The Past, Present and Future In Gold
...the ultimate store of value throughout recorded history has been gold, which outperformed just about every asset class in the stagflationary 1970s.
Back in late July, I published the original version of this piece, but nobody cared too much about gold back then.
As with all things though, positive price action gets people's attention, and spot gold over $700 is definitely finally turning some heads.
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Consequently, I thought I'd update the prior article somewhat and to bring us up to the present…
One has to know where we've come from in order to understand where we are potentially going in gold.
First, gold is the only precious metal that is recognized as a central bank reserve asset, which means it is "money".
After peaking at around $850 in 1980 as Fed Chairman Volcker's "tough love" of high interest rates finally killed the 1970s inflation, gold went into a 20-year bear market. Gold emerged from that bear market when it began to rally in 2000 and has since posted its highest spot monthly close in history.
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The Dollar's Demise?
That brings us to what appears to be a secular downtrend in the dollar, which for obvious reasons tends to be inflationary. While people like to concentrate on the U.S. dollar index, this is mostly a euro proxy. See what I've written about such topic here.
The trade-weighted dollar, which is what "matters" as far as import prices and the willingness of foreigners to finance the US' trade deficit are concerned, continues to make new multi-year lows on virtually a daily basis now.
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The Fed's major Currency Dollar Index, which consists of major foreign currencies that have a wide circulation outside their country of origin, has already made new all-time lows.
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What precipitated this decline in the dollar? Like all things, the cause is debatable, but the various global imbalances that are now feeding its decline have been building for years. One of the reasons the imbalances, like the U.S. trade deficit, could get as large as they did was due to the dollar's status as the world's sole reserve currency, which gave the Fed a great deal of flexibility in how it could respond to various financial and economic problems. However, that may now be changing as more and more foreign central banks begin to diversify their reserves.
The catalyst that kicked off the current decline in the dollar appeared to be the Fed's massive money printing operation that began in 2001 after the U.S. stock bubble began to come apart. That "inflating away" of the stock bubble has brought us to where we are today, where massive amounts of dollar "liquidity" is sloshing around the globe and looking for a home. And that home is increasingly being found outside of U.S. financial assets, like stocks and bonds.
Stock bulls like to say that they're bullish on U.S. stocks because there is a massive amount of "liquidity" sloshing around, and on this point I agree wholeheartedly. The difference between myself and most stock bulls is our perception of what "liquidity" is. Liquidity stemming from too many pieces of confetti looking for something to chase before the value of that confetti drops even more (i.e. fear of losing purchasing power, otherwise known as "fear of inflation") is not bullish for financial assets that are denominated in that particular piece of confetti. And in this case, the primary piece of confetti is the dollar.
Now, that liquidity mass is already avoiding certain markets in the U.S., like its credit markets. Next comes a liquidity preference away from the U.S. stock market, as more and more "liquidity" moves into "bad stuff" like gold and other hard assets, even residential real estate again eventually. But long before it gets back into residential real estate again, people should finally begin to see this "liquidity" for what it actually is: a massive inflation. And like all inflation, they are only seen for what they are long after the events that actually precipitated them and sowed the seeds of the inflation.
In this case, the inflationary wave began six years ago when Uncle Al began slashing interest rates and effectively monetized the biggest stock bubble in the history of the world. And that inflation continues to feed through to the real world today. We saw that inflation first occur in U.S. residential real estate prices, and we continue to see it today in the continued rise in commodity price inflation and the collapsing dollar. Unfortunately, the Fed can't (and won't) do a thing about it because of the housing bust's drag on the fragile US economy and its threat to the financial system. As a matter of fact, they will no doubt soon be forced to feed that inflation with rate cuts.
