Author: Ron Hera

(This guest post comes from Hera Research)

Investors often seek safety from financial market turbulence in US government bonds since they offer virtually no risk of default and, unlike cash or gold, provide a yield. 

At the same time, sovereign debt default concerns outside the US, e.g., Iceland, Dubai, and Greece, have been linked to short-term rallies in the US dollar and have diverted attention from the fiscal challenges facing the US. 

However, since seven US states are in worse financial condition than Greece, Ireland, Portugal or Spain, shelter may prove hard to find. 

With a $3.83 trillion budget, a $12.3 trillion federal government debt, a $1.35 trillion 2010 budget deficit and $63 trillion in unfunded liabilities, the fiscal condition of the US has come into question and foreign interest in US Treasuries has declined.  In late March, it was reported that the 10-year US Treasury Note yield had risen 30 basis points and that foreign holders of 10-year Notes were selling in record numbers.

Reports of US Treasury auction distress first appeared in December of 2009 when an article by Eric Sprott and David Franklin entitled “Is it All Just a Ponzi Scheme?” questioned the “Other Investors” reported by the US Federal Reserve.  The unidentified investors held $359.1 billion worth of US Treasuries in the forth quarter of 2008 but $880.5 billion by the end of the third quarter 2009, an increase of $521.4 billion.  Based on the Federal Reserve Flow of Funds Report, Messrs. Sprott and Franklin found the increase attributable to the “Household Sector”, which is defined in the Federal Reserve’s Flow of Funds Guide as “…amounts held or owed by the other sectors … subtracted from known totals … [such that] the remainders are assumed to be the amounts held or owed by the household sector.”  Thus, the “Household Sector” is strictly an artifact of accounting practices, and, as a result, there has been some speculation regarding the parties responsible for $521.4 billion in 2009 US Treasury purchases.

A recent analysis of 4-week Treasury auction results by OmniSans Investment Research suggested that US Treasury auctions are more distressed than has been generally recognized, and a similar analysis appeared on the popular Zero Hedge website.

The OmniSans and Zero Hedge articles focus on the percent of Treasury auction purchases made by the Federal Reserve’s own primary dealers, as compared with other bidders, and on the percentage of indirect (foreign) bids accepted. In particular, the acceptance of 100% of foreign bids suggests extremely weak foreign demand.  While the evidence is accurate, the conclusion is less clear since the changing pattern of US Treasury auction results is more complex.

Federal Reserve measures designed to increase financial market liquidity and to recapitalize the banking system, such as the Term Asset-Backed Securities Loan Facility (TALF), represent monetary inflation (or re-inflation), and some of this currency has certainly found its way into the coffers of the US Treasury, i.e., a rise in primary dealer purchases.  A rise in primary dealer purchases could also be a result of the low cost of borrowing from the Federal Reserve.  In theory, primary dealers can generate profits simply by borrowing from the Federal Reserve at near zero percent interest rates and buying Treasuries with higher yields.  Of course, primary dealer purchases funded by borrowing from the Federal Reserve would be tantamount to debt monetization.

An increase in primary dealer purchases, or in purchases by direct bidders, could compensate for a decline in foreign purchases of US Treasuries but would not explain it.  To be significant, a decline in foreign purchases would have to be evident in more than one type of Treasury, i.e., outside of the reported 1.0 bid to cover ratio for indirect bidders in recent 4-week Treasury Bill auctions.

What may be an emerging pattern of falling foreign demand and rising primary dealer purchases, both of which have been moderated by an increase in purchases made by direct bidders (financial institutions that place bids directly with the US Treasury, such as domestic depository institutions and mutual funds) is evident in 4-week Treasury Bill auction results.

Direct Federal Reserve purchases of US Treasuries (monetization) have been distributed over Treasuries of different types and maturities and have been generally implemented as a consistent, low-level of buying for particular Bills, Notes or Bonds.  Overall, the Federal Reserve increased its holdings of US Treasuries by $286 billion in 2009, an increase of more than 60% as of September 2009 compared to 2008, and, as of March 2010, the Federal Reserve’s holdings of US Treasuries had increased another $14 billion to roughly $777 billion.

