The Best of the Week

Dear Reader,

Welcome to the weekend edition of Casey Daily Dispatch, a compilation of our favorite stories from the week for the time-stressed readers.

Of course, if you want to read all of the Daily Dispatches from the week, you may do so in the archives at CaseyResearch.com.


China’s Gold Intentions

By Alena Mikhan

In broad strokes, today’s investment world seems to be divided into two large groups – gold optimists who expect the metal price to keep ascending, and skeptics concerned about a near end to the gold bull market. In this brief overview we present another reason why the former group may be closer to the truth – Chinese demand.

Look at the top gold-holding countries in the table below:

RankCountryTonnesPercent of total reserves
1US8,133.573.8%
2Germany3,401.069.8%
3IMF2,814.0n/a
4Italy2,451.868.0%
5France2,435.464.8%
6China1.054.11.6%
7Switzerland1.040.117.4%

Source: World Gold Council’s World Official Gold Holdings, March 2011

China’s gold holdings aren’t the largest by volume, but they stand out when compared to its percent of total reserves – they amount to only 1.6% (around $55 billion at current prices) of the country’s total reserve assets of $3 trillion.

There seems to be a lot of room to grow. Recently, opinions of Chinese economists and advisers started emerging, suggesting that the country’s central bank should increase its gold reserves as a hedge against the falling values of other currencies. In the annual report by the People’s Bank of China, their own analysts expressed an interest in expanding the country’s gold reserves. In brief, there seems to be a growing weight of opinion among Chinese decision-makers to add to the country’s official gold holdings. This process is already taking place – but as an unstated current in the gold market, so as not to impact prices significantly. There is a precedent for this, if you recall: In April 2009, Chinese officials announced increased reserves, but the purchases had been done in the preceding years in what we would characterize as “stealth mode.”

Official demand is only part of the story. What we believe will change the picture is the fact that China’s appetite for gold has been increasing by 14% a year on average since the market deregulation that took place in 2001. If this average pace is preserved, China will be consuming more than 1,000 tonnes yearly by 2015. Have a look at the trends for gold in China:

(Click on image to enlarge)

There are plans to further liberalize the gold market, according to the In Gold We Trust report: “[W]ith numerous banks granted access to the Shanghai Gold Exchange[, t]his could facilitate the purchase of gold for millions of Chinese bank customers.” (p. 51) Taking into consideration the Chinese savings ratio of 35%, a growing middle class with more disposable income, high inflation, and an overheated property market, there seems little doubt that the flow into gold will continue, and may well increase.

The interest in gold savings deposits for example is enormous. Industrial and Commercial Bank of China introduced this form of savings product in December 2010, and since then 1.5 million accounts have already been opened. Last year the World Gold Council expected the Chinese gold demand to double by 2020. Now the organisation believes that it could double sooner than that. (In Gold We Trust, p.59)

2011 may well be the first time that China surpasses India as the world’s largest gold consumer. This has clear and huge implications for investors; and that’s why we continue focusing on gold as a central feature of our investment strategy.

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The Condition of the Euro

By Vedran Vuk

How bad is the condition of the euro? That’s the question on my mind today. One way to look at the euro is by comparing it to the dollar. The past three months seem to suggest volatility.:

(Click on image to enlarge)

But this seems completely counterintuitive to the news lately. The euro has even stolen the headlines from the end of QE2. Every day, it seems to be one thing or another about Greece. The news trend is clearly downhill for the euro, not a mix of good and bad. In my opinion, the dollar is adding a lot noise to this chart, since the USD is not doing so hot either. As a result, alongside the dollar, the euro only appears to be volatile.

Maybe gold can give us a better picture of the euro’s condition. After all, with fiat currencies headed down, gold should be on the way up.

(Click on image to enlarge)

Here,the picture comes closer into focus. Clearly, gold is pushing an upward trend, but the last few months seem less clear. At first, gold fell; and now it’s jumping back with renewed vigor. Nonetheless, more factors affect gold than just the value of the euro. Hence, we can’t attribute this whole move to the euro alone.

