Gold News

Gold: Double or Quits

Expect the Gold Price to either double or halve in 12 months, says one market veteran...

A THIRTY-YEAR VETERAN of the US investment markets, Donald Luskin famously spent a decade building Wells Fargo Investment Advisors into the world's biggest investment manager, before selling it to Barclays Bank in 1995.

Now chief investment officer of strategy advisors Trend Macrolytics, Luskin is nothing if not opinionated. A weekly contributor to CNBC's "The Kudlow Report" and, he's a leading – and often controversial – voice on the politics and policy that drive global markets.

Here the team from catch up with Luskin to get his take on the outlook for gold and inflation... (HAI): Don, you've been on record as a bit of a gold bull in the past, and have made some pretty insightful comments in the press about things like how IMF Gold Sales may impact the market. What is your take, in a nutshell, of where gold goes over the next year?

Don Luskin:
I think a year from now, gold is going to have a very bimodal result pattern. As we're talking [mid-April 2009], gold in the futures market is at $883 per ounce. A year from now, it will either be double that or half that; nothing in between.

HAI: That's a fairly bold statement. You don't see any world where gold has just drifted a bit higher or lower?

Don Luskin: I regard gold as substitute money. So when you ask, "What's gold worth?" to me, what you're really asking is "What is the expected value of money?"

If the financial crisis deepens and the world's demand to hold safe-haven balances increases sharply again back to the levels of panic that we saw last October, November, December, then the world will be plunged into a monetary deflation; deflation defined as extreme appetite for money as opposed to any asset or any thing - a desire for the complete safety of money.

So when the demand for money completely outstrips the supply of money, you get deflation. In that kind of world, even Gold Bullion isn't a safe haven; the only thing that would do is liquid money.

HAI: So that's the downside scenario...

Don Luskin: Right. But on the other hand, the response of the central banks of the world to the crisis – to keep that scenario I just outlined from happening – has been to print money. If you look at the Federal Reserve's balance sheet, you'll see something you've never seen before in history: The assets and liabilities of the Fed balance added together now represent something like 30% of the assets and liabilities added together of the commercial banking system. That's completely unprecedented. The asset side of the Fed's balance sheet has almost tripled in the last four or five months.

When the Fed acquires assets, it has two ways of doing it. It can borrow money from the world – taking on liabilities – and then buy assets with it. That's what everybody else does to acquire assets in a hurry. But when the Fed wants to acquire assets in a hurry, it can do something that no other entity can do legally. It can just simply print the money.

If you do that, however, it's called counterfeiting. When the Fed does it, it's called monetary policy.

HAI: Right.

Don Luskin: So the Fed has engaged in this record amount of money printing in response to this extreme surge in money demand that we experienced when the credit crisis hit late last summer. In that sense, it's an appropriate response.

The Fed is meeting money demand with money supply. It's no different from a farmer who might go out and madly plant apple trees in order to increase the apply supply to deal with a surge in apple demand. The prices of apples won't change as long as supply and demand are kept in some kind of harmonious, stable relationship.

But problems occur when one side – supply or demand – nonlinearly gets away from the other side. So while the Fed has done approximately the right thing by meeting this money demand with money supply, the change in the money demand is so dynamic right now that if we were to get any kind of recovery in the world's economy, any kind of restoration of confidence, you'd see that money demand start to ebb. You'd see people wanting to own securities and "things" instead of simply hold liquid balances, and then the challenge would be on the Fed to extinguish all of that new money supply as quickly as it created it.

The Fed may very well do that, but if they got it right, it would be the first time in history.

HAI: Because this isn't like apples, right? You can't actually go out and count the number of people buying apples. It's supply and demand that's a world apart from the supply and demand for hard assets or things.

Luskin: Right. Now some people would suggest Gold Investment offers a way around that problem. Because we don't know have the Fed actually holding Gold Bars in a vault somewhere for every dollar that's issued – that's the old-fashioned gold standard of a century ago. In a new gold standard, they'd suggest that the Fed ought to target the gold price in a kind of virtual gold standard.

The idea is that because the Fed lacks information on when it's supplying enough money that it should look at some money substitute like gold, and that if they can stabilize the money substitute, they can stabilize money. You're basically using gold as a proxy for money because you can't observe money directly.

The price of money is the inverse of the Gold Price, so when gold falls, money rises. So when gold traded below $700 in October, that was telling the Fed that the supply of money was much too low because the price of money was rising, so the Fed did the right thing to restore the Gold Price.

The question is: "What is the right Gold Price?" But who knows...? If the Fed were to at least declare one, it could be right or wrong. If it declared the wrong one, there would be a painful adjustment, but five years down the line you'd have a world of stable money that would be quite wonderful.

HAI: So why doesn't that happen?

Don Luskin: The problem in all this is that the Fed regards deflation as a worse thing that inflation. When it contemplates controlling risk, it would rather err on the side of controlling deflation and permit error on the inflation side. The argument is that while inflation is pernicious – it gradually destroys savings, it corrupts the price discovery process and so on – at least in inflationary scenarios you don't normally see cascading defaults. You do see that in deflation scenarios.