What is important is that monetization has been most significant in 4-week Treasury Bills, reaching 38.59% of total 4-week Treasury Bill sales on January 26, 2010, but similar spikes in Federal Reserve purchases do not appear in auction results for other types of Treasuries.  Thus, it should come as no surprise that 4-week Treasury Bills have fallen out of favor with foreign investors.

Of course, the amount of currency created by monetization in a particular auction, regardless of the percent of Treasuries purchased by the Federal Reserve, represents only a small fraction of the monetary base.  Nonetheless, there is not only a psychological dimension but also aggregate effects on the balance sheet of the Federal Reserve, on the US dollar and, ultimately, on the viability of US Treasury auctions.

A general pattern of decreased indirect bidder participation offset by rising direct bidder participation, setting aside any increase in primary dealer purchases, is evident outside of 4-week Treasury Bill auctions.

Foreign demand for 30-year Treasury Bonds has fallen over the past year, suggesting that foreign purchases may have shifted towards the short end of the maturity continuum.  The more significant fact, however, is the marked increase in direct bidder purchasing, which has more than compensated for slack foreign demand at the extreme long end of the spectrum leaving primary dealer purchases flat.

Given the increase in direct bidder purchases, and reflecting on the questions raised by Messrs. Sprott and Franklin, it seems likely that the $521.4 billion worth of US Treasuries in 2009 reflects otherwise unclassified direct bidders, i.e., direct bidders other than recognized domestic investment funds and depository institutions.  Unfortunately, the identities of the bidders remain unknown in any case.

The most dramatic example of primary dealer purchases replacing indirect (foreign) bidders is in Cash Management Bills, but these represent a rolling debt of perhaps $100 billion analogous to the corporate bond market and are not representative of other types of Treasuries.

While there are apparent signs of Treasury auction distress, based on a survey of Treasury auction data from January 2009 to March 2010, there is no indication of an immanent auction failure so long as the primary dealers and direct bidders continue to step into the breach.  Further, the same patterns either do not appear or are much less pronounced in longer-term Treasury Note sales.

 

It seems unlikely that direct bidders within the US can compensate indefinitely, or to an unlimited extent, for falling foreign demand.  Commenting on the ambitious spending plans of the US federal government, Zhu Min, Deputy Governor of the People’s Bank of China said in December 2009 that “the world does not have so much money to buy more US Treasuries.”

It would certainly be unreasonable for the US federal government and Federal Reserve to assume that ambitious deficit spending and ongoing quantitative easing (QE) would have no cumulative impact on US Treasury auctions.  If there is a limit to foreign appetite for US debt, to foreign capacity to lend to the US, or to international tolerance for US dollar devaluation, the US government and Federal Reserve seem determined to find it.

China’s foreign exchange reserves, valued at $2,399.2 billion at the end of December 2009 (not including gold), include only $894.8 billion in US Treasury bonds.  In contrast, the US must issue or roll over $702 billion in debt in 2010 and a total of $2.55 trillion in Treasuries to be issued this year, while $3.7 trillion in US Treasuries are held abroad.

While US GDP was at $14.46 trillion in 2009 (with debt levels set to rise to 90% of GDP by 2020), China’s GDP is currently estimated as $8.791 trillion.  Although there are signs of recovery in Chinese exports, the entire value of China’s reserves, assuming that its current Treasury holdings could be liquidated, is insufficient to finance US federal government debt in 2010.

Since China recently liquidated $34 billion in US Treasuries, the statement of China’s Director of the State Administration of Foreign Exchange, Yi Gang, “[China is] a responsible investor and in the process of these investments we can definitely achieve a mutually beneficial result” seems obligatory.  In reality, the US is currently the largest debtor nation in the history of the world, while China is the US’ largest creditor, and neither China nor any other country is in a position to bail out the US should US Treasury auctions run aground.  Nonetheless, an overt Treasury auction failure seems impossible with the Federal Reserve as the lender of last resort to domestic depository institutions and to its own primary dealers.  Unfortunately, direct monetary inflation is not without consequences.  Specifically, increased debt monetization would impact the value of the US dollar and could spark high inflation, i.e., rising US dollar prices for imported goods and energy, or an eventual hyperinflationary collapse of the US dollar.

