09/29/09 Hong Kong, China
On one hand, the deflationists are claiming that given the extremely high debt levels in the West, further inflation is impossible. On the other side of the argument, many proponents of inflation are calling for Zimbabwe style hyperinflation. In this business, everyone is entitled to their opinion; however it is my contention that we will get neither deflation nor hyperinflation. If my assessment is correct, once business activity picks up, our world will have to deal with high inflation.
Although I have great sympathy for the deflation crowd, given the reckless attitude of the central bankers and their ability to create debt-based money, I do not believe deflation (contraction in the supply of money and total debt) is very likely.
For sure, in this post-bubble environment, American consumer debt continues to contract, but this is being more than offset by the expansion in federal debt. Over the past year alone, federal debt in America has surged from US$9.645 trillion to US$11.813 trillion. In other words, during the past twelve months, American federal debt has risen by a shocking 24.47% and it now stands at 83.52% of GDP! Now, given the ability of the American establishment to essentially create dollars out of thin air, I have no doubt in my mind that it be able to inflate the economy. However, this will come at a huge cost and the victim will be the American currency.
In fact, the recent weakness in the US dollar is a sign that central-bank sponsored inflation has started to dominate the private-sector debt contraction in the West. Furthermore, over the past few weeks, various governments have issued US dollar-denominated debt and this suggests that the carry-trade is back in vogue. In a startling move, Germany recently announced that it plans to borrow money in US dollars!
Now, given the ongoing federal debt inflation, debasement of paper currencies, sky-high budget deficits and competitive currency devaluations, the macro-economic environment has never been better for precious metals. Yet, both gold and silver continue to frustrate the bulls by staying below the record-highs recorded in spring 2008.
So, what is going on here? Have we already seen the end of the precious metals bull-market or are we about to witness an explosive rally? Before I attempt to answer this question, I want to make it clear that even though gold failed to better its all-time high during last autumn’s panic, it was the only asset, (apart from US Treasuries) which stayed relatively firm. And looking at the various markets today, gold is the only asset that is flirting with its all-time high. So, whether you like it or not, gold deserves some credit for fulfilling its role as a safe haven.
Now, unlike some of the die-hard gold bugs, I don’t believe that gold is the ultimate asset to own at all times. Without a doubt, there have been times in history when gold has proven to be a lousy investment. For instance, between 1980 and 2001, the nominal price of the yellow metal fell by an astonishing 70%. This horrible price action spawned an entire generation who grew up hating gold and up until a few years ago, the vast majority considered gold a barbaric relic.
However, during other periods in history, when macro-economic uncertainty was high and inflationary expectations were running out of control, gold turned out to be a fantastic asset to own.
If my take on the macro-economic situation is valid, then we are in such a period now and gold must form a part of every investment portfolio.
You may remember that over the past year, central banks have injected trillions of dollars into the banking system and it is only a matter of time before inflationary expectations start spiraling out of control. Up until now, this ‘stimulus’ money hasn’t permeated through the economy in the West but once money velocity picks up, prices will start rising and the investment community will become very concerned about inflation. When the deflation scare abates and people start protecting the purchasing power of their savings, capital will start to flow towards precious metals.
Long-term clients and subscribers will recall that about two years ago, I highlighted gold’s tendency to rocket higher every other year. Figure 1 captures this trend perfectly and you can see that since the outset, gold’s bull-market has been punctuated by lengthy consolidations and the yellow metal has surged to a new high every alternate year.
Figure 1: Is gold about to shine?
So, if gold remains in a bull-market and its trend consistency is intact, its price should surge over the following months. Conversely, if the price of gold fails to climb above its all-time high before year-end, it should start to ring alarm bells as this would open up the possibility that the bull-market may be over. Remember, certainty does not exist in the investment world and savvy investors should remain open to all outcomes.
