If Not Inflation, Then What...?

What the latest surge in Gold Prices tells us – and how to play it...

IT'S NO SECRET that Gold Prices have been on a tear of late, touching more than $1240 an ounce – a level that would have seemed a distant prospect only a year ago, writes Martin Hutchinson at Money Morning.

Yet there is no sign of resurgent consumer price inflation in the US economy, or in the economies of most other countries.

This time around, therefore, gold is not serving as a protection against inflation, as it did in the 1970s. But an increase in Gold Prices that's so sustained has to mean something. Divining that meaning will tell us what we can expect from the global economy and markets in the years to come.

While we have not seen consumer price inflation, in the last 15 years we have seen an unprecedented expansion in the US and global money supplies. From 1995 to 2008, the US broad money supply expanded 40% faster than the country's gross domestic product (GDP).

Then, in late 2008, the US Federal Reserve fully opened the monetary spigots doubling the monetary base in a matter of weeks. Internationally, almost all countries embarked on monetary expansion around 2000, and opened the spigots still further in late 2008.

You can see the result in world central bank reserves: They've expanded at a rate of more than 16% per annum since 1998, and stood at an aggregate $8.09 trillion at the end of last year.

Just think about those central banks for one moment. They control an unprecedented amount of money, almost all of which is deployed in short-term foreign currency assets.

That leaves the central bankers with an unenviable choice:

• They can put their money in US Dollars, which are subject to a record budget deficit that is showing no sign of being brought under control;
• They can put their money in Euros – and watch the European governments and the European Central Bank (ECB) organize a bailout totaling $1 trillion for a country, Greece, whose GDP is only one third of that amount;
• They can put their money in Japan, a country whose public debt exceeds 200% of GDP, that's also running huge budget deficits and that's blessed with a government who wants to run even larger deficits and isn't satisfied with interest rates around zero;
• Or they can put their money in China, a country whose currency is not freely traded and where inflation is becoming a real problem.

Of course, there are a couple of well-run countries like Canada and Australia, but between them they are far too small to provide a home for anything close to $8 trillion.

Alternatively, central bankers can put their money in Gold Bullion – an asset that has increased in value by more than 20% annually since 2000, and that shows no signs of ceasing to do so.

Rationally speaking, those central bankers will put at least part of their reserves in gold. The problem is that – even at these exalted prices – the annual output of gold is only $120 billion and the total world stock of gold is worth only $6 trillion. So with the world's central banks stepping up buying, mostly clandestinely, you can see that the Gold Price is likely to go much, much higher.

The dangers of investment in physical gold or Gold Mining stocks have however increased in the last few months. The Greek crisis and the European Union bailout have pumped even more money into the system, which is why gold – despite occasional profit-taking – has been given a further boost over the last week.

However, the uncertain reaction of the markets to the EU bailout of Greece has increased the chance of a liquidity crisis such as we suffered in 2008, in which risk premiums rise sharply. While gold can in general be expected to benefit from a rise in risk premiums, its price would drop back as it did in 2008 if there was a liquidity crisis caused by a major insolvency of a bank or country.

For the moment, therefore, gold has become a speculative plaything – rather than a safe store of value. Investors should not have more than 15% to 20% of their net worth in gold or gold-related assets, in case it all goes wrong.

Conversely, since there is a chance of a sharp "spike" in the price of gold, the current opportunity is probably one that shouldn't be missed: Out-of-the-money gold options traded on the Chicago Mercantile Exchange would seem worth a speculative "flutter" for 1% to 2% of a speculative investor's assets.

If you decide to pursue this strategy, you should go for options with more than a year to run, in case there are delays in the scenario playing out, and far out of the money, to maximize leverage on a small investment. The December 2011 call options – with a strike price of $2000, and currently trading at $35 – would seem worth a small investment wager.

One contract, representing 100 ounces and costing $3500, is the minimum investment, but for those whom that represents only a small fraction of the portfolio, it may be worth a small flier. After all, if gold really takes off, it's a thin-enough market that the Gold Price could easily reach $3,000 or even $5,000 an ounce.

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