Without a robust economic recovery in the US, it seems unlikely that the apparent distress of US Treasury auctions will abate.  Among other things, the gap between increasing US federal government spending and falling federal tax receipts is currently growing.  A continuation of current US federal government and Federal Reserve policies under deteriorating economic conditions suggests levels of debt that could not be absorbed by US creditors, and a so-called double-dip recession would put extreme pressure on the US dollar.  Indicators of Treasury auction distress include:

• Rising Treasury yields, regardless of interest rates, signaling inadequate demand.
• A continued decline in foreign bids, thus a higher percentage of accepted bids, particularly in additional types of Treasuries, outside of 4-week Treasury Bills.
• Direct bids failing to rise at a rate sufficient to offset falling indirect bidder demand, thus causing either primary dealer purchases or monetization to rise.
• A marked and sustained increase in primary dealer purchases versus direct or indirect bidders.
• Additional spikes in Federal Reserve purchases (monetization) in any type of Treasury, or a sustained increase in Federal Reserve Treasury purchases generally.
• An expansion of the incipient shift away from the long end of the maturity continuum towards shorter-term Treasuries.

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(Rob McEwen is chairman and CEO of US Gold Corporation (NYSE:UXG and TSX:UXG). In this exclusive interview provided by Hera Research, Mr. McEwen discusses financial markets, the McEwen Junior Gold Index (MJGI) and the junior mining sector, which he believes offers superior growth opportunities, and where the gold market is headed in 2010 and beyond. Mr. McEwen also offers unique insights into his strategy to create the next Homestake Mining Company.)

Rob McEwen formerly founded and served as Chairman and CEO of Goldcorp, Inc. (NYSE:GG), the world’s lowest-cost million-ounce gold producer. Mr. McEwen transformed Goldcorp from a group of small companies into a global, tier-1 gold mining giant whose market cap now exceeds $28 billion. Under Mr. McEwen’s leadership, Goldcorp’s share price climbed at a compound annual growth rate of 31%.

Mr. McEwen’s goal for US Gold Corporation, in which he is the largest shareholder, is for it to become Nevada’s premier exploration company. Since Mr. McEwen took the helm, US Gold’s share price has increased more than 1000%.

HRM: Thank you for taking the time to speak to me today. Before we get started, I wanted to ask you why you created the MJGI when there are other indexes such as the XAU and HUI?

Rob McEwen: We originally developed the index internally to monitor the performance of our investments relative to other junior mining companies in North America. There have been several articles about it and it’s been cited in research. To be included in the index, companies have to have a minimum market cap of $50 million and a minimum trading volume equal to $50,000. They have to be listed on an exchange and have no commercial production.

HRM: So all the companies are pre-production?

Rob McEwen: Yes. The companies are involved in gold exploration and discovery. This is where the growth is going to be.

HRM: Have you considered creating an Exchange Traded Fund (ETF)?

Rob McEwen: A number of investors said they wanted to have a product like that. We looked at creating an ETF and determined that the companies within the index are too small. Their shares don’t afford the liquidity necessary to move in and out as frequently as an ETF requires. You’d have to include producers, which tend to have greater market liquidity.

Rob McEwen: Shareholders have to approach this cautiously and they shouldn’t put all their money in one stock. An exploration company can promise you one thing. They can’t promise you a discovery, but they can promise they will spend all the money they have on exploration. Once they have a discovery, it has to be large enough to raise more capital, or to sell or joint venture with a larger company.

HRM: Exploration and discovery isn’t for the feint of heart.

Rob McEwen: Anyone who goes into the market thinking it will go up forever should get out now. People have to be thinking about how to grow their capital and individual investors have to diversify their risk. Major producers’ share prices will increase with the price of gold, but they won’t deliver the dramatic growth of a junior with a discovery.

