Dear Reader,

With the euro at $1.40/€, many investors seem to be taking Trichet’s call for higher rates seriously. However, I’m a bit skeptical. On the one hand, the European Central Bank appears to be seriously concerned about inflation. But on the other, it’s a case where the central bank wants to have its cake and eat it too.

A big problem for both the Federal Reserve and the ECB is the market’s future expectations of rate increases. As soon as the rate rises even a measly quarter point, investors will pronounce an end to the low-rate era. Future expectations will be reflected in today’s rates and currency prices. Hence, central banks can’t raise rates even slightly without shaking the market. 

An example of this is Bank of Canada, the Canadian central bank. Right now, the Canadian dollar is worth almost $1.03. Why? Because the central bank began raising rates, the market is expecting more of the same. Though Canada’s overnight rates are only 1%, the market has bid its currency upward. Bank of Canada has even taken a break from rate increases. But the market doesn’t seem to care; the currency continues to appreciate anyway.

Trichet is likely afraid of a similar scenario. Simply by discussing higher rates, he has taken the euro to $1.40/€. What do you think would happen if the ECB actually raised rates? Investors might officially perceive the euro as sounder than the dollar. These expectations could force the currency higher, much like the case in Canada. And once the upward path starts, it may be hard for the ECB to reverse.

This is the problem with Trichet’s message. He’s hinting at higher rates, but says that investors shouldn’t interpret a change in rates as a new trend. He wants the benefits of higher rates to stop inflation while at the same time not overshooting the problem. Essentially, the ECB wants the best of both worlds. But in reality, this result will be hard to achieve. Therefore I’m not so sure that the ECB is quite ready to lift rates higher.

Trichet must weigh the risk versus the reward. He has to take out the scales and make a sound decision. I don’t think that any side appears to him heavier at this point. The ECB wants higher rates to fight inflation, but without unintended consequences. That stand doesn’t sound like a rock solid resolution for higher rates –hence my skepticism. 

First up today, Jeff Clark will explain the next big driver in gold prices, pension funds. If they get an appetite for gold, the sky is the limit. Then Kevin Brekke will cover a new report on declining cities and the effect on real estate prices. It’s interesting how the dynamics of the real estate market are changing. Now long-term growth rates of cities have once again become important – as they should have always been. The industry is transforming back into an actual investment area that requires thought and planning rather than a bubble market where anything went up.

The Driver for Gold You’re Not Watching

Jeff Clark, BIG GOLD

You already know the basic reasons for owning gold – currency protection, inflation hedge, store of value, calamity insurance – many of which are becoming clichés even in mainstream articles. Throw in the supply and demand imbalance, and you’ve got the basic arguments for why one should hold gold for the foreseeable future.

All of these factors remain very bullish, in spite of gold’s 450% rise over the past 10 years. No, it’s not too late to buy, especially if you don’t own a meaningful amount; and yes, I’m convinced the price is headed much higher, regardless of the corrections we’ll inevitably see. Each of the aforementioned catalysts will force gold’s price higher and higher in the years ahead, especially the currency issues.

But there’s another driver of the price that escapes many gold watchers and certainly the mainstream media. And I’m convinced that once this sleeping giant wakes, it could ignite the gold market like nothing we’ve ever seen.

The fund management industry handles the bulk of the world’s wealth. These institutions include insurance companies, hedge funds, mutual funds, sovereign wealth funds, etc. But the elephant in the room is pension funds. These are institutions that provide retirement income, both public and private.

Global pension assets are estimated to be – drum roll, please – $31.1 trillion. No, that is not a misprint. It is more than twice the size of last year’s GDP in the U.S. ($14.7 trillion).

We know a few hedge fund managers have invested in gold, like John Paulson, David Einhorn, Jean-Marie Eveillard. There are close to twenty mutual funds devoted to gold and precious metals. Lots of gold and silver bugs have been buying.

So, what about pension funds?


