It is widely assumed that at the end of the day, Republicans and Democrats in Congress will compromise and cut a deal on raising the debt ceiling.

It’s widely assumed because everyone from Treasury Secretary Tim Geithner to House Speaker John Boehner to Senate Majority Leader Harry Reid has told anyone who would listen that this is what is going to happen.

One hopes they are right. Last week, Moody’s issued a statement saying that if something wasn’t done to get US fiscal policy under some kind of control, the credit rating of the United States of America would be downgraded. That would be a disaster of significant scale.

…They point out that these leaders don’t have a deal on the debt ceiling in their back pocket. They don’t even have the outline of such a deal. The various commissions and “working groups” and all the endless meetings to produce a rough draft of such a deal have gone, basically, nowhere.

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PG View: If no deal materializes ahead of 02-Aug and the US faces the loss of its AAA credit rating, the political blame game will begin in earnest. While that game plays out, the Fed may have no choice but to spool up the printing presses to avoid default. The implications for the dollar and for gold should be obvious.

June 13 (Bloomberg) — A “perfect storm” of fiscal woe in the U.S., a slowdown in China, European debt restructuring and stagnation in Japan may converge on the global economy, New York University professor Nouriel Roubini said.

There’s a one-in-three chance the factors will combine to stunt growth from 2013, Roubini said in a June 11 interview in Singapore. Other possible outcomes are “anemic but OK” global growth or an “optimistic” scenario in which the expansion improves.

“There are already elements of fragility,” he said. “Everybody’s kicking the can down the road of too much public and private debt. The can is becoming heavier and heavier, and bigger on debt, and all these problems may come to a head by 2013 at the latest.”

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PARIS — Standard and Poor’s slashed its credit rating for Greece on Monday by three notches to CCC, saying there is a significantly higher probability of a default in the struggling eurozone member.

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The European and Monetary Union faces an eventual break up and the euro “disorderly debt workouts” should the euro zone fail to resolve its “economic and competitiveness divergence,” economist Nouriel Roubini said Monday.

The monetary union “never fully satisfied the conditions for an optimal currency area,” Roubini, co-founder and chairman of Roubini Global Economics, wrote in an op-ed in the Financial Times.

The way to restore competitiveness and growth for members on the periphery, said Roubini, would be to abandon the euro, restore their national currencies, and “achieve a massive nominal and real depreciation.” While some may doubt the prospect of countries abandoning the euro, such as scenario “may not be so far-fetched five years from now, especially if some of the periphery economies stagnate.

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In opinion pieces Monday in the Washington Post and Financial Times, Summers, who was the first director of the National Economic Council under Obama, says that the United States is at risk of falling into a “Lost Decade” of prolonged weak economic growth and high unemployment unless more action is taken in the near term.

“The greatest threat to the nation’s creditworthiness is a sustained period of slow growth,” he wrote.

Among the proposals he made is increasing the size of the payroll tax holiday from 2% of income to 3% of income, and expanding it so that employers also get a break from paying the tax that goes to support Social Security.

“At a near-term cost of a little more than $200 billion, these measures offer the prospect of significant improvement in economic performance over the next few years translating into significant increases in the tax base and reductions in necessary government outlays,” he said in the Washington Post column.

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JK Comment: Certainly an interesting point of view considering the content of the debate surrounding the raising of the debt ceiling this August.

LONDON — Bond traders and officials at the European Central Bank have been unified in their warnings that a restructuring of Greece’s debt would set off an investor panic similar to the one that followed the bankruptcy of Lehman Brothers.

Others, however, have argued that Greece’s debt of 330 billion euros, or $473 billion, while too large for the country to bear, is small enough to allow banks and other institutions to take a loss without bringing the world financial system to its knees.

But the comparisons between Greece and Lehman grew more frequent last week as global markets reeled, spurred in part by the view that Germany’s insistence that private investors participate in a second rescue package for Athens would overcome the objections of the European Central Bank.