HRM: When the stock market crashed in 2008, the stocks of gold exploration and discovery companies fell more than other types of companies. Couldn’t that happen again?

Rob McEwen: Yes. They’re more thinly traded and they have a smaller number of shares outstanding. A large investor can sell a block of equity and adversely affect the stock price. They can’t absorb aggressive institutional selling. In 2008, the whole market was down. People were selling indiscriminately.

HRM: So pre-production, gold exploration and discovery companies are more vulnerable in a stock market decline?

Rob McEwen: I would say that’s true. In 2008, they had the largest declines. They’ve recovered well but have not returned to former levels. They’re reliant on equity capital. An extended decline in the stock market can limit their access to capital or force them to accept poor terms.

HRM: I would be remiss if I didn’t ask what you look for in gold exploration and discovery companies.

Rob McEwen: I start off looking at where their property is located. I tend to stay away from Africa and the former Soviet Union. I look to see if there is growth potential. I tend to buy distress, meaning companies that are undervalued or underappreciated or depressed because of market timing, and I take large positions so I can influence the company’s strategic direction.

HRM: That’s probably not something the average investor thinks about.

Rob McEwen: I agree. I look for combinations where the sum [of two companies] is greater than two, such as companies operating in established mineralized belts. In US Gold’s case I saw an opportunity to take over three companies. It’s a game of putting different pieces together to create a much stronger entity that can grow its value faster.

I look for companies that have been overlooked or are underappreciated, or whose assets are depressed because of market timing. I am a large shareholder in Minera Andes, Inc. (TSX:MAI), which operates in Argentina, and Rubicon Minerals Corp. (TSX:RMX), which has properties at Red Lake, in the Ontario mining district, as well as in the US.

HRM: What are your plans for US Gold’s Nevada projects?

Rob McEwen: We just released an updated gold resource estimate, last week, for our Gold Bar project in Nevada and a preliminary economic assessment will be released later this month that will highlight the initial gold production profile for Gold Bar. Our drilling program slowed down during the winter because the properties are above 6000 feet and we didn’t want to incur additional costs. We will be drilling throughout the summer. The Gold Bar properties are in an area that has been previously mined, so permitting should be easier.

HRM: I understand US Gold has another group of projects in Mexico.

Rob McEwen: US Gold has an exciting high grade, silver discovery at its El Gallo project in Mexico. We are rapidly advancing this project with a large $17 million exploration drilling program this year. In fact, it is probably one of the largest (330,000 feet) exploration programs being conducted in Mexico this year by a junior [mining company]. We’ll have an initial resource estimates out at the end of the second quarter followed by a second updated NI 43-101 by year end along with a preliminary economic assessment for El Gallo. The ore is close to surface and we can use inexpensive mining methods. Targets are shallow, between surface and 500 feet. The topography is gentle and we can do drilling quickly. There is a good chance this will be our first mine.

HRM: Do you see growing investment interest?

Rob McEwen: Gold tends to move up when paper currency and financial products are questioned. From 1981 to 2001, gold was going down and portfolio managers and investment advisers weren’t recommending owning gold or gold stocks and most are still thinking that way. Despite the fact, gold bullion and gold shares have been the best performing asset class over the past 10 years. Performance speaks for itself. There is a growing interest developing and I think we’re going to see substantial funds moving into gold.

HRM: That’s interesting because I understand Goldcorp did very well in the 1990’s even though gold was going down. Would you comment on that?

Rob McEwen: Goldcorp originally invested in gold bullion and gold mining shares but, because it was a holding company, it would sell at a discount to its net asset value when the gold market wasmovingdown. At those times, there was pressure from some shareholders to open end the company and distribute the assets. I thought there was an alternative not being considered which was to turn the company into a gold producer and get it valued at a higher multiple. Operating companies were trading at 2.5 times their net asset values. I started merging Goldcorp with other companies to generate cash flows. It took 8 years and three reorganizations during which we merged five companies into one and eliminated the debt, strengthened the balance sheet, improved operational efficiencies and started exploring aggressively. Originally, I was just going to do the financial architecture and leave the running of the company to the mining executives, but in the space of a year I stepped in as CEO and re-made the senior management team.

