Gold News

One Last Gold?

As the Fed makes a last stand against credit contraction, investors will flee into gold...

TUESDAY 22 JANUARY wasn't just dangerous. It was destructive.

   Yesterday alone Aussie investors lost A$110 billion (US$95bn) in the biggest one-day drop since 1989, and the fourth-largest in history. In the last twelve days the market has lost 18%. The ASX is down 25% since the November highs.

   It will pay to be a bargain hunter, we reckon. But having a steady hand is hard in times like this. So here's some free advice – after reading this story, turn your computer off and go for a nice long walk. Don't keep refreshing the screen. It will give you high blood pressure. We know from experience. So does Ben Bernanke at the US Federal Reserve.

   On Tuesday Ben Bernanke did almost exactly what we guessed he would, and for the first time since the end of 2001, the Fed cut rates between meetings. It was not the full 100 basis point "super cut" we'd predicted, but by a vote of 8-1, the Open Market committee slashed seventy five basis points off short-term US lending rates, saying the risks to growth were "appreciable".

   The risks are more than appreciable, however. They are a clear and present danger to share prices. So Team Bernanke had little choice.

   Indeed, central banking the world over is now besieged. On the one flank, the contracting credit bubble deflates stock and property prices. On the other flank, inflation puts the torch to real things. The lines of retreat are now all but cut off.

   Where will Bernanke & Co. make their last stand? In America, the markets offer a few clues.

   The Dow dropped 465 points at the open on Tuesday, but then clawed back most of the loss to end 1% lower from Friday's pre-long weekend close. Let's be clear though. The bear is on the loose in the credit markets, and he has bloodlust.

   None of this is bullish for most Aussie shares prices. First the bond insurer AMBAC lost its triple-A credit rating from ratings agency Fitch. Now analysts at National Australia Bank report that AMBAC guarantees at least $20 billion in Australian corporate debt.

   Bloomberg notes that "about A$2.2 billion of AMBAC-insured bonds sold by a unit of SP AusNet, an Australian electricity distributor, and Sydney Airport Finance Company Ltd. were this week stripped of their AAA ratings by Fitch Ratings, which lowered Ambac two levels to AA on Jan. 18."

   If S&P and Moody's follow Fitch's lead and strip AMBAC of its triple-A rating, expect more aftershocks. Either way, the deleveraging of the world's financial system is not over.

   Citigroup has cut its growth forecast for US GDP in half for 2008, down from 2.4% to 1.2%. Bank of America told investors its fourth quarter profit fell by 95%. And rather than soothing badly frayed nerves, the Fed's rate cut has ignited speculation there may be more corporate defaults ahead.

   "The risk of companies defaulting soared on concern that today's emergency interest rate cut by the Federal Reserve will fail to halt a global economic slowdown, credit-default swaps show," writes Shannon Herrington at Bloomberg. "Benchmark gauges of corporate default risk in the U.S. and Europe climbed to the highest since they were created in 2004."

   It is getting harder to buy risk insurance. Even easy money from the Fed is not trusted. But Bernanke had to do something, didn't he? An inter-meeting rate move makes the Fed look like it is behind the arc of events. And it is. But we believe that while the credit and financial markets will remain in turmoil, there will be at least one clear reaction:

   A less valuable US Dollar.

   After the Fed's decision to lower rates, the greenback declined vs. 14 of the 16 currencies against which it's most actively traded. The growing rate differential with New Zealand and Australian interest rates sparked a 2.7% rally in the Kiwi and a one percent gain in the Aussie.

   What next? This is genuinely uncharted financial territory, but we will give you our best guess: more deflating financial assets, but more inflation in real goods. And that puts Aussie resource stocks in a strange crossfire. Do they rise because the US Dollar is weaker and consumer prices are going up along with commodities? Or do they fall because they are stocks, traded by leveraged speculators now fast pulling in their horns?

   Gold rose on the Fed's rate cut, but oil fell. On the stock market, both gold and oil stocks traded lower.

   Does that give us a clue? Do the data support a conclusion? Should you just stay in cash? Load up on bargains?

   These are all questions you should discuss with your financial advisor. And if he didn't show up for work today, it's time to find a new one. We'll tell you what we think though. The world has seen a series of increasingly large bubbles since 1998, in emerging markets, the Tech Bubble, housing markets in the US and UK and here in Australia.

   The bubble that's deflating now – the credit bubble – was the biggest of them all. It was global, complex, and it ended up affecting everyone from individual households to pan-national investment banks.

   The Fed and its counterparts across the world now have only one more bubble to blow: tangible goods, and especially precious metals. History shows that monetary policy – making credit available cheaply – is a blunt tool at best. You can make it easier for people to borrow. But you can't control what they do with the money once they borrow it. You have no idea where it will go.

   Will investors hoard cash? Will debtors use new lines of credit to pay off old creditors? Will a new speculative bubble be kicked off in a new class of exotic financial instruments? We can't say for sure. But we suspect the answer to all those is, "No".

   As the Fed makes its last stand against the relentless forces of credit contraction and rising real prices, we think investors will flee for the only thing that seems solid, real, and steady in the world of assets: Gold Bullion.

   Take note, however. It is not a shoo-in that gold shares will follow the Gold Price higher. That is your risk in the share market these days, the risk that commodity-producing stocks behave like stocks and not like the underlying commodities they produce.

   Gold, base metals and energy resources should rise in price as the US Dollar weakens. But that doesn't mean the stocks of the companies digging them up will do the same.

   There are many more aspects to the unfolding story, of course. But the rise of epic inflation is upon us. Stay tuned.

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Best-selling author of The Bull Hunter (Wiley & Sons) and formerly analyzing equities and publishing investment ideas from Baltimore, Paris, London and then Melbourne, Dan Denning is now co-author of The Bill Bonner Letter from Bonner & Partners.

See our full archive of Dan Denning articles

Please Note: All articles published here are to inform your thinking, not lead it. Only you can decide the best place for your money, and any decision you make will put your money at risk. Information or data included here may have already been overtaken by events – and must be verified elsewhere – should you choose to act on it. Please review our Terms & Conditions for accessing Gold News.

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