macro-level, fracking has added large volumes of new energy to the national economy.
Every new barrel of domestic oil displaces an imported barrel. This helps keep a lid on global energy pricing, much to the chagrin of OPEC potentates. This oil price-lid is kind of like a massive tax cut to the overall energy-consuming economy. Meanwhile, reduced import levels for oil help to contain the US current account deficit in foreign trade.
There’s nothing like an ‘extra’ two million barrels of oil per day to help the Federal Reserve Chairman manage U.S. monetary policy. That’s a net gain of $200 million per day to the domestic economy, at $100 oil. And since oil is foundational to the rest of the economy – in the form of motor fuel, chemicals and the entire downstream industrial ladder – there’s a multiplier effect.
No wonder Ben Bernanke is smiling. He’s one lucky guy.
What Does the Future Hold?
They say not to bet against the Federal Reserve. OK, I get that. Then again, the Fed benefits from higher US energy output, and I have to wonder how long those US oil numbers will keep heading upwards. The Federal Reserve benefits from fracking and the oil that comes out of the ground. But fracking is capital intensive. Those fancy wells are expensive, and they deplete fast. And the Fed is tightening up on how much capital is out there.
In other words, what happens with the fracking revolution when the Fed raises interest rates and stops pumping big bags of new bucks into the economy? I believe we’re about to find out. We may not like what we see.
With higher interest rates, we’ll likely witness fewer wells drilled, first of all. They’ll be more expensive wells. We’ll see worse economics at the well head. Eventually, we’ll see a plateau in US oil output.
I won’t be overly pedagogical here. I’ll just say that the current sell-down for metals and miners is a classic shakeout of the weak hands. But gold, silver, etc. all ran up in the first place for a reason – the Fed. Now, what can we say has changed?
Eventually, I suspect that the Fed’s inflation will pop up to the surface in the economy. It would not surprise me that future inflation will be led by energy prices when…yes…the fracking revolution slows down. Courtesy of the Federal Reserve.
I’ll put it another way. Easy money helped increase the US energy supply. Tighter money will scale things back, out in the oil patch. The Federal Reserve is powerful, but it can’t have it both ways.
Byron King
Contributing Editor, Money Morning
Publisher’s Note: This is an edited version of an article that first appeared here.
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