HRM: So, you acquired gold producers?

Rob McEwen: Yes, we acquired two gold producers and with one came an industrial minerals division which produced lime and sodium sulfate.

HRM: Industrial minerals sound quite different from gold exploration and discovery.

Rob McEwen: Indeed, industrial minerals are usually long life, steady producers. The cash flow from our industrial minerals allowed us to pay down our debt and then fund the exploration at our Red Lake mine.

HRM: That sounds like a long-term plan. How did you achieve such phenomenal growth at Goldcorp?

Rob McEwen: Goldcorp’s success was based on a fantastic gold discovery made a mile below surface in a mine that almost everyone thought was at the end of its life and [that was expected] to close within 3 years. We invested $10 million in exploration and our chief geologist came back 1 1/2 months later with the assay results from 9 drill holes with grades (concentrations of gold) that were 30 times what we were then mining. That was the start.

We grew shareholder value. We increased our resources. We were aggressive in our exploration and innovative in the way we ran the company. We used The Goldcorp Challenge to find new resources. That was the inspiration for Don Tapscott’s best selling book Wikinomics. We also started off paying a dividend out of Red Lake; at first, annually, then semi-annually, then quarterly and then monthly. I saw the dividends as a form of rent to shareholders while they’re waiting for capital gains.

HRM: That’s amazing, because the price of gold continued to go down until the low of 2001.

Rob McEwen: In 2001 when gold was $270/oz, at Goldcorp we started to withhold part of our gold production. The reasons were threefold, one, I believed the gold price was going much higher, two, there were tax advantages to selling it several years later and three, we increased our financial assets by holding back the gold. Several years after we started we had more gold in our bank vaults than half the central banks in the world. When we started with holding the gold I predicted that gold would hit $850 per ounce in 2008. Gold has gone up more than four fold since the low of $250/oz in 2001.

HRM: I’ve heard people say that gold is in a bubble now. Do you think that’s true?

Rob McEwen: Absolutely not, I believe the gold price will climb significantly higher from the current level. Look back 20 years at the price of many asset classes and you will appreciate the enormous price inflation we have experienced. In 1985, in order to get on Forbes’ list of the 1000 richest people in America you needed to have $150 million. At that time, Warren Buffett was one of the 14 billionaires on the list. I saw that list a year ago and there were something like 990 billionaires and, basically, you needed to have $1 billion to be on the list. How was so much wealth created? It was financed by debt. A long period of low interest rates has encouraged very speculative investments financed by high levels of debt. Today we’re seeing the unwinding of financial asset inflation that has happened over the past 10 or 20 years. Areas that are susceptible to further declines are in real estate, so called collectible assets, derivatives, the debt market, and the dollar.

HRM: So, despite inflation, gold is not yet in a bubble in your view?

Rob McEwen: No. We’ve got a long way to go before that happens. If you think about the tech bubble, a few hundred companies became thousands. They all had stories and were looking to make a zillion dollars or be taken over for such an amount. Today, there are a lot of exploration companies [and] as gold goes up there will be more exploration companies and stories and more investor confusion about where to invest. One indicator is the attendance at the annual Prospectors and Developers Association show just held in March in Toronto. It was the largest ever!

HRM: You mentioned that there are many more billionaires. Doesn’t that simply mean that economic activity has expanded and that the wealth of society has increased?

Rob McEwen: Increased economic activity fueled by low interest rates and government monetary expansion, and by record levels of debt, has produced the growth in apparent wealth. It is built on a shaky foundation. In August 2007, when the sub-prime mortgage market blew up, I recall thinking this is like at no time in my career. There appeared to be no safe place to put your money. The global financial/banking system was collapsing. Just prior to British mortgage bank Northern Rock failing there were pictures of people who had deposits there lined up for hours trying to get their money out. That’s where gold comes in; it protects your wealth when the banks can’t. Gold is the ultimate currency that governments can’t create by printing more of it. The collapse of the banking system has been deferred.