According to estimates by Shayne McGuire in his new book, Hard Money; Taking Gold to a Higher Investment Level, the typical pension fund holds about 0.15% of its assets in gold. He estimates another 0.15% is devoted to gold mining stocks, giving us a total of 0.30% – that is, less than one third of one percent of assets committed to the gold sector.

Shayne is head of global research at the Teacher Retirement System of Texas. He bases his estimate on the fact that commodities represent about 3% of the total assets in the average pension fund. And of that 3%, about 5% is devoted to gold. It is, by any account, a negligible portion of a fund’s asset allocation.

Now here’s the fun part. Let’s say fund managers as a group realize that bonds, equities, and real estate have become poor or risky investments and so decide to increase their allocation to the gold market. If they doubled their exposure to gold and gold stocks – which would still represent only 0.6% of their total assets – it would amount to $93.3 billion in new purchases.

How much is that? The assets of GLD total $55.2 billion, so this amount of money is 1.7 times bigger than the largest gold ETF. SLV, the largest silver ETF, has net assets of $9.3 billion, a mere one-tenth of that extra allocation.

The market cap of the entire sector of gold stocks (producers only) is about $234 billion. The gold industry would see a 40% increase in new money to the sector. Its market cap would double if pension institutions allocated just 1.2% of their assets to it.

But what if currency issues spiral out of control? What if bonds wither and die? What if real estate takes ten years to recover? What if inflation becomes a rabid dog like it has every other time in history when governments have diluted their currency to this degree? If these funds allocate just 5% of their assets to gold – which would amount to $1.5 trillion – it would overwhelm the system and rocket prices skyward. 

And let’s not forget that this is only one class of institution. Insurance companies have about $18.7 trillion in assets. Hedge funds manage approximately $1.7 trillion. Sovereign wealth funds control $3.8 trillion. Then there are mutual funds, ETFs, private equity funds, and private wealth funds. Throw in millions of retail investors like you and me and Joe Sixpack and Jiao Sixpack, and we’re looking in the rear view mirror at $100 trillion.

I don’t know if pension funds will devote that much money to this sector or not. What I do know is that sovereign debt risks are far from over, the U.S. dollar and other currencies will lose considerably more value against gold, interest rates will most certainly rise in the years ahead, and inflation is just getting started. These forces are in place and building, and if there’s a paradigm shift in how these managers view gold, look out!

I thought of titling this piece, “Why $5,000 Gold May Be Too Low.” Because once fund managers enter the gold market in mass, this tiny sector will light on fire with blazing speed. 

My advice is to not just hope you can jump in once these drivers hit the gas, but to claim your seat during the relative calm of this month's level prices.

Jeff Clark is the editor of BIG GOLD, Casey Research's monthly advisory on gold, silver, and large-cap precious metals stocks. If this is the kind of in-depth information you’d like to utilize for your investments, give BIG GOLD a risk-free try with 3-month money-back guarantee.

Declining Real Estate Within Declining Cities

By Kevin Brekke

By now, just about anyone past puberty and above room temperature knows that home prices across America have declined sharply over the last few years and continue to fall, and will likely retain a downside bias for quite some time. And although recent signs of price stability are emerging in select real estate markets across the country, the somewhat tattered and discredited industry dictum citing the importance of “location, location, location” takes on new meaning when any discussion of recovery surfaces.

Specifically, the snappy sales principle formerly used to assure buyers of the wisdom of their purchase and its insulating value from price declines must now be used to question a property’s potential for price appreciation.

“Is the property located in a declining city? What is the economic outlook for the area?” are now crucial questions confronting property buyers.

