As the Credit Crunch Worsens, It Will Send the Gold Price Up, the $ Down


...expect to see gold rise faster than currencies fall, as more and more people want the protection gold offers.

Why are the banks hurting so much? In the U.K. banks have asked top U.K. corporate clients not to draw on lending facilities to which they are entitled in order to preserve their balance sheets as they approach the financial year-end. The banks are urging some of their biggest clients not to draw on standby credit facilities as the sub-prime crisis and squeeze on interbank lending have affected banks' ability to fund themselves. The problems started with the closure of the commercial paper market as a means of cheap funding for companies in the summer. Banks have to provide standby financing of up to 100% to backstop commercial paper programs. With banks struggling for their sources of financing through the interbank market, drawdowns are having a direct effect on their balance sheets. Several bankers have said Citigroup is one of those most affected and that the bank was asking some clients not to use standby facilities, which are part of the normal relationship banking arrangements made between banks and companies. By the end of the summer, the principal problem facing banks was not U.S. sub-prime or collateralized debt obligation exposure but the drawing down of standby loans and bi-laterals. In some cases banks are seeking to avoid further balance sheet capital pressure by asking clients not to use their standby facilities.

Standby financing is typically for 364 days and when un-drawn has a zero risk weighting. When it is drawn, the risk weighting goes to 100%. This makes the sums involved significant. If a company is unable to tap the markets for commercial paper to the tune of, say, Pounds 4 billion (€5.6 billion), banks may have to provide that amount in standby financing.Tightening credit can and does spawn inflation.And the problem is snowballing as institutions from State government level right through the banking system are tightening credit. This is an alarm signal in itself, for inflation is at its most dangerous, once it drives money supply to fill the gaps caused by tightening credit. This was the principal trigger for the hyperinflation in Germany’s Weimar Republic after the first World War until August 1923.

So how do things look as we move forward into the deep of winter? Fed Chairman Ben Bernanke and Vice Chairman Donald Kohn acknowledged the threat to spending from reduced access to credit had moved from the ‘roughly balanced’ October assessment for growth and inflation risks, to the point where expectations for the Fed to lower interest rates again on December 11th are strong. The outlook has been “importantly affected over the past month by renewed turbulence in financial markets,'' Bernanke said, “Officials must judge whether the outlook for the economy or the balance of risks has shifted materially. Uncertainty surrounding the outlook is even greater than usual, requiring the Fed to be exceptionally alert and flexible. The combination of higher gas prices, the weak housing market, tighter credit conditions, and declines in stock prices seem likely to create some headwinds for the consumer in the months ahead.'' Federal funds futures show traders see a 100% chance of a reduction in the benchmark rate next month, with a 30% probability of a half-point move. The resurgence in credit concerns is spawning safe-haven buying of gold was evident in the behavior of credit spreads in and out of the U.S. One-month LIBOR remained 75 basis points over Fed funds; given that the historical spread of LIBOR to Fed funds is flat or even negative, this indicates not only a reluctance by banks to lend, even to each other, but also a general rise in the search for a safe haven. European and U.K. lending rates have risen, indicating a similar flight from risk in the global economy. Meanwhile, investors continued to move into U.S. Treasuries, with yields on U.S. government securities retreating back to very near recent lows. Persistently high interbank rates are a clear sign that investors and financial institutions are unhappy, very unhappy.

Carry Traders increasing velocity. “Carry Trade” traders have to find interest arbitrage opportunities [borrow cheap in one market – lend expensive in another] or they don’t make money. So they have to be accepted as a fact of life in today’s global money systems, constantly placing pressure on such differentials. They are very quick to act and cause an increase in the dealing ‘spreads”, which affect the cost of the operation making profits that little bit more difficult to achieve. If they act as one, on an opportunity they have sufficient clout to affect a stock and market badly. They, alongside the new Soros-like speculators, give height and weight to Capital Tsunami flows, which is fine so long as the markets can bear it. But they will bring to light any weaknesses in the global money systems and exploit them. They have the punch to make nations impose Capital and Exchange Controls.

Official Actions. We have run a constant story on the dangers of Capital and Exchange Controls, which are the consequence of markets buckling under such pressures. We constantly keep our eyes open for signs of “Official” intervention to stop the holes showing up in the system in the face of the huge weight of money swamping this way and that in the system, or where a lack of it makes new holes. When watching out for these, we see that local mortgage companies fall into the global market, with ideas in the States being copied in other countries and other countries investing in local mortgage companies through the American banking inspired Structured Investment Vehicles. And these investments vehicles are hurting the global banking system [excluding China it seems] by plummeting in price, giving us signals that “Official” intervention is happening or about to happen. Here are some of the latest signals and actions: -

- While the Fed is set to slow release $20 billion next week, $20 billion the week, with more to come in the new year, the fact that all depository banks in America can draw from it anonymously is designed to reach into all the corners of the U.S. banking system and is a key feature to the ‘rescue’ plan. All U.S. banks can now use the “Term Auction Facility”, which allows them to hand in a much wider set of investments as collateral to raise money, including mortgage securities.

- Across the Atlantic, the Bank of England has to date injected Pounds 20 billion it is also selling liquidity against even housing and credit card debt at rates far lower then 6.5%.

- The E.C.B. is releasing €13.6 billion.

- The Swiss National Bank is releasing $4 billion.

- In the U.K., the British government is passing a law to permit the nationalization of Northern Rock, which was the 8th largest bank in Britain but one that has succumbed to a ‘run’ after suffering from an overdose of sub-prime related securities. This shows that the government/Bank of England are the “lenders of last resort”. However, few depositors and even fewer traders are inclined to wait on the painful process of government support to protect their money. So we experience “runs” on banks of this caliber, when it is discovered that their assets base comes under pressure.

- In the States the government is trying to have mortgages potentially in default, because they are about to be hit with the full impact of market interest rates, frozen for 5 years. Very noble and proper too! But the market wants to see the small print before they accept these moves are really going to be capable of shoring up credit markets. Until then the pressure remains on granting credit, resulting in a drying up of liquidity. But you may well ask, why is the problem so great? The answer lies in the balance sheet of the banks.

Consequences. What this means in essence is that we will see dropping interest rates, liquidity being pumped into the system and inflation taking off. The ‘carry’ traders will position themselves [as they are now doing] to borrow the $ and lend into higher interest rate currencies [the € even] to get their returns, as the $ drops down to give capital gains on the transactions. It will be like a red rag to a bull. This renews pressure on the exchange rate level of the $ and precipitates competitive devaluations in other currencies so importing U.S. inflation. As long as the problems persist matters will get worse for the $ in particular and gold will rise.

The effect on gold?As this happens, expect to see gold rise faster than currencies fall, as more and more people want the protection gold offers.

If the government’s efforts to support the banking and credit systems are not successful [really convincing] the pressures on the banks and credit systems will grow worse and this time will expose the real losses being made, across the globe, exacerbating the whole banking situation in the global money system. The attraction of gold will then be irresistible!

Shortly in our pages, we will be covering just how “Marginal Supply” and “Syndications” have also contributed to the instability and uncertainty has and will contribute to making gold attractive, short, medium and long-term.

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