SILVERAXIS - TODAY IN SILVER

First, apologies for not posting the past couple of weeks, it will pick up shortly. Second, I really appreciate all the comments (okay, not the silly ones that bemoan my absence) and hope that you will keep it up. I would particularly appreciate seeing some of the “regulars” linking to and discussing the major stories of the day as I know these discussions you’ve been having in the comment section are being read and enjoyed by a lot of people.

As far as the silver and gold market, what can I say? Another week and more of the same. The monetary base continues to explode and silver and gold continue to struggle near their lows.

Despite the obituaries that have been written about silver lately, the white monetary metal is alive and well, as am I. The rumors were well founded, however, considering my temporary disappearance and silver’s plunge to a low of $8.40 basis the December 2008 COMEX futures earlier in the week. The swoon in silver occurred as gold carried out a somewhat unconvincing recovery from its own low of $681.00 on Friday the 24th. Currently, gold remains below the important $730 range and needs to move up quickly or else gravity will drag it and silver back down again.

I must say that it was somewhat liberating to not post any comments or answer emails for a few days but now I’m back on the job. I was prepared to write had something extraordinary taken place but the past week didn’t offer much in the way of critical material with perhaps the only exception being that the Federal Reserve has once again proven me correct: the new Commercial Paper Funding Facility (CPFF) is turning out to be the primary mechanism of Bernanke’s helicopter operation as the latest Factors Affecting Reserve Balances H.4.1 Report shows. According to this report, Reserve Balances of banks grew a mind-boggling $200 billion in the latest week to $425 billion as the Federal Reserve acquired $145 billion of commercial paper. If this increase is not somehow neutralized by the Fed during the coming weeks, it will show up in the Monetary Base.

I believe the critical point for gold and silver will come if and when the banks begin to lend against these massive new reserves. Assuming I’m right about the consequences, we could see an initial move by gold to the $1,000 level and silver to $16 or so in the matter of a few days as the insiders position themselves. Alternatively, as long as the deflation theme continues to threaten the world order with the prospects of imminent financial collapse, gold and silver will remain depressed.

It would be a very bad thing if gold and silver should take out the lows of the last 2 weeks as that points to a near-term economic collapse of epic proportions. The best analogy I can think of is an empty bottle being held under water–the longer and deeper it is held, the more explosive the eventual rise, but if the bottle is pushed too deep, the extreme water pressure will cause the bottle to burst.

Today we got news that the U.S. monetary base consisting of bank reserves and currency in circulation has skyrocketed to $1.15 trillion from $850 billion a mere 6 weeks ago, which is an increase of 35%, or 300% annualized. Meanwhile, the Adjusted Monetary Base tracked by the St. Louis Fed (which calculates the monetary base using bi-weekly averages) clocked in at $1.19 trillion. Here is how it looks on a chart:

Click Chart to Enlarge

The Fed has added as much to the monetary base in 6 weeks as it has added in any prior 10 year period going back to the early 1980s. Indeed, the rate of increase appears to be about $100 billion every two weeks and yet the logjam in the credit markets still has not been cleared.

So, is this the fabled helicopter drop? Yessirreee! There is, however, a slight matter that deserves some mention. The money dropped from the helicopter has not reached the ground yet. In other words, most of this money is still being held by the banks in the form of Reserve Balances. Put another way, it has not yet started to work its way down through the fractional-reserve lending process to the credit-strapped private sector.

The reason these funds are being held and not loaned out by the banks is simple. The Fed is actually paying banks to hold the funds in reserves. Indeed, the Fed has just today increasing the rate it is paying by 40 basis points. Some of you may know that the Fed was originally going to start paying banks for excess Reserve Balances starting in 2011 but the recent emergency bailout legislation moved that date up so that Reserve Balances would start to earn interest immediately. The Fed’s intent is to try to keep the massive increases in Reserve Balances close to the heart so that these funds serve mainly to shore up the banks’ balance sheets but don’t create a tsunami of “unnecessary liquidity” in the money supply. Remember what I said earlier about jumping out of a burning building. In helicopter lingo, the $300 billion has been dropped but it is fluttering in midair due to an updraft created by the rotor.

I suspect, however, that the Fed will have to dispense with its “gradualism” before too long and fly the helicopter to open airspace in order to avoid a crash. Even if the Fed has no intention of moving clear, the longer the money stays out there fluttering in midair, the more difficult it will be to keep it aloft. Moreover, once the dropped money has cleared the updraft from the helicopter’s rotor, it can no longer be reclaimed by the Fed without consequences, especially while the global economy remains on an unsure footing. Thus I suspect most of the dropped money will eventually flutter to the ground.

