"If you're not concerned, you're not paying attention" say Axel Merk, founder and Chief Investment Officer of Merk Funds.
Like many, he sees today's excessive high-price, low-volume, zero-volatility markets as an unnatural and dangerous result of misguided intervention by the Federal Reserve. But Axel has additional perspective than most, as the senior economic adviser to his family of funds is a former President of the Federal Reserve Bank of St Louis and a former FMOC member:
What’s driving the excessive complacency is today's markets is monetary policy. One of the main goals of monetary policy has been to reduce the risk premium; to make it less expensive for risky borrowers to borrow money. We see that everywhere, such as when we hear about how Spain now pays the same as the US on its long-term debt. And so risky borrowers don’t pay much more than the credit worthy borrowers.
The reduction in the risk premium is what reduces volatility, and of course that spills over to other assets. We see that in the equity markets, the currency markets — we see it everywhere. And volatility is compressed as well.
Janet Yellen was asked about this just a few days ago and she pretty much said how she’s not concerned about complacency in the market. She’s complacent about complacency. To me that’s about as significant as Greenspan suggesting houses can never go down, and Bernanke suggesting subprime loans were contained. It’s a major, major problem.
Obviously, there are plenty of challenges in the world. Usually what tips a market over, though, isn’t the most obvious thing because that’s already “priced in”. As a result, nearly anything can tip this market over. Suddenly one day people wake up and the glass is half empty, and everybody runs for the hills.
Many see the Fed having run out of bullets in it efforts to keep markets elevated. Axel's opinion is "Not quite yet":
The Fed has bought all these assets by creating money out of thin air and now they’re stuck with these. If they were to sell them (it’s much easier to buy securities than to sell them), prices would plunge and, more importantly, the Fed would sell these assets at a loss.
Now, the capital base and the equity of the Fed is very small. Odds are that the losses would wipe out the equity at the Fed.
And so the Fed would rather not sell those securities — instead, they can pay interest on reserves. But I don’t think actually they’ll do that either, because of the conflict with Congress (if we’re going to start paying interest on reserves to somehow raise rates, that’s going to be political nightmare because we'd be paying $billions — if not over $100 billion — to banks to entice them not to lend).
There’s another tool that they have: it’s called reverse repos. I’m not going to explain this now in detail, but it’s essentially the same thing as paying interest on reserves with a key difference: Congress is not going to 'get it' for a year or so. And so the backlash from Congress is going to take a little longer to come. But that problem is going to come nonetheless.
As a result of these risks, Axel recommends the average investor be well-diversified outside of stocks and bonds, and maintain a high degree of liquidity. More information on the newly-launched fund (OUNZ) discussed in the podcast can be found here.
Click the play button below to listen to Chris' interview with Axel Merk (27m:11s):
Chris Martenson: Welcome to this Peak Prosperity podcast. I am your host Chris Martenson and today we are speaking with Axel Merk, President, Chief Investment Officer and founder of Merk Funds. Axel is a noted expert on world currencies and manages several mutual funds that manage currency risk for investors as well as an equity fund and a brand new gold fund that we’re going to hear about today.
Now for years he has been an outspoken critic of US monetary policy warning investors that the current course risks seriously devaluing the dollar. He’s also author of Sustainable Wealth, very readable guide to understanding our macro economic environment. Hey the risks that all investors face today, how they can manage their finances to achieve financial stability. Axel thanks so much for taking time to join us today.
Axel Merk: Great to be with you; it’s an honor.
Chris Martenson: So let’s jump right into it. These markets today, we can measure just how dead they are even as the equity markets hit new highs by declining viewership in cable business shows, really low trading volume and market volatility that seems to be all but non-existent. Is any of this concerning to you?
Axel Merk: Very much so. I think complacency is the mother of all bubbles and let me explain that a little bit. When you have complacency, which in the markets it could measure, amongst other things, volatility or when volatility is low but as the prices are rising. That investors are lured into an investment not fully aware of what the risks -- the dormant risks are, what they are when they pop back up and we see that over and over again and was in the tech bubble in the 90’s and the housing bubble. Emerging market local debt funds, everybody stormed into them and thought they’d get a free lunch and obviously all these things have a bad ending. And now we see in the equity markets prices going ever high up at the same time volatility, the VIX index for example, is going lower and lower. And to us that means that if the tide turns, if for whatever reason risk comes back to the market investors are going to be out in a heartbeat because they’ll suddenly realize, “Oh this wasn’t risk free; I guess I could lose money” and that’s when you can set yourself up for a really sharp decline and part of the reason is because obviously people take up leverage. They gear themselves up and then they have to scramble to liquidate their collateral and that’s how you have this contagion or whatever you’re going to call it but that’s how you can get a real market crash.