However, one chart tells the story best: the Swiss franc-to-euro chart. This currency pair doesn’t often make the front-page headlines, but in this case, it’s very important.

(Click on image to enlarge)

There’s no doubt about it. This is a straight shot down. Think about the significance of this: Switzerland is tied at the hip to the eurozone. If Europe’s economy goes downhill, Switzerland will also feel the pain. Hence, we can’t attribute the difference to non-currency factors. For example, in the EUR/USD pair, a good manufacturing report or a decent nonfarm payroll number could create a difference between the two currencies. But bad unemployment numbers in Germany aren’t exactly a promising sign for Switzerland either.

Consider the difference in interest rates. The Swiss benchmark rate has been stuck at 0.25% ,while the eurozone’s rate has increased to 1.5%. Theory would suggest that this means a stronger euro and a weaker franc – the exact opposite of the current outcome. At first, traders explained the appreciation in the franc by predicting a rate hike soon. Well, it’s been a few months, and the rate has not followed the ECB.

Hence, with the EUR/CHF chart, we can analyze the real condition of the euro in as close to a vacuum as possible. And it doesn’t take a genius to see its direction in past three months – straight down.

Kevin Brekke is up next with a great article on Chinese inflation, trade, and what may happen with the yuan. Before we get to that, however, I’d like to announce that there’s a new Casey phyle forming in the downtown Chicago area. To learn more about that group, contact ccasey@srr.com. To learn about any phyles in your area, please email phyles@caseyresearch.com.


Trade, Trial Balloons, and the Yuan

By Kevin Brekke

Just when the dust-up surrounding fraud allegations against Sino-Forest looked to have slipped off the front page ,we got hit with another “sino” announcement last week: China released its trade numbers for June. They showed a surplus of $22.3 billion – considerably wider than anticipated – and smashed consensus estimates.

China registered a trade deficit in the first quarter of this year, the first such occurrence in seven years. The quarterly deficit yielded some temporary cover for Chinese officials against the chronic calls by U.S. officials for further yuan appreciation. However, the deficit appears to have been a one-off event as a surplus re-emerged in roaring style in April and remained positive in every month since.

Like so many of today’s governments, China is struggling to attain a balance among many competing fiscal and economic forces. Often, policies used to tackle one area will aggravate another area. In particular, the juggling act between maintaining sufficient GDP growth to ensure ample job creation while also keeping inflation in check is now looking a little shaky.

In an effort to tamp down rising prices, the People’s Bank of China (PBOC) has raised interest rates five times since mid-October and increased banks’ reserve requirements numerous times to rein in liquidity. With inflation for June reaching 6.4%, a return to trade surpluses, and an expected 9%-plus rate of GDP growth this year, fears that monetary tightening would kill growth have subsided.

China’s inflation is not across all sectors and is being driven by rising prices for food, energy, and industrial commodities. Regardless of the source of inflation, it is a serious concern for Chinese officials. Chinese history shows that periods of high inflation are associated with social, economic, and political unrest – all things that the central planners in Beijing wish to avoid.

Toward that goal, the return to stronger export performance might provide a convenient pretense for another round of yuan appreciation. A strengthening yuan would lower the import cost of commodities and energy, both essential components throughout the food chain. China is the world’s biggest consumer of energy and soybeans, and its import bills have been soaring.

So, what are the odds that the yuan will be allowed to rise?

Managed Floating Exchange Rate

First, let’s take a look at the managed exchange rate of the yuan against the dollar, as it yields a chart unlike any other currency pair:

(Click on image to enlarge)

Since October 1, 1998, the yuan had been trading at a fixed rate of 8.27 to the dollar. The only variance in this rate happened at the third decimal point (.001). On July 21, 2005, the PBOC announced a revaluation to 8.11 per US$ – a 2% rise – and the switch to a managed floating exchange rate. The yuan would begin to trade in a 0.3% band around a midpoint to be announced daily by the central bank.