The current regime at the Fed believes that the single most persuasive explanation for the depression in the 1930s was monetary deflation. The Fed back then lacked the statutory authority to do any of the things that the modern Fed does even in non-crisis mode. What we think of now as fairly conventional open market operations were not possible to the Fed, were not made possible until Glass-Steagall in 1933. And the depression bottomed and began to turn into a slow grudging recovery pretty much as soon as the Fed got the powers to reflate and did so.

Bernanke is a student of the Depression – he's almost a hobbyist the way some people are about the Civil War. The good news is that Bernanke doesn't go out and reenact the Depression on weekends the way Civil Wars buffs do. Instead he's very focused, and he will do almost anything to avoid a Depression-like outcome.

When you look at recent mistakes that the Fed has made, I think that context is important. For instance, I think it's a very salient critique of Fed policy to say that the housing bubble and the credit bubble were, if not downright caused by, certainly very much enabled and exacerbated by the Fed's 1% interest rate policies in 2003 and 2004 when the economy was definitely already recovering. But that would be a small mistake compared to the gigantic mistake that the Fed made in the '30s, letting the money supply fall by almost 30% over four years.

Last year we saw CPI deflation – month over month, three month annualized – worse than at any time during the Great Depression, where there was a very, very serious deflationary shock. Thank God the Fed did what it did by creating this gigantic balance sheet. It couldn't lower interest rates any more, it simply had to print money.

Bernanke famously in 2002 spoke of dropping money out of helicopters. He was actually quoting Milton Friedman when he said that. And he did it. He dropped money out of C-5 Galaxies. If he hadn't done that the lights wouldn't be on today, and we wouldn't be having this conversation.

HAI: But you've said recently that we're headed too far in the other direction - that there are more inflationary concerns around gold than deflationary. Do you still feel this?

Don Luskin: I don't believe this because we've gone too far, I think it's because we will overstay our welcome.

HAI: Okay, well how does the Fed get out? What would they have to do to get it exactly right; what would the implication there be?

Don Luskin: Well, if the Fed were to very sensitively detect that confidence had been durably restored to the credit markets, and that the economy was on the mend and that the demand for money – for liquid riskless balances – was falling or about to fall, what the Fed would do would be to one by one shut down these facilities that it had put in place in the name of emergency. So it would shut off things like the Commercial Paper Funding Facility, the Term Auction Facility and all the other acronyms that it whipped up over the last year.

Now the problem is they can't just do that even if they were wise enough to want to. In some cases, these acronyms are real commitments. Sure, the Commercial Paper Funding Facility buys 90-day commercial paper, so if the Fed were to announce that it's not going to do any more of that, then after 90 days, that thing would just go away. But on the other hand, the Fed is only-one fifth of the way into a campaign to buy $1.25 trillion worth of agency mortgage pass-throughs. If it just announced that it weren't going to do that anymore, then mortgage rates that are being kept artificially low by the Fed's commitment would very likely rise substantially.

So in a sense, what they've done is fill up the reservoir of money supply and that reservoir is pretty much going to get trickled down into the river no matter what.

Don Luskin: Well, unless they siphon it out. But my guess – based on their extreme preference for inflation instead of deflation and their appropriate modesty to believe that they can't get it exactly right – is that those who put these programs in place very suddenly will withdraw them very slowly. So they will look at situations like the agency pass-throughs for example, and they'll say:

"Okay, on the one hand, this was about us acquiring assets and printing the money, simply getting money into the economy; that was part of it, the monetary goal."

But the Fed does things using monetary tools that are not monetary. The Fed simply wanted to have low mortgage interest rates. So it may believe – I think it will believe – that for years to come, that the real estate crisis is so profound and recovery from it so fragile, and that there will be such a preference by non-US holders of mortgage-backed securities to divest, that the Fed has no choice but to continue buying them.

The moment of choice comes when it's already bought them. It's not going to make this choice tomorrow; this fork in the road will come a year from now, where it will already have bought $1.250 trillion of them. So the question isn't when we stop buying, but when we start selling. The answer will be "not now", because they will still believe we need mortgage rates at 4% or 5%.

HAI: So the money that's been created isn't going away.

Don Luskin: Correct. The Fed is also committed to buy $300 billion worth of Treasuries. I think it's something like about a fifth of the way on that one too. The Treasury has an extremely ambitious borrowing program ahead because of all the spending that it's undertaken through things like the stimulus bill and things that are in the pipeline in Obama's budget.

We know what direction that's going – there will be more spending, not less. And we know that as this recession plays out that there will be fewer tax revenues, not more, and that widens the deficit even if spending were held constant. That deficit has to be funded by Treasury borrowing.

Now the Fed hasn't needed to buy all that much of the new Treasury issuance because part and parcel of this demand for money that I've discussed has been a demand for safety of all kinds, even if it's not strictly money. So while nobody is going to say that the 10-year Treasury bond is money – it does not have a stable value day to day like money does in nominal terms – it's not money, but it's a riskless investment at least in default terms, and so the world is beating a path to our door to buy our debt because as bad as things are in the United States, they're worse everywhere else.