Chris Martenson: Well this complacency breeds all kinds of things; certainly one of the things I didn’t mention which is sitting out there is margin debt on the NYSC; it's at new records as far as I can tell. So people have really decided to go long and go longer and every day I see the markets rise. There’s some pretty interesting macro economic developments out there whether we’re in Eastern Europe or in the Middle East. None of those really seem to be playing into the markets in ways that I recognize. You know 10 years ago what’s happening in Iraq would have fed into the oil markets in a very detectable way. I really can’t see the footprints of that except for one day last week. What are you seeing there?
Axel Merk: Well I can only tell you what’s driving this. What’s driving it is monetary policy. One of the main goals of monetary policy has been to use a technical term here, to reduce risk premium, to make it less expensive for risky borrowers to borrow money. We see that everywhere and mostly in the media we hear about how Spain now pays the same as the US on longer term debt. But risky borrowers don’t pay much more than the credit worthy borrowers. And so the reduction in the risk premium is what reduces the volatility and of course that spills over to other assets. We see that in the equity markets, we see it everywhere, in the currency markets, oil field, volatility is compressed as well. And Janet Yellen was asked about this just a few days ago and she pretty much said how she’s not concerned about complacency in the market. She’s complacent about complacency. To me that’s about as significant as Greenspan suggesting home prices can never go down, and Bernanke suggesting subprime is contained. It’s a major, major problem and obviously as you point out there are plenty of challenges in the world. Usually what tips a market over though isn’t the most obvious thing because that’s “priced in”; it can come out of the blue. Anything can tip this market over. Suddenly one day people wake up and the glass is half empty and everybody runs for the hills.
Chris Martenson: Well so let’s talk about that for a second. What can an investor do to protect their wealth if they -- if they’re concerned about this complacency about complacency, what would they do?
Axel Merk: Well the first thing is if everything in your portfolio has been going up you should be concerned. If you are not concerned you’re not paying attention. You should be glad if something hasn’t been moving up because then when the tide turns you have a chance at least that whatever that is you want to -- this might help you to buffer the down turn. Now one of the basic rule of thumb is obviously if you have an equity portion in your portfolio all that has gone up because equity markets have out performed a lot of other things and so re-balance.
Now to the extent that you are in equities consider using something that uses some hedging; there are all kinds of strategies out there where you can buffer yourself on the down side. Now ideally you may want to get out of equities entirely but obviously that’s not particularly diversified and I can’t give specific investment advice. Personally I have a lot of my equity exposure hedged and then I have diversified. I particularly like currencies because in the currency market you can design a portfolio that has a low correlation to the equity markets. The problem is that most folks now rebalance between equities and bonds. The bond market isn’t exactly one where at least I have a particularly positive outlook on and so it makes it difficult. The Fed has inflated all asset prices so hiding is very, very difficult and that’s why one has to look at alternatives, one has to look at hedging techniques. The precious metals obviously is one area one can look at. Gold has historically done well when the stock market has come down more severely. But all of these are trade offs; it’s not like gold is safe if your daily living expenses are in US Dollars. And so these are all trade offs and in this “risk free environment” I think risks are particularly high.
Chris Martenson: Okay I want to talk about both bonds and currencies. Bonds first; in the past bonds provided a nice, actually negative correlation to equities. But I want to talk to you about that because we live in a world where Spanish debt today is trading at 2.65% on the 10 year, France is at 1.76, Italy at 2.88; all of these compared to the US at 2.61. These seem more than adequately bid at the moment and so if I heard you right you think it might not be reasonable to expect that these yields should go lower if equities drop?