What I think we should watch for in particular is an increase in M1, which includes circulating currency (Federal Reserve Notes) and demand deposits. The latest data only goes up to October 13, but that data actually shows weekly average M1 shrinking by as much as $100 billion since the end of September. If and when we see M1 reverse sharply upwards, we could start to suspect that the first batches of the monetary drop are starting to reach the ground and that a “hyperinflationary event” will not be very far behind. How long could this take? I give it 6 to 18 months although others say it could be literally weeks from now. Jim Sinclair claims something big will happen in 13 to 88 days, which is the timeframe between the U.S. elections and the inauguration of the next President.

Below you will find one simplistic method to check spreads in various commodities and even in gold and silver, assuming you can use graphic programs to manipulate images. Normally I would reveal methodologies such as this only to paid GSUL members and Founding Members of The Metal Augmentor, but I’m hoping some of you will appreciate my sharing this by helping create similar charts for other commodities. If there is interest from enough of you to create more of these charts, please leave comments and I will walk you through how to do it as well as split up the commodities between the “volunteers”.

Note that in the case of Crude Oil, I was able to find a historical instance of 56% annualized contango in the spread between the December 2001 and March 2002 futures that existed during the summer of 2001. I’m not sure this is the highest level that was reached but it seems extreme enough for our purposes. Currently, the contango between the December and March futures is about 8% annualized. Although this is small compared to the summer of 2001, please keep in mind that Crude Oil was mostly in backwardation or very small contango for much of the past several years as the below charts demonstrate.

Actually, it is more appropriate to look at the March 2009 and June 2009 spread when comparing the current period to the summer of 2001 (when the 56% annualized contango took place). This is because we want to be about 6 months in advance of the first contract in the spread. In other words, during the summer of 2001 the December 2001 contract was 6 months ahead and as of October 2008 the March 2009 contract is 6 months ahead. When we calculate the contango between March and June 2009, we find that it is roughly 9% annualized, still a far cry from 56%. Here is one more important point. Although the timing is more accurate when using the March/June futures, the results are not adjusted for seasonality and therefore we need to be careful not to use such data in isolation to make our conclusions.

NOTE: Click the charts to enlarge.

Some commentors have referenced a guy named Karl Denninger who thinks he has a solution for the present credit mess. At the website http://market-ticker.org/authors/2-Karl-Denninger, he says we should simply deflate housing values and have everybody with an underwater mortgage default and walk away. At the same time, those with unsecured debts that cannot repay them in the short term should declare bankruptcy. Furthermore, all the Federal Reserve and U.S. Treasury bailout and financial rescue programs should be rolled back and eliminated. Although this might have some very painful economic consequences, Mr. Denninger believes it will preserve the borrowing capacity of the U.S. Treasury, which is key to maintaining American economic might. He views the choice as pretty simple: either we let the private sector default on all debts it cannot repay or the government will eventually be dragged down and defult on all the debts it cannot repay.

While his solution is intriguing, Mr. Denninger ignores the fact that the U.S. government is the largest debtor of them all even without the bailout packages. What is the point of having the private sector default on most of its debts when the total debt of the U.S. is $60 trillion including unfunded liabilities? With a U.S. GDP of $14 trillion, the U.S. government debt is more than four times the total economic output of the nation! At an overall savings rate of 10% (including personal savings rate, corporate retained profits and government budget surpluses), it would take 40 years to fully fund the U.S. debt assuming all private savings are taxed 100%, we ignore interest payments, and there is zero new debt in the private sector. In other words, even if the U.S. government allowed a deflationary collapse of private sector debt until it effectively reached zero, and then somehow managed to maintain GDP at current levels while generating a 10% budget surplus, it would still never be able to pay off its debts in dollars at their present value. And that means its own creditworthiness will evaporate.

Indeed, my back-of-the-napkin estimate is that U.S. government debt will have to be deflated by a factor of 8-12 times over the next few years and decades in order to retain any semblance of creditworthiness. Conversely, the government debt will have to remain static in nominal terms (that means no more deficit spending) while the supply of dollars is inflated by a factor of 8-12. Either method would make debt repayment at least plausible but not necessarily probable. In particular, deflating the government debt would put tremendous pressure on the tax base and would create massive new deficits and/or a complete destruction of the U.S. as an economic, political and military power on the world stage.

The fact is that we are way beyond the point for a constructive plan or structural solution to deal with the debt problems. Perhaps 15 or 20 years ago the plan proposed by Mr. Denninger would have had a chance to succeed. At this point, however, the only option is to either (1) systematically wipe out all debts and start over, or (2) hyperinflate the money supply to the point where debt service becomes manageable in both the public and private sectors. It’s understandable that nobody wants to face this reality. Both choices are ugly.

