Why the Gold Price Continues to Hit Record Highs

Gold up. Stocks down. Dollar down. Bonds down.

That’s not the sort of market summary that thrills very many folks, except, perhaps, about 99% of the folks who read The Daily Reckoning. But even Daily Reckoning readers like to see the stock market go up sometimes…and they usually don’t mind much if the dollar doesn’t fall.

Nevertheless, successful investing is never about what you would wish; it is about what you expect.

Despite their wishes, for example, your editors here at The Daily Reckoning have been expecting for a very long time that gold would go up and the dollar would go down, while most other investible assets went nowhere. That Big Picture call has been pretty much on target for more than a decade, and your California editor sees no good reason to alter course…or speed.

On second thought, you may want to alter speed a bit. You may want to acquire gold, silver and other hard assets more briskly than before.

Gold hit another new high yesterday. All-time highs are not usually the opportune moment to buy an asset. Then again, the gold price has nearly doubled since early 2008, when it hit a then-new all-time high of $850 an ounce. We would not be surprised to see the price of the yellow metal double again over the next three and a half years…or triple.

We don’t expect the gold price to soar because gold is such a great thing; we expect it to soar because the world’s major currencies are not such great things. A dollar bill looks good, only when you place it next to a euro or a yen. But all three look sickly when you place them next to a bar of gold.

The value of gold is backed by a 3,000-year legacy of being the ultimate currency and store of value. The value of a dollar, on the other hand, is backed by the full faith and credit of the United States. The problem is, there’s too much credit and not enough faith.

Yesterday, Moody’s and Standard & Poor’s both threatened to downgrade the credit rating of the United States. The threat of an official downgrade resonates with the real-time unofficial downgrade that is already underway in the market for credit default swaps (CDS).

To review: CDS are a kind of “default insurance.” The buyer of a CDS is buying insurance against default by a specific issuer of debt, whether that be a company or a country. The greater the apparent likelihood of a default, the higher the price insurance. That’s why the price of a Greek CDS is 1,000 times greater than the price of a Norwegian CDS.

This extreme pricing difference is to be expected. In absolute numbers, the national annual deficits of Greece and Norway are identical. But while the Greeks are running a budget deficit equal to about 14% of its GDP, the Norwegians are running a budget surplus equal to about 14% of GDP. Greece might default tomorrow. Norway is unlikely to default any time this century…or at least not until its North Sea oil runs out.

Interestingly, the price of 5-year CDS on US debt is also higher than that of Norwegian CDS. Both issuers are rated AAA. And not so long ago, CDS prices on both of these sovereign borrowers were identical. For a short while, in fact, Norwegian CDS were more expensive than their US counterparts. But the spread between the two has been widening out during the last several months. In other words, US CDS prices are rising relative to Norwegian CDS.

The CDS Market Downgrades the US

As of this morning, US CDS are more expensive than the CDS of six other AAA-rated sovereign borrowers. According to CDS buyers, therefore, the United States is somewhat less deserving of its AAA rating than Norway, Sweden, Switzerland, Finland, Netherlands and Germany.

Counterintuitively, despite the threat of downgrades and the rising price of CDS, demand for long-dated Treasury bonds appears to remain fairly strong. Yesterday, the Treasury attracted higher-than average-demand for an auction of 30-year bonds. “The bid-to-cover ratio on the $13 billion in bonds,” Bloomberg News reports, “which gauges demand by comparing total bids with the amount offered, was 2.80, versus a 2.64 average at the past 10 sales.”

But the longer Congress dithers about the debt ceiling and budget cuts, the greater the peril the US Treasury market faces…and the higher US CDS prices climb. Most likely, Congress will figure out some way to finagle a non-default by pretending to implement “tough” budgetary revisions, while functionally kicking the can down the road. Whatever the near-term outcome, the protracted bickering on Capitol Hill has confirmed what America’s largest creditors already feared: America has an enormous debt problem and has zero resolve to dealing with it.

But as one of our guest columnists recently remarked, “That’s why they made gold and silver.”

Eric Fry
for The Daily Reckoning