(Continued from Page 1)


Ahead of the Fed's panic, gold investors panicked even more than the Fed and sent the gold shares to near their lowest valuations versus the metal in the past seven years (see the chart of the XAU/GLD ratio below). Note that this ratio has also typically marked panic lows in the gold shares over the past seven years as well, but it doesn't mean that we can't revisit that low again in the coming weeks either. It's unknowable where the shares will be when the market becomes convinced that the Fed will inflate (I would argue for example that we've already seen that inflection point and that last week's discount rate cut was enough to turn psychology), but where they will be after the Fed begins to "print" is knowable in my view. And that's higher.


Click here to enlarge.

The Fed has still yet to cut the Fed funds rate (which would be the most beneficial for gold and gold equities), but I expect that to come shortly (and probably inter-meeting). And when the Fed does begin to ease and people see that the Fed has indeed chosen to inflate its way out of this mess, I suspect we'll see gold bulls return in force to gold equities.

The question is (much like three weeks ago) where will gold and the gold shares be before that "confirmation" comes (ie- how much will investors anticipate), even though the probability of the Fed beginning to ease is now obviously much higher than it was three weeks ago? As for the answer to that question, I think it's unknowable. If one believes the Fed will choose to print, then one simply needs to be long gold and the gold shares and ride things out because you never know when the mirror image of last week's downside panic will appear (i.e. an upside panic).

Remember, physical gold demand has remained consistently firm throughout the recent turmoil, and central bank sales out of Europe have been waning. The Streettracks Gold Trust's (GLD) gold holdings have actually risen to a new all-time high at 514 tonnes, and we're still not even into September yet, when seasonal demand typically picks up for gold.

When we look back a few months from now, I think people will be see this selloff in the gold shares in hindsight as a giant headfake and huge buying opportunity, but we obviously won't know that until the final scores are tallied many months from now.

Again, just to be clear on why (in my view anyway) one wants to be long gold and gold shares:

It has been my expectation that the Fed would print money in response to the housing bust, just as they have responded to all the prior bubble bursts, and the result will be inflation later on down the line just as the result of their printathon after the stock bubble burst led to the inflation that we are seeing today. This time, inflation is already roaring, but the public isn’t concerned about it enough yet to register on the Fed’s applause meter. Instead, people are predictably already coming out of the woodwork and telling (no, begging) the Fed to ease and ease now. Gee whiz, what is the Fed going to do?

Let’s see…

1) The U.S. is still fighting two wars that need to be financed.
2) International investors will be hurt the most by a big depreciation of the dollar.
3) There are the enormous social consequences of not inflating, and the fact that nobody seems to care about inflation right now (in fact, most seem to believe there isn’t any and they’re already begging for rate cuts).
4) The fact that one still has to inflate at the end of the day anyway after the banking system has imploded (which it would if the Fed suddenly changed gears, folded its arms, and decided to let all of the insanity that has taken place over the past ten years unwind all at once instead of trying to perpetuate it by printing money).

Hmmmm, how do you think this is going to end? Or better yet, how does the market think it’s going to end, given the dollar is just off historic lows, gold remains just off its historical highs, and the yield curve is steepening? All of this is occurring as the housing bust worsens, the banking system is seizing up, and the consumer is faltering ahead of a period where everybody knows that billions in ARMs will begin rolling over the next six months?

What’s the answer? The Fed will print. And Friday's discount rate stunt on the equity option expiration further confirms that fact.

With a fiat currency in a social democracy, all roads lead to inflation… period.

Don’t get me wrong. This will end in lower stock prices and a U.S. recession at some point, because the financial losses and economic pain yet to come won’t be alleviated by the Fed inflating. These consequences will merely be masked, just as they were masked by the inflation that was unleashed back in 2001-2002 (although we can see it via the Dow/Gold and SPX/Gold ratios obviously). Inflation, once it’s too great, obviously isn’t good for financial asset valuations either. But that inflation will propel gold dramatically higher. As always, it’s all a matter of how all this gels and comes together in real time, and that’s the really tricky part.

But by the time this process is over, I suspect the Fed will have lost all credibility and Heli-Ben will be the most hated central banker in history. It’s his unfortunate luck to be stuck with all the problems that Uncle Al put off for 20 years, but nobody ever said life was fair...