This type of denial is similar to what I imagine is a common experience of people trapped in a burning high-rise building. Until the very last second before becoming engulfed in flames, there is always some small hope that a rescue will succeed. But once the flames are close enough, jumping out of a window becomes a preferred alternative. There is at least some exhilaration in the free fall that precedes the inevitable splat on the sidewalk below. In most cases, death comes quickly and is relatively painless. On the other hand, being burned alive is recognized universally as one of the most painful, if not the most painful, ways to perish.

Thus we should not expect that the irreversible decision to hyperinflate will come at any moment before it is absolutely necessary. There is always some hope up to the last second, no matter how remote or misplaced, that a rescue will succeed. Yet as the flames of deflation engulf the financial system and all hope fades, there will undoubtedly be that last attempt to seize destiny as the global monetary regime jumps out the nearest window.

As I mentioned a couple of days ago, Rick Ackerman has recently wondered out loud how a hyperinflationary tsunami wave would hit the markets today. In If Gold Hits $5K, Would You Sell?, he says the following:

Indeed, the coming economic collapse may not be the slow, black-hole implosion that we have long imagined, but more like a tsunami. As such, it could make the 1920s German hyperinflation, which took nearly two years to play out, seem almost leisurely in comparison. Back then, the financial world wasn’t wired like the ganglions of a central nervous system. It is now, though, and that is why the banking system, along with the global economy, could conceivably short out instantaneously in a shower of sparks.

. . .

So, what of this idea that the financial system could collapse so swiftly that even those who have been preparing for it would not have time to react appropriately? Realize that many stocks have experienced bear markets in mere days, collapsing 50% to 90% before investors knew what hit them. Some of the largest financial institutions in the world have gone belly-up just hours after “problems” surfaced in the news. Even a whole country, Iceland, has gone from being a picture of financial normalcy to bankruptcy in less than a week. It happened in Argentina as well. Could the dollar collapse with equal swiftness, laying waste to the U.S. economy in a  matter of days? You better believe it could.  After all, the dollar is already fundamentally worthless, backed by nothing more than IOUs that have swelled far beyond our ability to repay them.

You say the dollar has been soaring recently? Well, yes, it has. But that doesn’t mean it is worth anything. In fact, the dollar is valueless, and the $1 bills in your wallet are worth no more intrinscially than the $100 bills. Those who do not understand why this is so or who would argue otherwise are simply ignorant or delusional. As we explained here a couple of weeks ago, the dollar is rallying because it is caught in a short squeeze. Short-term borrowers, unable to keep rolling their loans, have been forced to settle up in cash. This has created a made scramble for cash dollars, as opposed to credit dollars. And although the Fed has attempted to keep the system liquid with unprecedented infusions of new cash, the amounts pale in comparison to a global financial deflation that has already caused tens of trillions of dollars worth of financial and real estate assets to vanish from the economy.

For more than a decade, we have argued here that a ruinous deflation was the only possible outcome when the credit system finally collapsed. Although we still think that’s where we’re headed ultimately, we now see the possibility of a hyperinflationary spike along the way that would wipe out savers but also challenge the assumptions and investment strategies of gold bugs who have been preparing for the worst.  What would you do with your ingots, krugerrands, Maple Leafs and Pandas if the price of an ounce of gold were to soar in mere days into the thousands of dollars?  Would you continue to hold them?  We think this is a very risky strategy, since the world in which you will emerge from your bullion-lined safe haven will be too broke to pay a king’s ransom for a nugget, an ingot or a coin.

I don’t necessarily believe a deflationary wipeout is imminent but I do consider it a possibility that “a hyperinflationary spike” could come along and wipe out fiat savers over the course of a few weeks or perhaps even a weekend. What would you do with your gold if that were to happen? Sell it for dollars? Buy a cave in the remote wilderness and as many guns, ammo, beans and rice as your horse-drawn buggy can carry?

Gold is now testing the $729 level that our mystery technician correspondent identified several months ago as the likely low in gold, but thanks to its spunkiness yesterday silver is managing to stay above its own low of $9 reached a few days ago. An analysis by the same technician calls $8.88 in silver a very important level but is willing to suspend judgment down to the mid-$8 level should gold decline marginally below $729.

I think it’s fair to say that even U.S. dollar bulls are now caught by surprise at the reserve currency’s resurgence given that the United States holds the primary role in leading the world into the current credit and financial mess. Is this dollar rally illusory or somehow the result of currency manipulation? I think not. The fact is that there is a very strong demand for U.S. Treasury securities, which coincidentally is keeping interest rates low. Foreign buying of U.S. Treasuries requires buying U.S. dollars first. Actually, this is true only to the extent buying of U.S. Treasuries exceeds the U.S. dollars acquired as a result of the trade imbalance, which is precisely what appears to be happening right now.