By May 18, 2007, the yuan had risen to 8.11 from 7.67 – a 5.4% gain – and China widened the daily trading band to 0.5% in response to criticism about the slow pace of yuan appreciation. The yuan would rise by 11% over the following year.

On July 18, 2008, with the yuan trading at 6.82, China announced a return to the dollar peg in response to the global financial crisis, intending to protect its export market. As you can see, the central planners are very efficient at implementing and maintaining a fixed exchange rate, with the rate returning to near flat-line stability reminiscent of the pre-2005 years.

Then on June 19, 2010, China announced a return to increased flexibility in the yuan exchange rate. The yuan had its largest one-day gain, 0.42%, since China adopted its managed floating policy in 2005 and hit 6.79 per dollar. The yuan has since steadily floated higher and trades today at about 6.46, a 4.8% gain.

Trial Balloons

With the exception of the July 2008 “crisis” announcement, changes in China’s management of the currency have been preceded by calls from academics and officials within the party for the currency to rise. And recently, in reaction to rising inflation levels in China, high-profile voices are again expressing similar sentiments and backing another rise in the yuan.

Of note, an official with the State Administration of Foreign Exchange said the trading band should be expanded to 1%. Premier Wen Jiabao has said that the exchange rate may play a role in controlling prices, and deputy central bank governor Hu Xiaolian said more yuan flexibility would ease inflation pressure. Two prominent Chinese state researchers also called on the government to use the yuan to help curb inflation.

Christy Tan, a foreign-exchange strategist at BofA-Merrill Lynch, observed, “The recent comments appear to have been sequenced deliberately,” saying she thinks China is close to further currency loosening.

And if the history of the correlation between widening the trading band and yuan appreciation again holds, the currency could rise sharply in the months following any announcement on additional currency easing from the PBOC.

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Biotech’s Redheaded Stepchild

By Chris Wood

A few days ago in these pages, Alex Daley pondered whether the smoking-hot biotech sector was getting a bit bubbly. And that got me thinking about the one area of biotech that’s not getting much love from investors these days despite some notable recent advancements – stem-cell technology.

We all remember the promise of stem-cell technology when scientists at the University of Wisconsin and Johns Hopkins University first isolated and successfully cultured human pluripotent stem cells back in 1998 – that these miracle cells would lead to products that would revolutionize medicine.

Now it’s thirteen years later and the collective interest in stem cells has waned, but that doesn’t mean scientists aren’t still plugging away trying to realize the dream that once was. Before we get to recent advancements in stem-cell technology and why we think investors will soon show renewed interest in it, let’s take a step back and review what makes stem cells special, and how they could impact medicine.

Stems cells differ from other cell types due to three main characteristics that all stem cells share, regardless of their source:

  1. They are capable of dividing and renewing themselves for long periods;
  2. They are unspecialized; and
  3. They can give rise to specialized cell types.

Because of stem cells’ potential to develop into many different cell types and their unique ability to serve as a sort of internal repair system, dividing essentially without limit to replenish other cells, their potential implications for medicine are profound.

Studies of human embryonic stem cells (hESCs) could provide valuable information about the complex events that occur during human development. By identifying how undifferentiated stem cells become the differentiated cells that form our tissues and organs and developing a more complete understanding of the genetic and molecular controls of these processes, scientists may be able to develop new ways to treat various birth defects and cancer, which are the result of abnormal cell division and differentiation.

Stem cells could also be used to test new drugs. New medications could be tested for safety on differentiated cells created from human pluripotent stem cell lines, allowing for drug testing in a wider range of cell types.

And then there’s the holy grail of stem-cell research: the generation of cells and tissues for use in cell-based therapies. It’s no secret that the need for transplantable organs and tissues far outweighs the available supply. With the potential to develop into specialized cells, stem cells could be used as replacement cells and tissues to treat countless conditions, including heart disease, diabetes, spinal cord injury, and arthritis.

