11 July 2010

Jesse's Paradox: Gold Can Perform Well In Both Monetary Inflation and Deflation

The average punter understands the first graph to the right. Gold tends to increase in price in times of monetary inflation, because as an alternative store of wealth it provides a safe haven from central bank debasement of the currency.

By monetary inflation, we do not mean the simple, nominal growth in money supply, and of course the same can be said of a simple decrease and deflation. This is obvious when one considers that money must have a natural relationship to the demand for it relative to population growth, but most importantly to the growth of real GDP.

But notice the second chart, and this is the one which so many speculators and economists miss. Gold tends to perform well when the inflation adjusted returns on the longer end of the curve are low. In other words, when the real returns on bonds are inadequate to the risk. But the risk of what?

Inflation, pure and simple. Deflation is a prelude to inflation, and sometimes a brief hyperinflation, in a fiat currency regime.  And even while the nominal money supply may remain flat or even negative, the decay in the underlying assets that support it may be declining, and sometimes dramatically so. 

The smarter money is not chasing the latest wiggles in the Elliot waves, or the price manipulation shenanigans of the central bankers and their minions at the bullion banks. They have been buying ahead of the increasing likelihood of a monetary event.

The underlying value of the dollars are deteriorating. So even though there might be fewer dollars nominally, in fact there should be much fewer dollars because of the contraction in GDP.

And the quality of the assets underlying those fewer dollars are much lower quality than only a few years ago.

Gold seems to perform less well, underperforming other asset classes, in a healthy economy where the growth of money is related to the organic growth of real production and not to financial engineering. Gold seems to be a hold in 'normal' times.

I would suggest that the extraordinary price in gold now is because for many years the central banks artificially suppressed the price and the means of production for gold by selling their holdings in a conscious attempt to mask their monetization and the unreasonable growth of the financial sector. They wanted things to look 'normal' while they were becoming increasingly out of balance, especially with regard to debt and international trade balances, and so they opted for appearance versus reality.

As Fernando of the Fed would day, "It is better for the economy to look good than to be good, and dahling while we were printing money and selling the public's gold it looked marvelous!"

And what if the Fed starts allowing the 10 year Treasury yield to start rising naturally. Will that be the time to start selling gold? Probably not because the money supply would most likely be artificially increasing again, and that yield increase would be a remedial reaction.  Keep an eye to negative real interest rates if you can find an indicator of inflation that has not been corrupted.

Cargo Cult Economics

People who really do not understand what is happening in a complex system sometimes react in funny ways, and suggest things that would be laughable if there were not in a relative position of power. Anyone who has worked in a large corporation will understand what funny things bosses can be when struggling to deal with complexity that they do not understand. Our duty of course is to help them, for the good of all, but sometimes that is beyond our reach, especially in dealing with Type A bosses who cannot conceive that there might be something beyond their comprehension. Since 'killing the messenger' is their reflexive reaction, their learning curves tend to be quite long, generally resolved in the insolvency of the division or even the entire company.

What I find incredibly amusing are the high priests of the economic cargo cult, dressed up in the ritualistic accoutrement's of academic credentials, sporting the codpieces of monetary policy, carrying the totems of efficient market theory, arrogant and presumptuous even in their frustration and failure. They are just so incredibly and unsuspectingly funny. I am sure history will have a good laugh over it, and for us, well at times we have to grin and bear it.

Much of what Larry Summers is doing now makes me think of Dilbert's boss. If gold is the signal of a problem in the economy, well then, let's just manipulate the price of gold. If slumping stock prices are a sign of economic deterioration, well then, lets just buy the futures and prop them up whenever they slide. See how short term and easy things can be?

This is not always humorous of course. Powerful people who are frustrated and amoral can tend to do increasingly destructive things. And then the response of the people is to try to ignore them. If necessary one must basically tell them to 'stuff it,' and give them the boot. And if they persist and start acting out, well, tyrants eventually get replaced one way or the other, but it is far too early to discuss things like that now.

When Will the Gold Bull Market End

So, the frustrated investor says, when will gold finally start topping?

Gold have topped when the smart money is convinced that the real economy is becoming naturally sustainable, robustly organic in its credit creation and allocation, and healthy in the growth of the median wage to support consumption, without subsidy or interference or new unpayable debt from the Federal Reserve, or the draconian 'taxes' from an outsized financial sector that stifles real growth.

When people are no longer obsessed with what Goldman Sachs and their ilk are doing, or what Bernanke and his merry pranksters have to say that day, then will be the time to be out of gold. I do not see even a move in that direction anywhere on the horizon.  Because of the credibility trap, the impulse to reform is stifled in the corridors of power.

This is no top, and sentiment is unusually bearish. As I have said, I believe this is the base for a new leg up that is going to surprise all but a few. No one knows the future and I could be wrong.

But I do not think that I am, unless there is a new market panic and a general liquidation of all assets. The hedge funds, BIS, and the Fed can play their games, but they cannot hold back the tide of history without being overwhelmed.