In The Lead – Talking [Ratings] Heads: Burning Down the House

by Jon Nadler, Kitco Metals Inc. on August 9, 2011 · 0 comments

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Bullion BarsA highly apprehensive crowd of speculators put the pedal to yellow metal and pushed it hard overnight making for fresh records (it is now more costly than platinum!) and bolstering the value of the Swiss franc to new heights as well.

Following the 634-point rout in the Dow, the "waterfall" plunge in the S&P 500 over the past week, and the entry of the FTSE into official bear territory, one can appreciate the sheer panic that has taken a hold of the global investment psyche. Some have speculated that the markets might have been "better off" if the US had actually failed to raise its debt limit one week ago.

Gold’s ascent to levels as high as the $1,780 mark overnight has taken various normal metrics (charts, profit-taking, corrections, fundamentals, consolidation, etc.) out of the present discussion and has even begun to worry the bulls who had expected such values. The logic is that retreats — when they come-from such levels are generally anything but orderly events. Others, while acknowledging that gold could represent a form of insurance against equity market storms caution that purchasing such insurance after the financial house has already been consumed by flames might not be the wisest course of action.

To fathom that extreme volatility awaits these markets in the hours and days ahead is to do the obvious; the question will likely become to what extent people’s expectations of what constitutes "extreme" might be surpassed by the way the markets might come to act. In the classic sense of the expression, "all bets are off" might be the new "normal" in coming trading sessions. As CPM Group’s analysts put it overnight, this could be the "storm before the calm." And that "calm" may not be all that tranquil, either.

With but a few hours to go prior to the Fed’s meeting, the markets opened with the same level of nervousness that has shaped the past week of action. Only a modicum of pre-opening stability was noted in Dow futures and in crude oil. The latter was able to reclaim the $80 level as the US dollar gave up some additional ground on the trade-weighted index (down 0.38 to 74.46 at last check). With the notable exception of silver, which continues to offer worrying signs of a disconnect, the metals’ complex opened higher in New York this morning.

Spot gold gained $26 to start the day off at $1,743 per ounce; nearly $40 under the overnight record it established as waves of fear swept through global markets. To now expect $100+ moves on an intra-day basis might not be out of line considering how matters have shaped up. However moves of a larger order of magnitude ought not to be discounted, either. When one loses the tethers of gravity, all outcomes are possible. Gold has not only lost said tethers; it has gone parabolic. Visit market history for a primer on how parabolas come to conclude.

Silver fell by one dollar and one penny in New York this morning; it opened at $38.02 per ounce. Questions as to why the white metal is not exhibiting $60 or $75 price prints continue to nag the silver bulls but given the potential sag in demand for the industrial metal that an economic dip might engender, such questions do have at least partial (and logical) answers.

Platinum and palladium recovered some of the value ground they have lost in recent trading sessions but given the magnitude of certain previous moves, even their double-digit (in the teens) comebacks this morning were deemed as relatively tepid. The former climbed $15 to open at $1,728.00 the ounce while the latter added $14 to start Tuesday’s session at $728.00 per ounce. Rhodium remained lower with a bid-side quote at $1,825.00 following a fairly sizeable loss on Monday.

The so-called "Tea Party Downgrade" has prompted the Obama administration to intensify its efforts to reassure the American nation that the events of the last week do not imply that the country is not deserving of a AAA rating but that they merely reflect the outcome of the political fist-fight to which the country has been subjected since late July.

And now, the Fed meets. While Mr. Bernanke and his colleagues have given indications in recent months that the US central bank was essentially done with stimulating the economy, the FOMC will sit down today amid a reality on the market and economic front that has been substantially altered. On top of that, the number of dollars that has actually gotten into the system (M2) during the current year has actually been on the decline after it rose in 2010.

When factoring in the 13% drop in the stock market that took place over five days and the fact that each time such a thing happened (1987 and 2008) the outcome was a recession, well, you can see where the Fed might have to lay out a fresh set of blueprints at the meeting table today and tomorrow. There is one exception to that 13% / five-day drop rule; it came in 1962 and that time, the same decline actually signaled the end of the recession and the start of a long period of growth. One-in-three. Some odds.

Some economists have suggested that the way out of this pickle is for the Fed to simply raise its inflation target. Going from 2% to 4% (or even to 6%) might make for easier repayment of debt (public as well as private) but it carries with it the risk that when the time to pull the trigger comes, the mechanism malfunctions. At the moment, the US as well as the rest of the world (for the most part) is trying to cope with falling levels of inflation and slowing growth amid rising debt.

One place where the disappearing inflation problem is apparently not a problem at all, but quite the opposite, is China. The latest tally from that country shows prices rising at a 6.5% clip; beyond the comfort level of the PBOC and China’s leadership. To make matters worse, the country’s real estate investment and sales patterns showed nothing but acceleration in July.

Thus far in 2011, China’s property investment expanded at a rate of 33.6% and property sales grew at a 13.6% pace. All of this took place despite concerted efforts by Beijing authorities to contain housing inflation and rampant property speculation with various drastic purchase-restrictive measures. Trying to keep a "good thing" down is proving a difficult task for Beijing. However the efforts are only likely to continue and to become more serious as the country’s leadership is very aware of the potential consequences of such bubbles. All they have to do is look across the Pacific, to the shores of the USA…

And now, back to the principal catalyst for this week’s market "moves" — if one can call them that anymore. The "rating game" — a game where everyone is handed a rose and told to take a hike in the woods. In a devastating piece on Huffpost Politics, writer Richard Eskow goes for the jugular of the agencies that hold such power over markets and governments. Mr. Eskow proposes four steps to end the "reign of error" that these firms are apparently engaged in. He calls the industry "a racket." The evidence for that strong label? Well, consider just these three things:

  1. Federal, state, and local governments, as well as pension funds and other investors, relied on their "AAA" ratings to protect their savings.
  2. They traded those AAA ratings to paying customers in return for more business.
  3. 90% of the mortgage securities they rated "AAA" in 2007 were later downgraded to junk-bond status.

Oh, and a couple more things:

  1. Nothing has changed. Key rating provisions of the Dodd/Frank bill have been delayed and deferred. Why?
  2. Because lobbyists for the big three rating "agencies" have spent $1.76 million since January, mostly directed at Congress and regulators."

Mr. Eskow’s four-step solution entails stripping the agencies of their NRSRO status for starters. The rest of the proposed measures are even more drastic. But, at this juncture, and following what has taken place before and after the 2008 crisis as a result of the aforementioned ‘racket’ being in place, the economy might just be the one to be saved as a consequence of such changes. Or, so opines Mr. Eskow.

Back to Fed-watch. Keep the fire hose handy.

Jon Nadler
Senior Analyst

Kitco Metals Inc.
North America

Disclaimer: The views expressed in this article are those of the author and may not reflect those of Kitco Metals Inc. The author has made every effort to ensure accuracy of information provided; however, neither Kitco Metals Inc. nor the author can guarantee such accuracy. This article is strictly for informational purposes only. It is not a solicitation to make any exchange in precious metal products, commodities, securities or other financial instruments. Kitco Metals Inc. and the author of this article do not accept culpability for losses and/ or damages arising from the use of this publication.

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