For example, take diabetes. In people with Type I diabetes, the cells of the pancreas responsible for producing insulin are actually destroyed by their own immune system. Studies have shown that it may be possible to direct the differentiation of hESCs in cell culture to form insulin-producing cells that eventually could be used in transplantation therapy.

But what about the ethical issues involved in stem-cell research?

Thanks to advancements in technology, the research is becoming less controversial.

During the early days of human stem cell research, scientists worked with two kinds of cells: embryonic stem cells and non-embryonic “somatic” or “adult” stem cells. Each of these types of stem cells has advantages and disadvantages regarding potential use for cell-based regenerative therapies, but embryonic stem cells are usually more highly prized because they are pluripotent and have the potential to differentiate into almost any cell in the body. Adult stem cells are thought to be limited to differentiating into different cell types of their tissue of origin.

What’s more, large numbers of cells are needed for stem-cell replacement therapies, and while embryonic stem cells can be grown relatively easily in culture, numerous challenges remain when it comes to isolating adult stem cells from the tissue and expanding their numbers in cell culture.

But in 2006, scientists came up with a solution that would allow research on pluripotent stem cells while bypassing the ethical issues associated with the production of hESCs. Researchers working at Kyoto University in Japan identified conditions that would allow specialized adult cells to be genetically “reprogrammed” to assume a stem-cell-like state.

To quote Dr. Charles A Goldthwaite’s article, The Promise of Induced Pluripotent Stem Cells (iPSCs):

These adult cells, called induced pluripotent stem cells (iPSCs), were reprogrammed to an embryonic stem cell-like state by introducing genes important for maintaining the essential properties of embryonic stem cells (ESCs). Since this initial discovery, researchers have rapidly improved the techniques to generate iPSCs, creating a powerful new way to “de-differentiate” cells whose developmental fates had been previously assumed to be determined.

Although much additional research is needed, investigators are beginning to focus on the potential utility of iPSCs as a tool for drug development, modeling of disease, and transplantation medicine. The idea that a patient’s tissues could provide him/her a copious, immune-matched supply of pluripotent cells has captured the imagination of researchers and clinicians worldwide. Furthermore, ethical issues associated with the production of ESCs do not apply to iPSCs, which offer a non-controversial strategy to generate patient-specific stem cell lines.

While numerous technical hurdles remain – and it’s unclear whether iPSCs could ever fully replace hESCs in the lab – the technology represents a big step forward in stem-cell research.

Some other recent advancements that could stoke investor interest include:

  • In January 2011, researchers at Tottori University in Japan successfully made heart pacemaker cells using the embryonic stem cells of mice. The achievement could lead to breakthroughs in the treatment of arrhythmia and could reduce the need for electronic pacemakers in human patients.
  • In November 2010, the FDA approved a trial to test an embryonic stem-cell-derived therapy in the treatment of an inherited disease that causes blindness in young people.
  • In October 2010, 12 years after human embryonic stem cells were first isolated, a therapy derived from such cells was tested in humans for the first time.
  • In August 2010, according to an article from the Daily Telegraph, scientists created synthetic blood using hESCs, which could aid victims of large-scale disasters when blood bank supplies are low. The scientists, who are working with the Wellcome Trust in Great Britain, say their ultimate goal is to create the rare O negative blood type. It can be given to any patient without fear of rejection, but is produced by only 7% of the population.
  • In January 2010, researchers at Stanford showed that transplanted neurons grown from embryonic stem cells were able to form proper brain connections in newborn mice. The discovery, which demonstrates that stem cells can be directed to become specific brain cells, could lead to new treatments for nervous system diseases like ALS (Lou Gehrig’s disease) as well as for spinal cord injuries.

The point is that advances in stem-cell research are being made every day. The technology has finally reached the stage of human trials. And while years of intensive research are still necessary to overcome the technical hurdles that remain, there’s little doubt that fortunes will be made by prudent early investors in the space.