Now, given the uncertainty in the world today and the ticking inflationary time-bomb, my view is that gold will soon embark on its north-bound journey. So, I suggest that investors hold on to gold and the related mining companies which will probably continue to perform well until next spring.
As far as silver is concerned, it has always been a high-beta play on the direction of gold. If the next up leg in gold’s bull-market materialises, the price of silver will also head towards the heavens. Accordingly, investors may also want to allocate a portion of their investment portfolio to silver bullion and silver producing companies.
Regards,
Puru Saxena
for The Daily Reckoning
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So, if we do not see inflation over, say, the next year, will we all agree that the Quantity Theory of Money has been completely and totally discredited? Further, can you get someone to explain why increasing wage costs causes inflation, increasing energy costs causes inflation, but increasing interest costs causes deflation???
Increasing wage costs are one effect, not the cause of inflation. First, there is the increase in the supply of the fiat currency called inflation. As a result more dollars are chasing the same goods, services, and labor that exists, unless you get greater productivity from the labor. Prices then get bid up and you have the result of the inflation of the currency.
Inflation is a decrease in the “general” purchasing power of the currency. When we had the huge runup in the oil price in 2008, that was not inflationary since people had finite amounts of money–they spent more on fuel for the car and had to cut back somewhere else (causing the price of those items to go down). Only an increase in the money supply can cause inflation by definition.
“Inflation is a decrease in the “general” purchasing power of the currency.”
…due to an increase in the supply of the fiat currency, facilitated by the Fed. This is called ‘inflation’.
“When we had the huge runup in the oil price in 2008, that was not inflationary since people had finite amounts of money.”
It WAS inflationary, because people were paying more for gas, big screen TVs and vacations with BORROWED MONEY encouraged by the Fed. The easy credit policies of the Fed forced an increase in the money supply.
Sure it eventually ran out, but it HAD to. It COULDN’T go on indefinitely.
( So, if we do not see inflation over, say, the next year, will we all agree that the Quantity Theory of Money has been completely and totally discredited? )
Hardly! The “beauty” of the current situation can be seen in the conversion of that purveyor of derivatives ( Goldman Sachs ) to a correspondent bank of the FED. Now the FED pumps liquidity directly into the $700+ Trillion derivatives market!
And if you consider derivatives to be a Ponzi scheme, then the purveyors have found the last and best “greater fool” to keep the show going… for now.
However, not everyone is thrilled to see this… starting with certain other central banks. They have either stopped selling gold, or are serious buyers of gold. Anyone know where the 403 tons of IMF gold went? You know that when central banks start taking physical delivery, prices there aren’t going to fall… but supply sure will!
There have been rumblings of 50-75 basis point rises in interest rates, around the world, on a MONTHLY(!) basis if gold goes past about $1200-1400 and same for every $100 that gold rises after that.
Can we see 30% interest rates here???
There is a huge danger that gold begins to underpin currencies again. That would easily put gold over $32K/oz! The problem is that would discount the entire first world economy by far more than the typical 90% drop one sees in a recession…
Think about it…
In Response to Bill. Increasing interest rates causes deflation. The Federal Reserve controls interest rates through the sale and purchase of bonds. To inflate the currency they buy bonds, To deflate the currency they sell bonds. The price of a bond is the opposite of the interest rate. A $1000 bond paying 10% gives you $100. If the price falls to $500 you get 20%. If the price rises to $2000 you get 5% To deflate the currency they sell bonds, this lowers the price and increases the interest rate. They take the currency from the sale and put it back into the black hole from where it came.
lets make it simple. we have a lighted-fart economy.
To my knowledge, foreign debt purchases by the German government are always hedged against currency “risk”. All they want is the dollar’s low low interest rate, and that’s all they’ll get, too. No dollar carry trade here.
I meant debt sales, of course (not purchases).
and “debt in foreign currency” (not foreign debt)
$3,400 AN OUNCE GOLD. GET OUT OF THE DOLLAR WHILE IT IS STILL WORTH FOUR CENTS.