In that sense we're the tallest pygmy, and there's capital flight in nations like Iceland. If Iceland has any capital left, it's coming here. Countries that are feared to be the next Iceland – like the United Kingdom – any marginal money that's looking for safety coming out of the UK, it's not going to go in UK Treasuries, it's going in US Treasuries. We're the lucky beneficiary of the rest of the world's capital flight and that has two very interesting dimensions. One is that the US Dollar is the world's reserve currency. No other central bank has that status. So when anyone else in the world wants to save, as opposed to invest, you buy Treasury bills. It's just what you and I would do if we wanted riskless balances: we'd buy Treasury bills.

But what does the Treasury buy? How does the Treasury save? That subtle logic paradox: Who cuts the barber's hair? The Treasury has no capacity to save. It lacks the physical mechanism. It could invest, it could go out and buy an S&P 500 index fund, but that's investing, and it's not eager to invest, because at the moment, at least the culture is that the federal government doesn't want to be an equity owner in private enterprise.

So with all this money being thrown at the Treasury from around the world, there's really no choice but to spend it, so an $800 billion stimulus bill like we just rammed through in a rush to judgment a couple months ago is entirely feasible. In fact it was kind of a rational response to the world just throwing money at us, and so that's the setup. But here's the thing. If this were a rational thing for the Treasury to do, then you could say it was rational for unqualified homeowners to accept subprime mortgages three years ago to buy inflated tract homes in Stockton, California, on the theory that three years from now when the mortgage reset, they could just walk away. So what the US is doing with its Treasury debt is in essence the world's largest teaser mortgage.

HAI: And the kicker is inflation?

Don Luskin: Ultimately, but we're funding most of this with debt that's with an average maturity of around three years. So three years from now, if the world credit crisis is healed and you don't have the world throwing money at you anymore, then this is going to reset and we're going to have to roll this debt. We're going to have to refinance.

These three-year notes are going to mature, and what will interest rates be then, when people aren't desperate to own Treasury bills because they're afraid of owning anything else?

So this long detour to tell this story has really been about inflation. There's going to be a run-up to this; it won't wait until three years, it will be anticipated. So at the year-and-a-half point, when people start talking about it and it starts to be part of the dominant narrative, rates will start to go up, and the Fed's going to say, "Oh hell, just when recovery started to set in!" And the fact that recovery is setting in is what's causing these rates to go up.

So just when things are starting to look good, these rates will start looking a little scary, and the dollar will be falling in value, things will get kind of crazy again. But the Fed will say, "We can't let this nascent recovery be killed by a 5% ten-year rate! That was the kind of rate we had just when the wheels came off starting in 2007. We can't let that happen again!" So it's going to be time for the Fed to buy another $300 billion worth of Treasuries and another $600 billion and another $900 billion.

So that's where it's headed, and I just don't see any way out.

HAI: Looping back, that paints an inflationary picture, and a scenario for gold being a lot higher, despite the low inflation predicted by TIPS [inflation-protected Treasury bonds]?

Don Luskin: Gold Bullion has just been lower than it was a year ago. Right after Bear-Stearns Sunday, it traded at $1,030. If you look at the Fed fund futures where they were priced at that time, the market was anticipating the inflationary nightmare of a 1.5% interest rate. We now have a zero interest rate and a Fed balance sheet that's three times the size that it was a year ago.

So the objective inflationary expectation, the water behind the dam so to speak, is objectively much greater than it was a year ago, and yet the Gold Price is lower than it was a year ago. So that would be another way you could frame the no-inflation prediction equation. My answer to that is that in the intervening year we went through a deflation experience that was very transient – it lasted only three or four months. But it was the most intense transient deflationary experience since 1921.

That was a shot across the bow that showed people vividly how fat that tail is. There is no guarantee. What's the consensus that the economy is going to recover? What's the consensus that Citibank and Bank of America have a positive net worth? There's none.

The world's economic grid – some large fraction of it – is blacked out and another fraction of it's sending weird power surges into the rest and a bunch of it's flickering and browned out. We'll get out of this eventually. Human endurance is very powerful. But we could go through more hard times before we recover and if that happens, and the Fed doesn't respond like it did last time or can't, or if no money supply is sufficient to meet the money demand, then you've just got to say there is some probability that it has to be weighted into all these price forecasts that one of the outcomes is deflation, and that's going to be probability weighted.

So while it's not untrue to say that there is some consensus that all this monetary policy is going to lead to inflation, I can point you to five speeches in the last two weeks by Ben Bernanke and Donald Cohen; they don't agree with it.

HAI: Which comes back to your thesis: Either we've got inflation (and higher Gold Prices), or things are truly, truly dismal...

Don Luskin:
So I have good news and bad news. The good news is that our outcomes here are a bell curve, the normal distribution just like always. The bad news is that it's upside down. The least likely outcome is where we are now, and the highest probability outcomes are the tail. is a research-oriented website devoted to sharing ideas about investing in the natural resources sector. Published by Van Eck Associates Corporation, the site offers an educational resource for both individual and institutional investors interested in learning more about commodity equities, commodity futures, and gold – the three major components of the hard assets marketplace.

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