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The Looters

By Doug Hornig

Lately, every second dispatch out of Washington D.C. has involved the debt ceiling. For anyone who’s been living under a Martian rock for the past two months, the federal government reached the statutory limit of what it’s able to borrow back in mid-May. In other words, without running up further debt, it can’t pay its bills. But the law prohibits the issuance of any more funny paper. Impasse.

This has happened in the past, and it has always resulted in an increase in the debt ceiling. Now we’re bumping our heads against it one more time. Unless that limit is raised, and soon, the “full faith and credit of the U.S. government” will be a thing of the past as the Treasury begins to default on its obligations.

President Obama and the Republican leadership in the House have been at loggerheads over this issue. The GOP wants drastic spending cuts to the federal budget before it agrees to raise the limit; Obama wants some form of tax increases to make the cuts more palatable. Both sides throw out words like “non-negotiable.”

‘Round and ‘round it goes – with each party accusing the other of holding the American people hostage to its ideological agenda – but where it stops, everyone knows. Some kind of deal will ultimately be struck. The limit will be raised, the government will get the extra money it needs to further bloat its spending programs, the levers of power will be greased, and life will go on. That’s what all involved want. For the most part, the rest is grandstanding for the folks back home.

But do you see the more interesting question here? If not, go back to that first paragraph and reread it. See it now?

Right. The debt limit was reached on May 15. So how come the defaults didn’t begin immediately? Who’s been paying the bills in the meantime?

Did you guess that, some way or other, we have? You’re pretty much correct. If you were reading the newspaper back in May, you might have seen a small reference to a statement from Treasury Secretary Geithner to the effect that he could delay the day of reckoning until August. You probably didn’t see any specifics, but some kind of accounting gimmick was involved, you were led to believe. No biggie. Don’t worry.

In fact, what happened was that Geithner declared a “debt issuance suspension period” (DISP), to be in effect from May 16 to August 2. No new debt would be issued. Ok, that sounds good. But what about the aforementioned bills that would come due in the interim?

Well, as Geithner explained in a letter to congressional leaders, during this period the Treasury “will suspend additional investments of amounts credited to, and redeem a portion of the investments held by, the CSRDF, as authorized by law.” And he went on to say the same regarding the “Government Securities Investment Fund [‘G Fund’] of the Federal Employees’ Retirement System.”

The CSRDF is the Civil Service Retirement and Disability Fund. The G Fund is part of the Thrift Savings Plan. Though there are some differences in employer vs. employee contributions, both are basically pension plans for civil service employees. And both have basically been looted.

Here’s what happened to the former (figures are for the end of the month):

As you can see, at the end of last year, the CSRDF held over $775 billion in assets. The Office of Personnel Management estimated at that time that the total would swell to $806B by the end of this year. They may have a tough time getting there. Note the $22B drop in May – that’s the DISP at work. And it’s gotten worse since. According to the just-released Monthly Statement of the Public Debt, as of the end of June, the Fund had plunged to $680B. More DISP.

The situation over at the Thrift Savings Fund? Check this out: Around $130B in assets at the end of April shrank to less than $75B by May 31. And it gets worse – the June report shows a meager $27B left in there.

So, prohibited from issuing debt, the government raided – excuse me, borrowed from  –people’s retirement funds instead. And they took a lot. More than $180 billion. Of course, in Secretary Geithner’s encouraging words: “Each of these actions has been taken in the past by my predecessors during previous debt limit impasses. By law, the CSRDF and G Funds will be made whole once the debt limit is increased.”

Perhaps so. But these sorts of shenanigans do not exactly inspire trust in our financial overlords. They suggest desperation. And they also raise some disturbing possibilities.

Consider that while the Treasury lists the CSRDF under “Government Account Series – Intragovernmental Holdings,” the G Fund is denoted a “Government Account Series – Held By the Public.” That is more or less people’s personal money. One would be forgiven if one thought that, despite Geithner’s historical precedents, it should be off limits to government fingers.