Yes Virginia, We Have An Inflation Problem No Matter What The "Core" Rate Says:
Speaking of inflation, what exactly is the rate of inflation in the U.S.? Well, if we look at the pre-Clinton administration's formula for the CPI, for example, the headline rate of inflation is running at above 6%. If we use the CPI version that was in place back in 1980, headline inflation is running at over 10%. (Thanks to John Williams' Shadow Government Statistics for this data)
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And keep in mind that this is occurring even as the US economy slows due to the drag from the housing bust. With the rest of the world's economy booming, for the Fed to cut rates at this point is no different than some South American Banana Republic printing money to offset a slowdown in its economy. What's the result? Obviously, their confetti currency collapses. Inflation accelerates and the economy still sinks into recession. It will be no different for the US given the changing attitude toward the dollar.
For a long time, the Fed had the privilege of printing money at the drop of a hat in response to all economic and financial problems but was still able to avoid this Banana Republic eventuality because it printed the world's reserve currency. But that fiat dollar based currency system is now breaking down. That's what the dollar's collapse and gold's rally are telling us, and that means the game is changing.
Won't The Fed See This Problem And Therefore Not Ease?
As for all the talk of "will the Fed cut or won't they", this is irrelevant in my view. Given the Wild West nature of the way the modern financial system has evolved over the past 20 years, it requires ever-expanding rapid credit growth, or it just dies. If credit growth slows, the system dies like a shark that stops swimming, and the social consequences of that option are much worse than an inflation problem, at least in the near term.
As Martin Feldstein, president of the National Bureau of Economic Research, said just this past weekend at the Jackson Hole pow-wow: "The economy could suffer a very serious downturn… A sharp reduction in the interest rate, in addition to a vigorous lender-of-last-resort policy, would attenuate that very bad outcome." He went on to say that lowering interest rates may result in a "stronger economy with higher inflation than the Fed desires,'' but that this was the "lesser of two evils.''
Rather than a "stronger economy" with "higher inflation" if the Fed were to ease, I would argue that the US economy is likely to be extremely weak and still experience rising inflation, due to the rest of the global economy remaining firm. Thus, we get stagflation here in the US.
But the more important point behind Feldstein's line of thinking (i.e.- that inflation is the lesser of two evils) is precisely what I believe the Fed consensus has been all along and exactly how we've always expected the Fed would respond to the housing bust. When given the choice between a deflationary depression and the possibility of higher inflation on down the line, the Fed will always choose to inflate (because it must in order to assure the survival of the system), and that's precisely what Feldstein was urging them to do this past weekend.
Just as the Fed was forced to "inflate away" the stock bubble 6 years ago, it will now be forced to inflate away the housing bubble. It doesn't matter who the Fed Chairman is. Uncle Al is still to blame for this mess because he's the one that allowed the financial system to develop the way it has. But it doesn't matter who is at the helm at this point. The path ahead is already "preset" in my view. I didn't necessarily believe this back in 2000 when I saw that bubble bursting, but I've come to realize it over the last few years (and kick myself for not realizing it sooner too).
As the financial system has seized up recently, the world's central banks have rushed to the rescue of the system with more credit, since their chief concern is the continuation of that system. It was simply inevitability.
More "printing" will still be required, and more will come, not because the Fed or ECB choose to do so, but because they have to do so.
All this talk of "will the Fed cut" or "won't they" is a completely useless exercise in my view, regardless of what the Fed heads may say, just as we saw proven in real-time several weeks ago when the Fed claimed inflation was the chief risk at the August FOMC and then slashed the discount rate just a few days later as the financial system seized up.
The Fed must "do whatever is necessary" in order to keep the system intact, and that requires a massive inflation given the enormous credit bubble in real estate that was blown in the wake of the stock market bubble bailout. In essence, all roads lead to the same place in my view: to more inflation.
There is no "choice" in the matter. The Fed has already "eased" unofficially by keeping fed funds below its target rate for weeks on end, and it will be easing officially very soon as well. Maybe even today. That won't solve the problems in the economy and financial system that have stemmed from the housing bust but that flow of easy confetti will insure that we see some form of stagflation.
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