Axel Merk: Well no I don’t think so -- having said that I’m far more comfortable with Spanish bonds now than they were before; not because I would ever buy them but because it is speculators buying them. It used to be the financial institutions bought those bonds and they thought they were risk free; they clearly were not. That’s why you had this contagion in the Eurozone and now you have yield chasers go after these things and the money that went out of emerging markets didn’t go back to the US. The US dollar is no longer a safe haven of choice. It was Portugal because Mr. Draghi, head of European Central Bank promises to do whatever it takes; so why not capture some additional yields? I’m not suggesting you should do that but the positive of that if you want to see the glass half full is it's speculative money -- who cares if speculators lose money? It is a problem if banks lose money not because I pity with the banks but because our financial system comes crashing down if they lose too much money. And so it is hedge funds buying Greek banks for example rather than having the capital of Northern European Banks exposed to the banking system in Greece. And so from that point of view it’s healthy. What is not healthy of course is that people are not being -- don’t have to pay the amount that they should be paying given how reckless some of these finances are in some of these countries. And so we are re-enabling some of the bad behavior that got us into trouble in the first place, but of course that’s a story for another day and a problem for another day. And for the time being these countries want to live happily ever after.
Chris Martenson: No one sheds a tear for the speculators, I see. Well that’s an interesting way to look at it and I’m certainly -- I see everything out there as more speculation than pure investment at this point in time and that makes a certain amount of sense until as you say, the tide turns. So talking about tides turning: currencies, your area of unique expertise I think is -- your depth is really centered there. There has been a lot of chatter lately coming out of Russia primarily but China and a number of other nations calling for a move away from the dollar. Is this chatter? Is it actually really happening or is this just something we just keep our eye on in case in the future it becomes real?
Axel Merk: Well if you can keep an eye on it you just might not notice it’s happening. I mean that’s -- it’s been happening in front of our eyes for years. Think about a frog in a boiling pot. The people are going to say “Oh the dollar loses reserve currency status and if and when that happens I’ll get out of the dollar." Well I just mentioned earlier when -- a year ago when the Fed taper talk started and money fled emerging markets it did not go to the dollar; it went to the Euro. And so similarly if you look at when there’s a “risk-off day” the dollar has more often than not in recent months been going down rather than up. So this so called flight to quality has not happened to the US. Now you can argue maybe this crisis hasn’t -- we haven’t had a severe enough of a crisis but when the Ukraine crisis first was announced for about a few hours the Euro went down. Ever since then the Euro has been going up.
If you think about it if you’re Russian where are you going to put your money? You’re not going to put it in the US; you’re going to put it into London real estate or you’re going to put it into the Euro. And so the world is changing and it doesn’t mean that if we don’t have a -- if we have a big crisis the dollar won’t benefit, but it has been changing. People like the dollar because if liquidity, not because of quality. But if the US starts to introduce capital controls such as on Russians why use the dollar if you can use something else? And that’s why gradually the dollar is losing its reserve currency status.
Chris Martenson: And so as you watch that process happening is this something you think it’s -- it’s like how Hemingway described how a man goes broke, slowly then all at once? Do you think this is the frog boils for a while and then all of a sudden it -- goes worse? Or is this just something you think we’re going to see a steady sort of a repositioning away from the dollar on a percentage basis in term of reserve assets and that is more of the same?
Axel Merk: When I look at investing I do probability analysis. I assign certain scenarios and give certain risks to them. Now the more likely scenario is going to be slow and gradual but there is certainly risk out there that’s more abrupt. In fact if you look at the -- the minutes of the European Central Bank every month since the inception until just about when Mario Draghi took over they had a warning that there might be a disorderly adjustment of global imbalances. That’s a code word for dollar crash; they took that out then at some point and -- but that is something that’s certainly on the minds of policy makers the world all over. But at the same time of course is the Chinese, they own the debt market in the US and so they can’t just dump it. Some people will say “Oh if they don’t like the US, they’ll just dump it”. Well they’re shooting themselves in the foot if they do that. And so usually policy makers try to do it slow, gradually, prudently. By the way one of the reasons why I got into this business in the current form, in the first place is because back in 2003 the then head of the European Central Bank said, “We hope and pray that global adjustment process will be slow and gradual”. My response to that was “When Central Bankers revert to hopes and prayers, I got to act”.