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Europe Continues to Unravel

Despite weeks of machinations on the part of the ECB/IMF/EU, the eurozone debt crisis continues to worsen. Most recently, the troika’s focus has been on providing additional aid to Greece without triggering a “credit event.” Germany has been insisting that private investors play a role in any new bailout for Greece. While members of the troika have warmed to that idea, the credit rating agencies have suggested that any whiff of compulsion to accept rollover terms would likely be viewed as a credit event tantamount to a default, or at a minimum worthy of a multi-notch downgrade.

As it has become increasingly obvious that the stake-holders and the rating agencies have reached an impasse, borrowing costs for Greece and other EU periphery countries have continued to rise. CDS premiums for Greek sovereign debt hit a record high 1600 bps today, which drove CDS on Irish and Portuguese debt to record wides as well. Spanish CDS rose 13 bps to 289 bps, according to Reuters. With S&P, Moody’s and Fitch disinclined to cut the troika the necessary slack to save Greece, Europe is fast running out of options…and time. Some are beginning to worry that a restructuring of Greece will trigger a Lehman-like investor panic that could put the global banking system in jeopardy once again.

Safe-haven flows into bunds are keeping yields suppressed in Germany, exacerbating the inflation worries there. With the German economy humming along, largely due to very low interest rates, price risks are elevated as is pressure on the ECB to hike. The ECB did indeed indicate last week that a July rate hike is in the offing. However, in raising benchmark rates for the eurozone, it adds additional upward pressure on periphery rates as well. Something Greece, Portugal, Ireland, et al. can ill-afford.

Rising risk aversion is seen as generally supportive to the gold market as well. The yellow metal remains within striking distance of record highs against the euro, sterling and of course the dollar. Downward pressure on the euro has been somewhat supportive to the greenback, but America’s own debt woes provide a counterbalance that has investors reluctant to commit to the dollar, despite the currencies traditional — albeit eroding — role as a safe-haven. The safe-haven field has effectively been narrowed to the Swiss franc…and gold.

Gold remains consolidative, but underpinned as concerns about Greece continue to percolate. The euro is under pressure amid rising calls for private participation in a Greek bailout, which are being answered by worries of a possible credit event. CDS spreads for Greece, Portugal and Ireland have all hit record-wides today. Safe-haven flows are supporting German bunds and the Swiss franc, which has set a new record high against the euro.

China new yuan loans moderated to CNY551.6 bln in May from CNY739.0 bln in Apr.

Japan core machinery orders -3.3% m/m SA in Apr, -0.2% y/y from +9.1% y/y.

The BoE’s Quarterly Bulletin suggests that inflation expectations are reasonably well-anchored. However, there is apparently rising concern that those high — but reasonably well anchored — expectations will become entrenched based on the past experiences of other countries. The bulletin also notes that satisfaction with BoE policy setting has deteriorated since mid-2010. This is likely the result of falling real wages stemming from inflation.

Stock Losses Raise Pressure on Fed

The stock market has rolled over, recording its sixth weekly decline since the DJIA peaked in early-May at 12,876. On Friday the market closed below 12,000 for the first time since March, losing about 7% of its value over the past 6-weeks. In recent weeks the Dow has fallen below the important 20, 50 and 100-day moving average complex. The 20-day MA has crosses below the 50-day MA. From a technical perspective, the stock market looks terrible. This comes at an inconvenient time, with the Fed’s QE2 operation winding down over the next 3-weeks. Or perhaps the slump in stocks is because QE2 is poised to expire.

The recent raft of bad economic data on jobs, housing, manufacturing and consumer confidence are all weighing on investor sentiment. The weak economic recovery is sputtering; but is it just a temporary soft-patch, or is something more ominous and protracted brewing? The Fed made it clear this week that they believe the slowdown is transitory and that growth will be revived in the second half of the year. They seem prepared to stick to their guns, and allow QE2 to expire at the end of the month. Now the market seems inclined to test the Fed’s resolve.