If civil service pension funds can be molested, what about IRAs? Some have suggested that the government is already eyeing our private retirement accounts, to see what might be gotten out of them. Washington created them; it can change the rules any time it wants… to require, say, that a certain portion – or all – be invested in government paper. What a windfall that would be.

In the end, “debt issuance suspension,” a term no one will ever remember, could turn out to be the wellspring from which all manner of mischief flows.

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Notes from the Field: Lithuania

By Louis James

I'm checking in from Trakai, Lithuania this week, where – for once – I'm not kicking rocks. Lithuania does produce amber, actually, and I suspect there may be other resources here, but this is not a place known for mineral wealth, nor is there any serious mineral exploration going on here that I know of.

I'm here to teach entrepreneurship. This is my yearly sabbatical, my semi-vacation, the thing I do that recharges my batteries for another year: the Casey Youth Conference on Liberty and Entrepreneurship (CYCLE). That's because I'm teaching some of the best and brightest young people in the world – mostly Belarusians, but also Lithuanians, Ukrainians, Romanians, one Latvian, one Australian, and an American. (Unfortunately the three Azeris and several more Americans couldn't make it.) What I get for the knowledge and encouragement I give is a deluge of such positive energy that I almost can't stand it. I think I laugh more during this week than I do at any other time of the year. My cheeks ache from smiling so much.

An example:

A young man from Germany just gave a talk. He was one of my students last year, and after hearing what I and the other teachers – including Doug Casey and Rick Rule – had to say, he went back to Germany, turned down the job offer he had, and launched several businesses. He wrote a business plan and raised $2 million for one idea alone. Unfortunately, his idea got regulated out of viability before he could roll it out; but fortunately, that happened before he spent any money, so he was able to return the capital he raised to his investors. Now he has several businesses going, including a consultancy that pays him four times what the job he turned down would have paid him, and at which he works about 25 hours a week (the job would have been 50-70 hours a week). He's gone even further and lives a “permanent tourist” lifestyle, with his banking mostly in Lithuania, his business based in Estonia, and since he has no residence in Germany where he came from, no tax liability there. And no residence anywhere else, either.

He tells his story, then looks at me and the group, and says, "CYCLE changed my life!"

I'm so proud, I could burst!

“Well,” some readers might think, “that’s very nice, but what does it have to do with making us money?” Shouldn't I be out somewhere kicking rocks, looking for gold? Perhaps; but there are different kinds of gold. One gold nugget I turned up in running these conferences is Andrey, my assistant, who makes it possible for me to travel constantly, looking for good speculations without losing track of all the companies we are covering.

Plus, you've got to stop cutting wood and sharpen the saw sometimes, or the saw gets dull and your efficiency drops and drops, eventually to zero. Brainstorming with these brilliant young people sharpens my mind like nothing else imaginable.

And of course, in the 21st century work is wherever you are, as long as you are online. Deals continue flowing through my inbox, and I am lining up my next batch of due diligence trips.

But more important to me is the reminder that all that we do at Casey Research to help our readers increase their wealth is about more than money. Don't get me wrong: We are focused entirely on maximizing your returns in our various fields. That, however, is a means, not an end. Life is more than money; the goal is the good life – however each of us defines that. Making money is a powerful means to that end, but it is not the end itself.

Teaching young people how to invest, start businesses, and so forth reminds me of this very simple and obvious – but often forgotten – truth.

I hope you too, dear readers, will take the time to stop and smell the roses sometime soon, and remember why you are here, working on whatever goals you are working on, and enjoy the fact that you are an entity in purposeful motion – and what a glory that is!

And that, dear reader, is that for this week. Until next week, thank you for reading and for subscribing to a Casey Research service!

Vedran Vuk
Casey Daily Dispatch Editor

Jul 16, 2011