Chris Martenson: Well let’s talk about the Central Bankers because as you’ve mentioned several times already and which everybody listening to this already knows Central Bankers are really driving the bus. They’re doing it with their own liquidity injections; they’re doing it by picking winners and loser respectively and how they put their money out there. They have a very, very large impact on the market. So your senior economic advisor at Merk Funds is William Poole, the former President and CEO of the Federal Reserve Bank of St. Louis and FOMC members; so obviously he’s got some insights. What can you share with us about his views of recent and potential future Federal Reserve actions?
Axel Merk: Obviously he is not an active participant but he has very strong views. He is very much more in the hawkish camp of the FOMC but I have the discussion with him specifically about these compressed risk premium and we were discussing whether it is possible for the Fed to engineer an orderly exit. And I’m not talking about here the raising interest rates or tapering per say, but an exit from these low risk premiums and we just -- we just cannot imagine how that’s going to be done easily. And so nothing has ever worked, that’s my interpretation the way that the Fed has wanted it to work; so why should this work any better? Now Bill Poole is very critical of many of the policy and one of the things he’s very critical of is that if we’re going to start paying interest on reserves to somehow raise rates, that’s going to be a political nightmare because the fact that we’re going to be paying billions, if not over 100 billion to banks to entice them not to lend. They currently park all this money at the Fed; if the economy gets going they would want to spend more. They could but then the Fed is going to hold them back, not by selling securities but by paying the banks and pretty much telling them “Oh you can’t lend because we are going to pay you so much interest by keeping the money here”. And so that’s going to be a nightmare and then the Fed is going to use administrative tools to try to prevent the banks from lending and most notably they can talk about things like capital adequacy ratios.
Well if you're J.P. Morgan you can easily raise money in the markets; so those are discussions, the sort of discussions we have with Bill Poole, the sort of challenges that are going to be ahead. One of the things the Fed -- Bill Poole is very critical of is that there’s no -- there’s no clarity on what the Fed is going to do. The Fed is conducting policies ad hoc and Janet Yellen clearly says she does not pursue a rule-based policy right now but how can you price risk if you don’t know where the Federal Reserve is going. And so a lot of the uncertainty in the market is due to the varying policies that the Fed is pursuing; this age the markets are quiet and this is not a very good omen as we’re going to get into rougher waters down the road.
Chris Martenson: Well Axel it’s very interesting, one of the things you mentioned in there I’d like to get some more clarity on which you mention that the Federal Reserve would probably not sell securities in it’s efforts to reel in additional bank lending that might come when the economy recovers or if it does. Why wouldn’t they do that as compared to raising interest rates on reserves? What would happen if they sold those securities back into the market?
Axel Merk: Sure lots of topics here at once. Basically the Fed has bought all these assets by creating money out of thin air and now they’re stuck with these. If they were to sell them it’s much easier to buy securities than to sell them, all their prices would plunge and more importantly they would sell them at a loss. That’s quite expected by everybody including the Fed. Because the capital base and that equity of the Fed is very small, odds are that the losses would wipe out the equity at the Fed. Now free or not a central bank is not like a corporation, the Bank of Israel for example has had a negative net worth for over 20 years but it doesn’t look good. And so the Fed rather not sell those securities, instead they pay interest on reserves. No -- I don’t think actually they’ll do that either because of the conflict with Congress. There’s another tool that they have, it’s called reverse repos. I’m not going to explain this now in detail but it’s essentially the same thing as paying interest on the reserve with a key difference that Congress is not going to get it for a year or so and so the backlash from Congress is going to take a little longer to come but that problem is going to come nonetheless.
Chris Martenson: Interesting, okay I’m going to look into that and obviously we don’t have the time to really go into reverse repos at this point but thank you for that. Now I really want to talk about gold for a minute; we’ve hopefully maybe hit bottom on gold prices. Who knows, we’ve had a little bit of resurgence but you have an exciting new product that Merk Funds is offering. The Merk Gold Trust Trading under the ticker symbol OUNZ, tell us about what it was like to ring the opening bell on the NYSC floor at the launch of OUNZ and then tell us about the fund?
