The Gold Basis Weekend Edition

Last Thursday, I touched on a theme of the silver-euro correlation.  Clearly, the euro is heading to zero (not necessarily immediately and not necessarily all at once) and clearly silver is not. This means that the correlation will eventually end, and silver will decouple from the euro to the upside, perhaps violently.

As one mulls what could catalyze this event, and as one mulls the next logical move for the Euro leaders, one way this could happen becomes clear. I think this is the likely scenario.


The Futile Attempt to Save Creditors

The problem in Euroland on the monetary side is that the peripheral countries are drowning in debt that they cannot pay.  No formula of "austerity"–tax increases plus spending cuts–can fix the problem. 

Imagine a family of four with a total annual income of $50,000 that has somehow managed to rack up credit card debt of $1,750,000.  Sure, they need to cut spending!  But this can't fix the debt problem.  Nothing can fix it other than default.  On top of this is the other problem which is that government spending is a huge percentage of the economy, especially if you include government contractors and vendors.  Worse yet, all sorts of non-economic activities have been incentivized due to artificial interest rates.  Every attempt to cut back government to save a little cash to service the debt sees a disproportionate reduction in economic activity and thus reduction in taxes (as well as a surge in unrest).

On the other hand, the banks in euroland are loaded up with this debt on the asset side of the balance sheet.  Defaults by the peripherals will blow huge holes in the banks.  On top of this, the banks are highly leveraged.  They will be forced to default, and then everyone who holds the debt of the banks who somehow escaped the default of the peripheral bonds will be impacted.  It will cascade until there are no dominoes left standing.

This problem cannot be fixed by more lending.  It may be extended a while longer, though they have already extended it for years–who knows?  And this isn't the point.  Political appetite for more bailouts of Greece (much less Spain and soon Italy) is waning rapidly.  And this is assuming current leaders in the payor nations even remain in power.

The Next Step -Bailing Out the Banks

I think the next logical step is to inject euros (I won't call it "money" or "capital" though they will!) by buying equity in banks.  One Friday after close of market, they will announce massive infusions into the major banks via the purchase of shares.  If this is done "big enough" (and I bet it will be), it will help the banks survive the coming defaults of first Greece, and then the Euro leaders will cut Greece off from all further subsidies and let it collapse.  There may or may not be political support for bailouts of Deutsche Bank but there surely is none for bailouts of Greece.  In any case, the bailouts for Greece have been passed through as a bailout of core banks anyways.

Obviously, this massive new wave of creating euros will have a negative effect on the value of the euro.  This could drive the euro to parity with the dollar, if not below.  But this is a sea change. In the current environment, the euro goes down along with everything else because the world's leveraged markets are extremely sensitive to changes in credit at the margin.  When the euro is going down today, it is because credit is, on net, contracting.  When the euro is rising it is because credit is expanding.

But in this new paradigm of equity printing rather than debt printing, the euro will begin to fall, not due to credit contraction (it will be expansionary) but due to unbridled creation of unlimited new supplies of them that are not claims on (dubious) debt but on ever-more-diluted banks and probably other financial corporations.

This will be the next stage in collapsing confidence in the governments of Europe and their currency.  Gold especially, but I think silver also, will be one logical place for people to flee the lethal circus that paper currencies are becoming.

This is when we could see silver surging past $50 while the euro is dropping below $1.00.  This is just my $0.02, but I would wager an ounce of fine silver against a soggy and torn dollar bill that it will play out this way, if not exactly then at least in a similar way.



Silver in US dollar terms, weekly – click for better resolution.



Silver in euro terms, weekly – precious metals charts in euro terms look more bullish than in US dollar terms – click for better resolution.




Gold in euro terms, weekly – it appears as though an upside break-out could happen soon – click for better resolution.






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