As we’ve discussed in the past, many in the US — no matter how misplaced the notion might be — view the stock market as the critical measure of the health of the economy. In pointing to the performance of the Russell 2000 as an indication that Fed policy is working, chairman Bernanke has actively encouraged that mindset. With the Russell down more than 10% since forming a key reversal on 02-May, my guess is that Bernanke doesn’t reference RUT again anytime soon. Nonetheless, the stock market is curious to know at what point the Fed might consider additional accommodations. Certainly they can ill-afford more than a 20% retracement in the Dow as that would result in a bear market, which would further sap investor and consumer confidence. My guess is that in order to protect that 20% retracement level, Fedspeak starts eluding to heightened potential for QE3 around DJIA 11,000.

I’m quoted in a MarketWatch article today referencing the recent tighter correlation between stocks and gold as QE3 expectations have waxed and waned. Quantitative easing has a tendency to bolster most asset classes because the artificial demand provided to the Treasury market suppresses yields. This has a negative effect on the dollar and low yields effectively discourage investors and savers from being in yield baring instruments such as bonds, bills, CDs and money market accounts. The quest for a yield that at least keep up with inflation makes stocks, commodities and of course gold more attractive. The weaker dollar and investor demand for commodities further increases the inflation rate, creating a vicious circle.

The more normal negative correlation between stocks and gold is likely to reestablish itself if equities continue their retreat and investors start looking for a safe-harbor to weather that storm. At the point where the Fed once again starts to worry about higher unemployment and deflation, they’ll cry “uncle” and likely announce further QE because with interest rates already at essentially 0%, they really don’t have any other tools at their disposal. Stocks and gold will become positively correlated again and both will take off to the upside.

Here’s the wildcard though: Bernanke has already acknowledged that the size of the Fed’s balance sheet can become problematic. There is a point, where the negative effects — most notably the devaluing impact on the dollar — will outweigh any positive impact derived from artificially low yields. That’s the point of reckoning that everyone should be worried about, because once QE doesn’t offer any additional benefit the game is up and the dollar will have to be devalued.

The Fed announces the final phase of QE2, totaling approximately $62 billion. This represents $50 billion in purchases of the announced $600 billion purchase program, which will be completed by the end of June, and $12 billion in purchases associated with principal payments from agency debt and agency MBS expected to be received between mid-June and mid-July. As always, this schedule is subject to change should the FOMC choose to alter its directive to the Desk during the monthly period.

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This is part of the operational readiness program announced 07-Jun.

By Mark Gongloff
Ladies and gentlemen, if you look out the window to your left, you’ll see the 12000 mark on the Dow, which we haven’t crossed since mid-March. We’re going back through it in the other direction this time.

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By Benoit Faucon
LONDON (MarketWatch) — OPEC Friday warned of a looming supply gap in the second half of 2011, but tempered this by highlighting economic uncertainty amid gloomy U.S. economic data and European sovereign debt concerns, a view that could imply weaker-than-expected demand.

“The world economic growth forecast for 2011 remains at 3.9%, but challenges to the forecast have become more pronounced,” particularly due to European sovereign debt concerns, said the Organization of Petroleum Exporting Countries in its monthly oil market outlook.

At the same time, OPEC warned “expected supply/demand balance indicates a tightening market” in the latter part of the year.

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By Shannon D. Harrington, Jody Shenn and Sarah Mulholland
June 10 (Bloomberg) — Federal Reserve auctions of mortgage securities that the central bank assumed in the rescue of American International Group Inc. are fueling a selloff in credit markets as Wall Street rushes to hedge against losses on stockpiled debt.

Declines in credit-default swaps indexes used to protect against losses on subprime housing debt and commercial mortgages accelerated this month, reaching almost 20 percent in the past five weeks as the cost of the insurance climbs, according to Markit Group Ltd. The plunge this week started infecting everything from junk bonds to the debt of financial companies.

The Fed has been selling the $31 billion Maiden Lane II portfolio piecemeal after rejecting a $15.7 billion bid from AIG for the entire pool in March. Since then, Europe’s sovereign debt crisis has deepened and the U.S. recovery has shown signs of slowing, with unemployment rising to 9.1 percent, the highest level this year, and the economy growing 1.8 percent in the first quarter, less than forecast.