HRM: What do you mean by a shaky foundation?

Rob McEwen: OTC derivatives have multiplied wealth like a fractional reserve banking system, but they’re hollow. When someone can no longer provide a guarantee, the system collapses or at least part of it does. Investors and the public have been too cavalier in their approach to risk.

HRM: But the wealth created by OTC derivatives is real?

Rob McEwen: The obligations are real, at least on one side. What we’ve seen is that when banks fail, governments bail them out. It’s in the interests of banks to create these instruments. Real wealth for the investment banks is generated by their creation and transaction fees generated by selling these derivatives. Huge money has been taken out of investors’ pockets.

HRM: This is fascinating but what do derivatives have to do with gold mining companies?

Rob McEwen: The introduction of the gold ETFs (a derivative) has broadened the market for gold and created an attractive, convenient alternative to buying senior gold producers. I would rather buy bullion than [shares in] a gold ETF. There is greater certainty of ownership when you have a bar of gold.

I would like to comment on a place and time when gold performed and we appear to be on the same path today. After World War I, Germany’s manufacturing base was in ruins, and the victors, the Allied nations, were demanding enormous payments as compensation for the damage Germany caused. Prior to the war Germany had been one to the world’s richest and most powerful nations. Initially, America was providing Germany with the credit to make the payments to the Allies but that soon stopped and Germany, burdened by an enormous debt load and without a manufacturing base to provide employment and tax revenue, turned to printing massive amounts of money to pay its bills. Fast forward to today, where globalization of world trade has opened up Asia for huge capital investments and created the low cost manufacturing center of the world. There’s been an outsourcing of production from the US and the West to Asia. The US went from being the world’s biggest creditor to the biggest debtor. Its largest creditor is China which appears to be growing impatient with Washington’s disregard for maintaining the value of the dollar. Like Germany in the early 1920’s, America is struggling with an enormous debt load [and has] large, expensive, new social programs, in addition to a very expensive war in the Middle East. Those are some of the parallels I see today along with the need to own gold to protect one’s wealth. What happens if China stops buying America’s debt?

HRM: Are you saying that the US is headed for hyperinflation, like Germany?

Rob McEwen: That is a very real possibility. You need to protect your savings, your retirement, [and] your financial independence. Gold can provide part of your solution. From 1929 to 1939, Homestake Mining, which you might think of as a proxy for senior [gold] mining stocks, rose from $80 per share in October 1929 to $495 per share in December 1935, which was 519% and it paid large annual cash dividends while gold was only increased from $20/oz to $35/oz in 1933 by government decree. The Depression of the 1930s started with a severe deflation followed by inflation later in the decade. Senior gold stocks are up perhaps 200% from their lows, and [from the low of] gold in 2001, and still have room to go higher.

Rob McEwen: People are going to turn to gold as they have repeatedly over the millennia. Whenever a monetary system fails, confidence in the country’s fiat (paper) currency rapidly disappears and gold performs. The monetary expansion of the past 10 or 20 years is going to cause big problems going forward. Gold is money, the ultimate currency, store of value and a very liquid asset. If you sell your gold through a bank it’s 2-day settlement, and you have cash in any other currency in two days. If you take a gold bar into a bullion dealer, it’s immediate. You can go anywhere in the world and sell gold. It’s recognized internationally.

HRM: Where do you see gold going from here?

Rob McEwen: More people are moving into the gold market but it’s still a tiny number compared to the amount invested in the stock, bond and derivative markets. In 1929, something like 10% of the working population owned stocks. Now, with retirement funds and mutual funds, it’s probably closer to 90%. A shift of 1% to 2% of this money into gold would have a profound and positive impact on the price of gold and gold shares. Unlike governments printing massive amounts of paper money with the push of a button the supply of gold increases slowly. Annual mine production increases the supply by approximately 1% per year. When a growing number of investors start adding gold to their portfolio, they will find a limited supply and the gold price will climb. I believe gold will ultimately reach $5,000/oz.

HRM: Thank you for being so generous with your time.

Rob McEwen: My pleasure.

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