The Great Reinflation

Responding to growing concern about the quality of the Federal Reserve System’s assets, former Federal Reserve Governor Lyle Gramley told reporters last week that “You have to reckon with the fact that one of the Fed’s assets is gold certificates, which are priced, as I remember, at US$42 an ounce, and if we were to price them at market prices, the Fed’s leverage would look a lot less than it is now.”

Humor me. Let’s crunch those numbers.

Those gold certificates have a book value of about US$14 billion, if you include special drawing rights and coin holdings ($1.7 billion). Even if you revalued this inventory, it would still total less than $300 billion, or 12% ofthe Fed’s total assets. So far, that’s a weak defense against our allegations. And it only goes downhill from there. Assuming it still got the goods at all, a lot has changed in just three months. In August, this gold had a market value that represented over 30% of the Fed’s assets.

Back then, additionally, U.S. Treasury securities still made up half the Federal Reserve’s asset base.

Today, however, in a very short space of time, the market value of both of these assets together comprises just 30% of the central bank’s total assets. It is fruitless to discuss what makes up the rest of its “portfolio,” because whatever it is, it is of lesser quality — aka higher risk.

His proposal was interesting, however, for other reasons. In case you missed its inference, the idea of a revaluation in gold reserves on the Fed’s balance sheet is to boost confidence. It is but a keyboard stroke away, a technical matter. Most analysts already take gold’s market value into account anyway.

Still, two outcomes of such a revaluation occurred to me over and above the obvious, I think.

The first: It would align the Fed’s interests with gold prices — by increasing gold prices, it would boost the value of its balance sheet, for instance.

Second, it would inflate gold’s perceived importance — an endorsement of sorts, in the eyes of the Fed. The public and the market would have to reassess their fundamental outlook about the importance of gold, too.

On the surface, Gramley’s proposal aims at making the Fed look like some kind of gold standard bank. But in fact, this kind of thing, especially if it were spun out in reaction to a crisis of confidence, might be so bullish for gold that it sinks the Fed.

If Bernanke were smart, he would want that gold to disappear off the balance sheet without notice.

But let’s forget about what would be bullish for gold and point out what in fact is the fear of deflation.

The Great Reinflation Update

In December, the Fed shoveled another couple hundred billion new Washingtons into the banking system, out of its many open windows. B-r-r-r!

Its balance sheet expanded to over $2.3 trillion as of last week’s report, which came out the day after it decided to cut rates to nothing. My guess is that we’ve seen nothing yet. You thought “cheap money” was bad. This is the era of FREE money. This stuff grows on trees. You don’t even need choppers. Already, despite the intensity of the deflation rhetoric, the money supply numbers continue to point the other way — toward the Great Reinflation. Or should we say “because” of the intensity of the deflation rhetoric!

This week’s money supply numbers suggest the alleged credit freeze continues to thaw.

After stagnating with little or no growth, stuck at under $1.4 trillion over the past four years (since the Fed began hiking rates in 2004), even as the Federal Reserve started cutting rates in 2007 again, U.S. M1 has grown by over $130 billion, or 10%, since August alone. That’s when it stopped sterilizing its “liquidity” injections. But this kind of growth in three months is a record. Percentage-wise, too.

Most of that growth, moreover, is occurring in checkable (demand) deposits. U.S. M2 is growing at almost $100 billion per month, and it is approaching a 9% year-over-year growth rate — its strongest growth since early 2002, midway through the Fed’s last reinflation effort (2001-03).

Most of that growth is occurring in money market fund holdings.

The definitions of money supply that I put stock in suggest that the banking system is inflating deposits at roughly5% year over year, but of special significance is that this growth rate is picking up now.

It certainly is not as robust as the narrow measures of money or the Fed’s balance sheet.

But it is not deflation.

I promise to keep looking for it, nevertheless.

Contrarian Bet on Oil ETF Calls Has Attractive Risk-Reward

New lows in oil prices drove the value of the United States Oil Fund to a new low on a couple of weeks ago, when I put out my buy recommendation on the April 2009 $35 Calls (UBODI). This is still a good time to be picking away at those calls, in my opinion. But this kind of thing is not for the faint of heart.

Options are very volatile. I never put in any more than I’m prepared to lose on a given situation, and the risk-reward ratio has to be very attractive. This trade fits the bill. I continue to believe we should be taking advantage of the extremes in the market today. I think they are being driven by irrational fears over deflation. My conviction is strong about that. If you’re with me on this, you just have to be buying the biggest and fastest drop in oil prices in decades. In less than six months, you’ve seen oil prices fall from $147 to as low as $32 in some contracts last week, for a 75-80% drop in value.

I mean the market has discounted a lot of bad stuff. Sure, we could drop another $10 in an instant and those calls could go to zero. I didn’t say there wasn’t risk in the trade. However, I think four months is enough time for a return to normality. Whether we drop another $10 in the oil price or not, if it can drop more than $100 in five months, it can rally $20-30, or more, in four, especially if we are right about the deflation bogeyman.

But forget about that. It’s all technical. We’re not betting on any new highs here, just a return to normality. It’s a contrarian call, and it’s risky, but if we’re right, the price of oil should be back up above $60 by April. The U.S. Oil Fund could nearly double in such a situation, and the April 2009 $35 Calls, which you can buy for $3.50 today, would be intrinsically worth near $20.

That’s 300% upside from my purchase price, but it is closer to 500% from today’s price.

I would continue to buy April 2009 United States Oil Fund $35 Calls (UBODI).

Please note that these calls have no intrinsic value while USO shares trade below $35, and there is no guarantee that if oil goes up USO will gain the same amount. It is an ETF that invests in oil and has matched the movements in oil, more or less, so far. Moreover, in buying these calls, I am fully aware that we are going against the trend on the chart, but in my experience, such trends are not very definitional or sustainable in times of market panics or extreme volatility. This is a contrarian, bottom-fishing bet based solely on my instincts as a trader.

I’m sure you’ll hear from me again soon, but let me take this opportunity to wish you a safe and prosperous new year.

Ed Bugos

January 7, 2009

The Daily Reckoning