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The debt problem of peripheral Europe is structural. It cannot be solved by piling debt on debt. There is an analogy to a Ponzi scheme, under which more money is continually paid in to keep the pyramid-like edifice from collapsing. The debt/GDP ratio increases over time because new loans are given to pay old debt and to finance the remaining fiscal gaps.

There is a good argument for taking necessary decisions on debt restructuring sooner rather than later. Further “muddling through” is a recipe for disaster. Unless a proper program of coordination and adjustment combined with debt relief is decided soon, Europe faces the risk of becoming the next emerging market.

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Gold fell in early US trade as risk aversion has pushed stocks sharply lower and simultaneously weighed on commodities. The dollar has rebounded and gold probed back below 1530.00 before finding support.

Stocks appear poised for a sixth consecutive weekly loss amid rising concerns that the tepid economic recovery in the US is sputtering and the Fed’s QE2 operation winds down. With no immediate signal from the Fed that further accommodations are in the offing, the stock market might be inclined to find the level where the central bank might return to the bond market. Weaker stocks are likely to make gold look increasingly attractive.

China exports +19.4% y/y to new high in May, but narrowed from +29.9% y/y in Apr.

German CPI for May confirmed at 2.3% y/y. About what the market was expecting.

UK industrial production -1.7% y/y, well below market expectations, vs negatively revised +0.2%.

US import prices +0.2% in May, above market expectations of -0.7%. Export prices +0.2%

A Chinese ratings house has accused the United States of defaulting on its massive debt, state media said Friday, a day after Beijing urged Washington to put its fiscal house in order.

“In our opinion, the United States has already been defaulting,” Guan Jianzhong, president of Dagong Global Credit Rating Co. Ltd., the only Chinese agency that gives sovereign ratings, was quoted by the Global Times saying.

Washington had already defaulted on its loans by allowing the dollar to weaken against other currencies — eroding the wealth of creditors including China, Guan said.

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By Myra P. Saefong, MarketWatch
SAN FRANCISCO (MarketWatch) — Many investors have a great love affair with gold, but as with any relationship, they’ll have to work hard to get the most out of it, be patient and most of all — understand the reasons for gold’s actions.

That’s particularly true in the current trading environment, where action in the U.S. dollar, commodities, stocks and global economies have pushed and pulled at investors’ heart strings.

…Usually, gold has a strong inverse correlation to the dollar and positive correlation to oil, said Romero, and “it tends to be strongly correlated with the economy at extremes: positive correlation in inflationary booms; negative correlation in deflationary recessions.” But gold also does well under extreme “positive or negative conditions” — inflation or recession, for example.

…Gold and equities are trading off expectations for a third round of quantitative easing, which has understandably resulted in some correlation of late, said Peter Grant, senior metals analyst at USAGOLD-Centennial Precious Metals Inc.

…Still, “gold was actually quite resilient in the face of last week’s stock losses that stemmed from some pretty significant data misses,” he said. “The ongoing debt-ceiling battle, the general weak tone of the dollar and uncertainty about the [European Union] debt crisis, all conspire to underpin gold.”

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PG View: Okay, “nerves of steel” strikes me as a bit melodramatic. Most of our wealth preservation minded clients have a long-term buy and hold mindset when it comes to gold. Many are continually accumulating physical gold to maintain what they perceive to be an appropriate percentage of their overall portfolio. We suggest somewhere in the 10-30% range. They actually don’t fret too much about the price. Sure, they like to take advantage of pullbacks, but in many instances they view holding dollars as a greater risk than buying gold near its highs.

If you’re looking to improve your own level of understanding of the gold market, we’re happy to take your call at 1-800-869-5115 ext. 100.

Here is an exclusive interview with James G. Rickards, a leading practitioner in the realm of capital markets, national security and geopolitics, on inter alia “quantative easing as a success,“ the currency wars of the past and the present, and the question why you are fighting every central bank in the world in case you own gold.

with Lars Schall

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Snippets:

….Well, I gave you two metrics to explain why gold is not in a bubble. I would watch them also when we get closer to a bubble territory. For example, gold at $7000 an ounce with the current money supply and the current supply of gold, then we would be back where we were in 1980, and that might indicate a bubble. But we have plenty of room between $1500 and $7000. And remember also: a bubble can always overshoot.

