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Goldilocks Dies

By the end of the day, a "store of value" like gold may become the chief beneficiary of the official sector's response to the housing bust.

In a previous piece, I posed the question: Is "Goldilocks" For Real Or Just Another Fairy Tale?

Today I got the answer, as the equal-weighted CRB (CCI) made a new all-time high.

That's not Goldilocks, ladies and gentlemen. Despite the hopes of the Fed and equity bulls wishing to relive their late-1990s youths, commodity inflation has not peaked, and a peak in commodity inflation was one of the key ingredients of the Goldilocks/soft landing of 1995.
On the contrary, commodity inflation appears to be accelerating, which means (barring a monetization effort by the Fed to hold rates down in the long end) bond yields are likely going to rise, regardless of what the Fed does going forward. In fact, one could argue that rates in the long end of the curve may rise even faster if the Fed continues to drag its feet and merely pay lip-service to inflation, just as the Fed has done since September in an obvious attempt to avoid turning the housing bust into a housing meltdown.

Nevertheless, a rise in rates at the long end is going to put more pressure on the housing bust by pushing up mortgage rates and further slowing the economy. The Fed is aware of this and will no doubt try and fight it by attempting to hold long-term interest rates down (or at least slow their rise) by buying treasuries and expanding its balance sheet, which has already expanded 60 bps since the end of September. This is inflation by definition, which reminds us once again to watch what the Fed is doing, not what it says.

What is the end result?

I don't know, but I'd say the odds favor stagflation. And that's not exactly a bullish environment for stocks. Thus far, the inflation in the system has merely "manifested" itself in higher commodity prices, but at some point, the market becomes conscious of what is happening. And when it does, that's typically when "stores of value," like gold, outperform basic commodities, which are not stores of value.

What are the "smart guys" doing?

Since 1998, the "smart guys" have asked not how can I attack this bubble that is popping (in 1998, that financial bubble was embodied by failed hedge fund LTCM), but instead how will the "powers that be" respond to the bubble popping and what asset will benefit the most from that response?

In the case of 1998, the massive amounts of liquidity that were injected into the system by the Fed to avert a financial meltdown following LTCM's collapse resulted in the tech and equity bubble of 1999-2000. So, the "smart guys" bought Internet and technology stocks in 1998.

In 2000, when the tech bubble popped, it became apparent that the Fed would once again respond by printing money. What did the "smart guys" do? They bought real estate and housing stocks in anticipation that the Fed's actions would create a bubble in housing.

Fast forward to today… the housing bubble has now unquestionably popped. How will the Fed respond? The answer is obvious. They will print money, just like they always do in response to problems, except this time there are no more asset bubbles left to blow.

Instead, all you are left with is an eventual collapse in the dollar. But since the dollar is also the world's reserve currency, other paper currencies also derive their "value" from the purchasing power of the dollar. So, the dollar may not necessarily "collapse" against foreign currencies, although it will most certainly depreciate, as self-interest eventually forces foreign central banks to raise interest rates.

The true "collapse" will be in the dollar's purchasing power and the purchasing power of other global currencies that hold dollars as their primary reserve asset, and the biggest collapse will likely be against a "store of value" like gold.

Thus at the end of the day, a "store of value" like gold may become the chief beneficiary of the official sector's response to the housing bust. So, perhaps the "smart guys" are now buying gold? Thus far in November, the Gold Shares (GLD) ETF has inhaled 21 tonnes of gold, or an increase of about 5 percent in its gold holdings.

Is China one of the "smart guys?"

Now throw in today's comments from PBOC governor Zhou, when he said that the PBOC has "had a very clear diversification plan (out of its dollar reserves) for several years," and we can see how what was already a growing inflation problem in the US could quickly become a huge problem should China begin selling treasuries or even reducing its buying of treasuries going forward in favor of other reserve assets, like gold.

The fact that China was going to eventually be forced to diversify its forex reserves, which topped $1 trillion in October (up $850 billion in just the past five years), is not news, but as is often the case, the conditions may now be such that the market is going to react a little more violently to what appears to be an inevitability, even though the exact timing of that event remains somewhat elusive.

But can China diversify a large portion of its $1 trillion in forex reserves into the euro for example? Practically, no, China cannot. A massive exchange of dollars for euros would drive up the euro vs. the currencies of the rest of the world, straining trade relations and causing mass financial chaos (not to mention crush Europe's economy).

The logical choice for China to diversify its dollar reserves into is the only other widely recognized reserve asset held by central banks around the world and the only reserve asset held in any size by the US Federal Reserve, gold.

So, who are the "smart guys" this time?

One never truly knows the answer to that question until after the fact, but I think a good case can be made that the "smart" trade at this point is to be long gold.

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