The answers to these and other related questions were examined in a recent research paper from the Research Institute for Housing America (RIHA). The paper begins with an executive summary, a lucky break for the time-stressed reader, and answers the fundamental question, “What is a declining city?” Quoting the RIHA:

Simply put, a declining city is one in which the people have left, but the houses, apartment buildings, offices and storefronts remain. At the extreme, think of a ghost town from the Old West, a town that lost its reason for being. Are there cities or large metro areas in the United States at risk of disappearing back into the desert (or the swamp) today? Probably not, but there are certainly neighborhoods and submarkets within metro areas that have passed a tipping point, and have little prospect of returning to anything close to their previous peaks. Lastly, another type of declining city may also be emerging — places that grew substantially during the housing boom and are now experiencing unprecedented declines in house prices and increases in foreclosures. [emphasis mine]

    And there you have it; within this definition is also the paper’s long-term prognosis for housing markets within areas that are in decline.

    In the interest of a balanced review, I must mention that the news out of the RIHA is not all dire. Also included in the its forecast is this:

    Though the pace and extent of the overall economic recovery of these markets is still far from certain, many places will likely resume growth and fully recover within the next decade or so.

      Bear in mind that the RIHA was founded by the Mortgage Bankers Association and is, as stated on the RIHA website, “devoted to independent research on expanding housing and mortgage markets to reach all Americans. The Institute sponsors and disseminates balanced and credible research focused on increasing housing and credit opportunities for underserved communities and populations.” The old advice to “never ask a barber if you need a haircut” comes to mind.

      The consensus at Casey Research is that the probability of high numbers of cities, or submarkets within cities, achieving a full recovery in house prices – meaning a return to pre-2007 levels – in 10 years is low. Very low. Unless of course, the Federal Reserve ignited serious double-digit inflation.  Then, we’ll see higher prices, but they won’t come without a bagful of other problems.

      The paper does a thorough and respectable job of analyzing the consequences of declining cities on the housing market. But outside of defining what distinguishes a declining city, it fails to identify why a city would fall into decline and what triggers the erosion of residents.

      There are references to “metropolitan market[s] particularly hard hit by a major negative economic shock” and the role of public policy. But the obvious culprit is never identified: taxation and government regulation. The confiscation of wealth via taxation is the largest economic shock to every American’s budget, and taxation is the outcome of public policy. Government regulation is almost universally Shakespearean; taxation by another name.

      I covered the role tax competition between state and municipal governments is playing in the migration patterns of Americans in a previous Dispatch you can read here. As the finances at all levels of government become increasingly dire, we should expect envy-driven tax decisions to squeeze more money out of more people. This action will only cause added cities to tip into decline or accelerate the process already underway in others.

      Anyone considering investing in real estate must consider the threat of cities in or near decline. The old rules no longer apply.

      The Not-So-Strategic Oil Reserve

      By Vedran Vuk

      Many congressmen are urging the use of the strategic oil reserve to alleviate high gas prices. But there’s a problem with this approach. First of all, the strategic oil reserve doesn’t really save the consumer in the long run. Consider this: how did the oil reserve get there? Of course the government had to purchase the oil. And what did that do to the price of oil? At some point, this meant higher demand and hence higher prices.   

      So, let’s say the government releases the supply to reduce the price from $100 to $95. Great right? Well, sort of. In the past, the government purchased this oil on the market. For the sake of simplicity, suppose that the oil purchases took place all at once. This might have increased the price of oil from $70 to $75. In a way, the consumers aren’t saving much. They already paid for the reserve in the past, when oil prices were lower. 

      The strategic reserve should be utilized only for physical disruptions in supply, not to manipulate prices. If the gas pumps are seriously in threat of running dry, let it loose. The government shouldn’t pull the parachute before the plane is crashing.

      Furthermore, there are other ways to restore consumer confidence. How about extending temporary tax cuts while gas prices remain high? This seems like a much easier and better solution than trying to depress oil markets with the strategic reserve. Furthermore, while a temporary small tax cut is easy to repeal, the oil reserve won’t be easy to refill in a real crisis.

      That’s it for today. Thank you for reading and subscribing to Casey’s Daily Dispatch.

      Vedran Vuk
      Casey's Daily Dispatch Editor