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JK Comment: I could have literally cut and paste this entire interview and not had an irrelevant word to both current and prospective gold owners. If you own gold, or are considering gold diversification, you won’t want miss this interesting and enlightening read. Enjoy!!

Ratings Agencies Disinclined to Play Along with Governments’ Games

Eurozone stake-holders have been trying to spin a palatable restructuring of Greece’s debt for months now, but the ratings agencies simply wont play ball. Whether you call it a soft-restructuring, a re-profiling or a Vienna-style rollover, the ratings agencies are pretty adamant that it will be a credit event tantamount to a default. A technical default is exactly what all the recent machinations within the eurozone were hoping to avoid, for a default creates a whole host of problems for the EU, the IMF and the ECB…not to mention Greece.

The most recent tact that the troika is attempting to advance is a Vienna-style “voluntary” rollover by private sector Greek bondholders. In this scenario, rather than taking a cash payout when their GGB’s mature, the investors immediately roll them into new Greek debt. Yet, given the deterioration of Greece’s fiscal situation, why would a private bondholder voluntarily choose to not be compensated for the additional risk? One might argue that the alternative is a haircut, but that would unquestionably qualify as a default. Greece and the troika seem to be trying to bluff their way through this with a weak hand, and S&P/Moody’s/Fitch seem inclined to call. Greece and the EU have painted themselves into a corner.

Where the ratings agencies understandably get hung-up is: How do you incent the private sector to take on additional risk without a corresponding additional reward? The reward is obviously a higher yield, which of course Greece can ill-afford. Now the ECB in particular holds a fair amount of sway over the private banking sector, which holds a great deal of Greek debt. There is certainly a trade-off for the banks to consider between a rollover and a haircut, but the banks are obliged to make decisions that are in the best interest of their shareholders. It would seem that a “voluntary” rollover without fair compensation — which Greece can’t afford anyway — is not in the best interest of shareholders.

However, if the ECB for example attempts to coerce the private sector into taking that less than favorable deal, the ratings agencies have said they would indeed view that as a credit event:

S&P: “In situations where investors consider a default to be possible and where the rating has fallen, it becomes more difficult to conclude that investors are exchanging securities voluntarily.”

Moody’s: “If we concluded that there was an element of compulsion, we would very likely class this as a default.” They added that they would define compulsion “very broadly.”

Fitch: “If [investors] agreed to a rollover on existing terms, given that clearly the market would demand different terms for any new lending, that would be problematic in terms of being considered genuinely voluntary and not a distressed debt exchange.”

The market is getting increasingly skittish as the parties continue to thrash about for a solution. If that eventual solution for Greece is deemed a default, it will become obvious that the troika doesn’t have a solution for unsustainable debt that isn’t a credit event. At that point, there is considerable risk that the dominoes that are the other PIIGS nations start to tumble.

Even with the ECB smack in the middle of the debate on Greece, they further complicated matters by indicated today that a rate hike in July is likely, amid still rising inflation concerns. The prospect of rising benchmark yields in the eurozone is going to put additional upward pressure on yields in the periphery, including Greek yields. With one more plate spinning, it increases the chances that they all come crashing down. That probably at least partially explains why the euro fell today and gold rose, even as rates appear to be poised to rise in the EU.

The Agriculture Department said Thursday that rain delayed planting schedules and will likely diminish crops by harvest time in September. This followed a more optimistic forecast in May, which predicted a drop in corn exports that could have replenished U.S. food supplies and eased prices.

More expensive grain has led to food price increases this year. That could ultimately make everything from beef to cereal to soft drinks more expensive at the supermarket. For all of 2011, the USDA predicts food prices will rise 3 percent to 4 percent.

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JK Comment: Just about the only statistic not showing inflation these days is the CPI.

Gold has a good intraday bid, despite similar strength in the dollar.