Van Eeden: Gold to Drop, U.S. Dollar to Rise, China's Economy May Collapse

Paul van Eeden is President of Cranberry Capital. I am an admirer ever since this very sharp guy since his first appearances on, and even more so whe he was on BNN in early 2008 and stated pretty much everything that was about to happen in the markets, everythign about the financials and the phony derivatives, and so on. At the time, he said he was going to cash, to his interviewer's total astonishment. He has stopped publishing his newsletter, but still appears on TV very sporadically. We reported on his BNN appearance here, when he said gold was $150 too high. Since then, gold has rallied. However, he sent out a new letter in which he explains why gold is overpriced.

Below is a summary, excerpts, and explanation of why the U.S. Dollar may sise, and gold may drop, and China's economy may collapse. If what he says happnes, it will not be pretty.

Gold and the U.S. Dollar

- The Fed said that it would purchase a total of $1.25T of agency mortgage-backed assets and $200B worth of agency debt by the end of Q1 2010, this in addition to the $300 billion worth of Treasury debt it should have bought by the end of October 2009. Since December 2007 the Fed's balance sheet has already expanded by $1.2T. That $1.2T represents mostly new money created. When the Fed creates new money it inflates the money supply, which, in turn, devalues the dollar. By devaluing the dollar the Fed hopes to prevent prices from falling.

- "The question before us is therefore whether the rally in the gold price is founded in reality, or in fear induced fantasy. "

- The fair value of gold increases in proportion to the dollar's inflation rate. Thus the Fed's $1.2T expansion of its balance sheet should cause the value of gold to increase versus the dollar.

- In December 2007 the US money supply was approximately $7.5T. The current money supply is approximately $8.4T, an increase of roughly $900 billion. We also know that the Fed's balance sheet has expanded by $1.2T over the same period of time. Items that added to reserves (increased the money supply) on the Fed's balance sheet increased by approximately $1.2T, and items that reduced reserves (removed money from the money supply) increased by approximately $300B. That means that the expansion of the Fed's balance sheet since January 2008 added approximately $900B to the US money supply, which happens to be about the same as the total amount of money that the Fed created during the same period by monetizing US agency and Treasury debt, and from the bailouts of AIG and Bear Sterns.

- "What we need to take home from this is that while the Fed has been increasing the money supply by monetizing debt, the extent to which it has inflated the money supply is $900 billion. And while the increase in the US money supply as a result of the Fed's priming is material, and has maintained US monetary inflation at historically high levels, it is nowhere near hyper-inflationary rates, nor is there any reason to believe that hyperinflation is remotely likely in the US".

- The average increase in the US money supply over the past twelve months, on that basis, has been 8.44%, which is a very high rate of monetary inflation for the U.S.

- To correctly analyze gold's value the inflation rate of the gold supply needs to be considered, this is the increase in gold due to production. If there is more gold around, it is less valuable. Its price declines in proportion to the net amount of gold that is added to the above ground supply of gold, just like dollar inflation devalues the dollar. He estimates that the gold inflation rate could be around 1.5% for the year. He does a quick and dirty calculation to arrive at a rough guide to what gold's average value for 2009 could be in terms of US dollars. The average value of gold was $762 an ounce in 2008. The new estimate is $815 an ounce as the average value of gold in terms of US dollars for 2009. He emphasizes that this method of valuing gold is an attempt to quantify the value of gold, not predict its price.

- The Fed clearly announced that it would end the monetization of Treasury debt by the end of October and the monetization of agency debt in Q1 of 2010, so in 6 months the Fed will stop creating inflation. Therefore it seems the current Fed manufactured inflation is coming to an end.

- The US government, however, will continue to sell Treasury debt to finance its massive deficit. If the Fed stops buying bonds and the Treasury keeps issuing record quantities of new debt, US interest rates will start to rise.

- Rising interest rates would be positive for the dollar and negative for the gold price.

- So in spite of the facts that the Fed has been inflating the US money supply by monetizing debt, and that the US dollar is very likely losing its status as the sole reserve currency, there is a good chance that US interest rates will have to rise and that could cause a rally in the US dollar and a drop in the gold price.

China

- Exports represented 35% of China's GDP last year, and its exorts fell 30% last year. according the World Bank, which means China's GDP should have declined by more than 10% this year. Instead, the Chinese economy grew by 8%. He asks how is this possible?

- The reason is that the Chinese government announced a huge stimulus program, much larger than the US stimulus package as a percentage of GDP, of which only a portion of it has been executed. A more likely source for China's growth is the expansion of its bank credit this year. Bank credit in China has increased by 28% of GDP since January. To put that in perspective, that is equivalent to a $4 trillion increase in the US money supply, more than ten times the amount by which the US money supply actually did increase since January this year. Anyone concerned about inflation should be concerned about the inflation of the Chinese renminbi.

- Here is a big problem. In North America GDP is measured by expenditures while China's GDP is based on production. The act of manufacturing of products is a component of Chinese GDP - not the sale of those products. If China wanted to increase its GDP all it had to do was produce more goods without consideration for whether there was a market for those goods.

- This would explain quite a lot, and it has severe repercussions. It explains why China continued to buy large quantities of raw materials that could not be reconciled with the collapse in the market for its goods (exports). "An economy cannot sustain itself if debt is used to manufacture products for which there is no market. Either the banks, or the manufacturers, or the retailers have to eat the losses. Regardless of where those losses come home to roost such an economy as a whole is rotten to the core".

- That means that China's economy has the potential to implode with a reverberating bang unlike any other that has ever emanated from the East.

- This situation however can last much longer. China has vast resources, approximately $2 trillion in reserve assets. Even so, just like the debt financed US consumer spending spree had to come to an end, so too must China's debt financed demandless production spree. Earlier we reached the conclusion that US interest rates could potentially start increasing and cause the US dollar exchange rate to strengthen, which, in turn, would cause the gold price to fall. We can now add that the massive inflation of China's money supply can cause the renminbi to collapse and send another currency crises rippling through financial markets. A collapse of the Chinese renminbi could also result in a stronger dollar and lower gold price.

- "But consider what could happen when the Chinese miracle economy is unveiled to be no better than the US miracle economy had been. Last year when the US was the epicenter of the financial crises the US dollar rallied and the gold price fell. What would happen if China were the epicenter of an economic collapse? What happens when the gold and commodity bulls realize China cannot continue to consume at an even greater pace than it had been when the world was buying its goods, but, instead, now has to work down the excess inventory it built up? It would be a good bet that the US dollar would rally and the gold price would fall. Given that the gold price is trading at a 25% premium to its fair value and that we can imagine several scenarios whereby the US dollar could rally and the gold price could fall, it seems to me that betting on a higher gold price right now is merely a bet on the Greater Fool Theory. That is not to say that the gold price could not continue to rally - markets can remain irrational far longer than rational people ever imagine they would. Personally, though, I have no interest in buying an over-priced asset in the hope that it will become even more over priced - not even gold".


The full content of his letter is available on the Internet. It can be found just by searching for the quoted passages.