Axel Merk: Oh sure, it was -- in May we had the honor of ringing the opening bell on the New York Stock Exchange for OUNZ as you point out. What was really special about is where the other folks that joined us. It was -- the ceremony is obviously one thing -- it’s always a nice marketing event but it was really -- we had a lot of influences from the gold community come together and that made that day really special. Now OUNZ what it is it’s a deliverable gold ETF and what we mean with that is just like other ETF’s out there you can buy gold now through the New York Stock Exchange with the key difference that investors can take delivery of the gold. And not only can they take delivery of the London bars that we hold but at the time investors take delivery they can opt to have it exchanged into other coins because we don’t think most investors really like to have a London bar that are these big clunky things you see in James Bond movies, but they’d rather have a Maple Leaf on American Gold Eagle and so we give them that option.
Now we don’t think everybody is going to now buy their gold on the exchange floor for physical delivery but we do think people like that option and one of the key things is that taking delivery of what you already own through shares is not a taxable event. And so if you’re buying these shares now and then a couple years down the road gold has appreciated and now you suddenly want the coin in your pocket, with our product you don’t have to sell it, have a taxable event, and then buy the coin. Instead you can call us up and say “Hey I’d like to get my gold delivered” and we can do a tax exchange into coins and send them to your home.
Chris Martenson: Well that’s really handy sounding. And so some details then; where is the gold going to be housed and what kind of trading volumes are you expecting here?
Axel Merk: Yes so we hold the gold in London and the trading it's -- now we talk today, it is a nice day in the market, we trade over 120,000 shares and the share price is priced at 1/100th of the price of gold so as we talk it’s at $13.18. The key thing here is that this is a gold ETF and in order to -- the secondary objective is to track the price of gold. The primary objective is obviously to hold the gold and to be able to take delivery, but the secondary objective is to track the price of gold and the nice thing about this is that the market makers that help to keep the price near the underlying value of the gold, they hedge the entire gold exposure. So for them it is no extra work, no significant extra work to work within our gold trust versus the other gold ETF’s and so we historically, or since inception, had about a $.01 spread in the market. A fabulous spread. We can take large orders and so it has not been a problem for anybody to place large orders. And the dispatch of course the interest in gold hasn’t been all that exciting in recent weeks and with that we are already able to get some decent volume. We have about 50 million dollars in the trust at this stage and we’re looking forward to getting much, much more down the road.
Chris Martenson: Well fantastic. And so when somebody -- describe the actual process of taking delivery. You made it sound very simple. Somebody calls somebody up and says they’d like delivery and it happens; is it that simple?
Axel Merk: Almost; we do have a website Merkgold.com where we go through the process. But the short of it is that on our website we have a calculator. You plug in how many shares you have, we tell you how much gold it corresponds to and it guides you through the process where you have to specify the type of gold you want to have, give your account details and so forth and you can submit that to us for evaluation. You do have to pay a fee for that process and because obviously a coin usually sells at a premium versus the spot price. But what you do is you talk to us and you agree on the type of gold you want to have, you agree on the delivery location. Coins as I indicated we can deliver to someone’s home address, we can deliver anywhere in the world by the way. If somebody wants to have it delivered abroad you can request that. London bars we have to deliver with an armored truck, those can’t be delivered to residences; so there’s going to be a little bit back and forth to agree on the location and the type of gold and then you pay your fees up front. We will give you a window in which you can deliver the shares. You basically do a regular share transfer to the trustee, the trustee is Bank of New York and then the shares are accepted, they’re retired and then we initiate the delivery. The entire process for coins to be delivered takes a good week or so. You can initiate at any time. If you have a more exotic request that can obviously take longer.
Chris Martenson: Excellent, I appreciate that. And is this only in one ounce increments or are you doing franctionals too?
Axel Merk: No, one ounce is the minimum and also one ounce increments. And so -- by the way we specifically made one ounce the minimum investment. Having said that it is not really economical because we have some minimum fees that are associated with it. if you have something like 40 ounces delivered -- a 10 ounce Australian bar for example -- you’d pay about the same as you would pay through other sources of being able to buy those 10 ounce bars for example. If you get much less than that then the minimum fees are going to make it more expensive than to go to your local dealer. But the point here is that we really want to encourage people to take the liberty to test the process. In fact we were awarded a patent on this process, we believe our process is highly scalable. If there was ever a rush to take delivery we think we can make it happen with our process and so that’s really different from these other products that are out there. You have an ETF, it tracks the spot price of gold, you can take the delivery, taking delivery is not a taxable event. Our view is why would you buy any of the other gold ETFs when this one is available? And we charge 40 basis points a year, which is the same as for the leading gold ETF out there.
