In December of 1974 I was kid on an FX desk for a Swiss Bank in NYC. History gave me a lucky break. The dollar was in the crapper at the time. Too much debt and no plan to deal with it was the problem then. To stabilise the dollar and shore up a weak international balance sheet President Ford announced that Treasury would auction off gold. Because Switzerland was a big player in the gold biz my bank was involved. I ended up having a role in the process. Along the way I made some observations that have stuck with me. I look at QE and what lies before us and wonder if history might repeat itself.
Back in 74 the gold price plunged on the news. The dollar finally found some demand. Equity markets rejoiced. I attended meeting at Treasury on the gold sales. I got to meet some real players. The initial assumption was that the gold price was in for a long-term plunge. There simply was not enough buyers for the AU that was coming up for sale.
We could not have been more wrong. The first auction was over subscribed. Each following auction was for larger amounts and saw bigger demand. This continued for a few years until the next bombshell came. In 1978 the IMF announced that it too would sell gold. (The US told the IMF to do this).
From 1975 to 1980 the US Treasury and the IMF sold a combined 42 million ounces (1300 tonnes). What did the price of gold do while all that selling was going on?
The price of gold went up nearly every week for five years. The more the US sold the more the market demanded.
The numbers back then look silly by today’s standard. The whole 42mm oz were sold for a measly $25b. But numbers were different back then. For example, the Dow closed 1974 at 580. Today it is 20X’s higher. I would use the same multiplier to value the scale of those long ago gold sales. The current value in gold terms is still only $60b. But the comparison to the size of GDP and money supply makes its impact closer to $500b. Therefore it isn’t so different in size than Mr. Bernanke’s QE-2 program.
My lesson from this history is that when governments are selling something of value it just increases the demand until the government selling is ended. Can history repeat itself? In reverse?
In 2011 the Fed will be buying dodgy securities at the highest prices in history. The market is anticipating the coming demand and driving up prices on the assumption that there will not be enough sellers when the real POMO action starts.
What happens if those auctions are blowout successes? What if the Fed stands up one day and says, “We will buy $25 billion”, and the market offers them $150b? What if each of these big POMO buys sees a B.T.C. of 3 or 4 Xs? What if the big holders like China, Hong Kong, Korea, Singapore, OPEC and Russia say, “If they are buying, we are selling”.
Put yourself in a position of foreign CB that holds boodles of unwanted Treasuries. Now, in comes the Fed buying huge slugs at premium prices. Those same big holders all hate QE and the negative impacts they are feeling from it. How many of those CB’s will just vote with their feet? One or two and this turns into a rout.
The first few big POMO buys will probably not be conclusive. We need to get a few under our belt. However, should we see a pattern where the supply of paper that comes out at the auctions overwhelms the Fed’s buying interest we are going to have a very big problem on our hands.
There are many who have said that the US financial system will end on the day that there is failed Treasury auction. I have never believed in that. The Fed is there to print money and insure that there will be no failure. But it will be an interesting muse of history if the US financial system comes under a big strain as a result of some spectacularly successful auctions. But those reverse auctions would result in holders lining up to either wash their hands of US paper or to reduce what the own by significant amounts.
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