In addition, the recent increase in FDIC insurance and other U.S. Treasury and Federal Reserve actions may have resulted in large depositors moving funds back into the U.S. banking system. Even if this has happened only at the margin, it might have been enough to tip the scales. Yes, I know that many other countries have also started to guarantee bank deposits, but if this Mother Of All Crises continues to its inevitable conclusion, even some of their own citizens would probably prefer to have their money in U.S. banks. By contrast, I don’t believe that many Americans are looking to move money into foreign banks at this point. If they are moving money, it is to put it under the mattress, or in small numbers (what will likely turn out to be the “smart crowd”) into gold and silver.

It used to be that on the way to the inverted peak of Exter’s pyramid [PDF] where gold (and silver) resides were the more ethereal forms of fiat money layered according to counterparty risk. The fiat currency itself, in paper form as Federal Reserve Notes, has the least amount of counterparty risk and therefore it was the layer closest to gold. Yet recent government guarantees of bank deposits, commercial paper, money market mutual funds and other investments raise an interesting question. If every form of fiat money is just as good as any other form, what happens to Exter’s pyramid?

My initial answer is that the pyramid has been flattened and now sports a much broader base, with the necessary result being that the angle of monetary devolution from more risky forms of money into the risk-free form (gold) has just gone from steeply vertical to almost horizontal. In other words, it is possible that virtually all forms of money and not just Federal Reserve Notes now reside just a single step away from the peak of Exter’s pyramid. If true, this theoretically means that vast amounts of wealth are now poised to move into gold should conditions warrant such a move.

Putting it yet another way, if every form of fiat money has received a guarantee or bailout, there isn’t much reason to move wealth between these forms other than perhaps to chase a higher rate of interest. In effect, fiat money now exists as a single layer. Adding up all the sums, this single fiat layer now consists of tens of trillions of dollars (and Euros, Yen, Remnimbi, etc.) that is now a single heartbeat away from gold. I can’t recall a historical episode where this has been the case, but perhaps some of you can correct me. In any case, it would seem to me that a flattened Exter’s Pyramid is a bullish precondition for a historic flow of funds into gold. The mere existence, of course, of a precondition does not mean that a particular event will or will not happen, but it is an enabler for a path or least resistence especially when we consider the eventual need of governments worldwide to inflate or die.

If any of you with artistic talent happen to also have a handle on Exter’s pyramid, I would ask that you consider illustrating the “Flattening of Exter’s Pyramid” and sharing it.

Finally, a quick note on those copper put options. Any of you still holding these should really consider taking the majority of profits now. The December 250 puts traded up to 6650 points ($16,625) today as copper fell toward the $1.80 level. Even if you are unable to sell many of the puts for that price (you probably cannot given how thinly these options are traded), you can easily offset them with long positions in the copper futures. As I write this, you should be able to lock in profits of around 7000 points ($17,000) per put option, which is not bad considering they cost around $200 each when I first discussed them. While my copper price target of $1.60 still looms large, a prudent speculator will have taken profits on the majority of the position and will only have a small portion left to ”let it ride”.

On a day when just about every market is taking a beating including gold and the entire commodity sector, silver is actually up by a healthy amount. Clearly the recent run below $10 was overdone although it is still possible that we get a decline into the low $9’s or even high $8’s as gold looks intent on testing the September low around $730. But at least for now we can enjoy the moment while we ponder if silver will ever be the ideal investment that, by most knowledgable accounts, should be beating the pants off just about every other investment.

There were some great questions posed regarding my essay on industrial inventories and I will post answers shortly.

The Federal Reserve has injected another $100 billion of liquidity in the form of Reserve Balances into the banking system last week and I will also be discussing this soon, including my long-promised explanation of the helicopter drop itself. Alas, the Fed will not leave us alone, announcing yet another program today, the Money Market Investor Funding Facility (MMIFF). The MMIFF is similar to the Commercial Paper Funding Facility (CPFF) in that it will use Special Purpose Vehicles to inject liquidity into the short-term money markets. Along with the Asset Backed Commercial Paper Money Market Mutual Fund Liquidity Facility (AMLF), the MMIFF and CPFF now stand ready to generate a hyperinflationary wave of liquidity that could seemingly come out of nowhere, like a tsunami. Rick Ackerman recently made an intriguing point about this possibility, claiming that hyperinflation could occur literally over a weekend due to the fast pace of modern markets (I’ll add the link later).