Chris Martenson: That’s fantastic; that is a huge distinction between the one that’s out there. I get questions about some of the other gold ETF’s all the time; I’ve not been a fan of them for a variety of reasons. But this delivery takes away one of the biggest reasons that I’ve not been a fan of them for starters and that’s just fantastic. So gold has been -- if I can just get your views very quickly now you -- obviously it takes a long time to set something like this up. Congratulations on getting it done, it’s out there. How do you feel about gold in this current environment?
Axel Merk: Well the reason why I like gold in the medium to long term is because I don’t think we can afford positive real interest rates, meaning interest rates net of inflation, not in the US, not in the Euro zone, not in Japan. Mario Draghi, the head of the ECB has said as much. He said real interest rates are negative; they’ll be more negative over time. If you think about it what happens if the Japanese succeed with the policies, if they get economic growth? Bond prices are going to fall, how can they afford to finance a deficit? I don’t think they can; so they’re going to be biased towards lower rates in Japan as far as the eye can see. In the US we have the same problems if we don’t tackle entitlement reform and I don’t think the political consolation is such that we will, we will kick the can down the road which means if indeed we get economic growth, real economic growth, yes the Fed can talk tough but how on earth are we going to impose positive real interest rates if indeed we do have inflation pop up in the numbers that the Fed really cares about. We cannot finance our government debt 10 years down the road if we have to go back to the historic levels that we’ve been paying to service our debt. Now fear not the economists don’t think we’ll ever get there. But I actually agree it may not happen, but the reason it will not happen is because the Federal Reserve is going to be biased towards low rates and even if they nominally move higher, on a real basis they will be negative. And with that I think the price of gold should do quite well over the next five to 10 years.
Chris Martenson: Very interesting, yeah. Negative real interest rates obviously is one big lever for gold prices. Also it correlates reasonably well with excess government spending. I think governments are tied to levels of deficit spending that I don’t know how they get out of just like you say the Federal Reserve is trapped. When I look at debt to GDP across literally every major industrialized country from 2007 to today on just the debt to GDP ratio they’re all higher; so I don't know how they get around that either.
Axel Merk: Yeah debt to GDP I agree with you in principle. Having said that, it’s very difficult to forecast really anything with just a nominal ratio. But if you extrapolate out just how much we’ll be paying to service our interest expenses. We currently pay around 200 billion a year; if you use the CBO, the Congressional Budget Office projections 10 years out they think we will be spending about 900 billion a year. Now that assumes we’re not going back to the historic average that we have been paying on our debt. If we go back to the historic average it’s going to be about 1.2 trillion a year just to service the debt on our interest. Now some people say “Oh the CBO projection is always wrong and how can you rely on that?” Well they might be wrong, but again it’s about the risk. There is of course “risk opportunity” that we’ll get a grand bargain and we’ll fix our major entitlement obligations and so forth. But for that to happen we actually have to go a lot in the direction of some what you’re probably suggesting we need to have a carbon tax, we need to have a value added tax, all those sort of things to generate sufficient revenue to be able to afford those sort of things. I just don’t see the political reality right now that’s going to get us there if we have a printing press called the Federal Reserve that’s going to keep rates low.
Chris Martenson: I couldn’t agree more. Absolutely. Well with that we’re out of time; I really appreciate your time today. I’m very interested in directing people towards your excellent work, investment opportunities and ways of following your thinking; how would they do that?
Axel Merk: Sure we have a free newsletter at Merkinvestments.com and so we have three websites but you can browse through them from one to the other Merkgold, merkfunds and merkinvestments.com; look at our gold products, look at our mutual funds and obviously sign up for insights, follow me on Twitter, any of that or keep listening to your program as I hope I’ll talk to you again because this has been a great pleasure.
Chris Martenson: Well thank you so much for that and for everybody listening that’s Merk, M-E-R-K and we’ve got some links at the bottom of this podcast so that you can just click away and I do hope you read some of the excellent macro investment advice that exists over there at Merk. They’re really very well done. So with that thank you so much; it’s always a pleasure Axel.
Axel Merk: My pleasure.