Gold Getting Nervous

Gold may have hit new Dollar records, but it's still a "marginal" investment...for now...

GOLD HAS ADVANCED towards a new milestone, writes Bill Bonner in his Daily Reckoning, the level of $1100 an ounce.

It makes us nervous. We always feel more comfortable out in the wide, open spaces...that is to say, in trades we have all to ourselves.

But gold is still a marginal holding by marginal investors like us. Central banks – especially those in emerging countries – have very little gold. The man on the street doesn't know anything about gold. He wouldn't know a Gold Coin if it hit him on the head. As gold becomes accepted as a true store of value, we can expect more and more people to want to own it.

Governments are running breathtaking deficits...and accumulating alarming debts. Japan has a national debt of nearly 200% of its GDP. Where did that debt come from? It came from 20 years of trying to buy its way out of a slump with borrowed money. Of course, it didn't work. But now, Britain and America are following the Japanese lead...and the Japanese are still at it!

At the present rate, Japan's government debt will grow to 300% of GDP in 10 years. America's debt could grow to 100%...and then 200% of GDP...over the next decade (depending on whose projections you believe). And Britain, if we read the report in the Financial Times correctly, will have debt equal to 200% of GDP within 3 years.

Just what kind of crisis do these numbers portend? It's hard to say. Probably a combination of confidence, followed by debt default and inflation.

Would the US actually default? We agree with Paul Samuelson; the answer is "maybe". Samuelson, writing in The Washington Post:

"The idea that the government of a major advanced country would default on its debt – that is, tell lenders that it won't repay them all they're owed – was, until recently, a preposterous proposition. Argentina and Russia have stiffed their creditors, but surely the likes of the United States, Japan or Britain wouldn't.

"Well, it's still a very, very long shot, but it's no longer entirely unimaginable. Governments of rich countries are borrowing so much that it's conceivable that one day the twin assumptions underlying their burgeoning debt (that lenders will continue to lend and that governments will continue to pay) might collapse. What happens then?

"People have predicted such a crisis for decades. It hasn't happened yet. The currency's decline has been orderly, because the dollar retains a bedrock confidence based on America's political stability, openness, wealth and low inflation. But something could shatter that confidence – tomorrow or 10 years from tomorrow.

"Despite huge deficits, interest rates on 10-year Treasury bonds have hovered around 3.5%. In time of financial crisis, investors have sought the apparent sanctuary of government bonds. But the correct conclusion to draw is not that major governments (such as Japan and the United States) can easily borrow as much as they want. It is that they can easily borrow as much as they want until confidence that they can do so evaporates - and we don't know when, how or whether that may happen."

And why wouldn't the US just print its way out of debt?

Because it's not that easy. In effect, the feds are trying to print their way out of debt now. They've added huge amounts to the monetary base. But that money is not getting into the real economy. Instead, it's going into vaults and speculations.

"Jittery Companies Stash Cash," says The Wall Street Journal. And banks, too, borrow...but they don't lend. They can borrow at negligible rates of interest...and buy US Treasury bonds on a leveraged basis...producing a 20% yield. That means, the US Dollar has replaced the Yen as the go-to currency for speculators.

Net effect? Lots of cash in what appears to the Mother of all Carry Trades. The Financial Times:

"The US Dollar has become the major funding currency of carry trades as the Fed has kept interest rates on hold and is expected to do so for a long time. Investors who are shorting the US dollar to buy on a highly leveraged basis higher-yielding assets and other global assets are not just borrowing at zero interest rates in dollar terms; they are borrowing at very negative interest rates – as low as negative 10 or 20% annualized – as the fall in the US Dollar leads to massive capital gains on short Dollar positions."

But in the economy itself? As in Japan, very little economic progress comes from this kind of speculation.

Bankruptcies rose 7% last month. Unemployment gets worse. The financial markets bubble up. The real economy shrivels up. And people with any sense are stocking up.

David Rosenberg at Gluskin Sheff, again, on gold:

"We are still contemplating the massive gold purchase by the Reserve Bank of India – the largest in at least 30 years that took up half of what the IMF intends to sell. Look for China to come in next.

"But here is the reality. All India did was bring gold to a 6% share of its total FX reserves from 4%. Fifteen years ago, that representation was closer to 20%. China has increased its gold holdings by 76% over the past six years but they are a mere 1.9% of the aggregate 2.2 trillion of reserves and Russia's gold holdings is just under 5%. This is not the 1990s when Bob Rubin was running a hard US dollar policy, US fiscal deficits were vanishing and gold production was on the rise. Today's world is exactly the opposite.

"Policymakers beginning in the 1990s wanted disinflation and got it. Now they want inflation – it will take years, maybe a decade, but it will come. For the near-term, we are still optimistic on Treasury securities but be forewarned that this view has an expiry date that is earlier than the peak we are likely to see in gold.

"It is very clear that central banks are behaving in a way that would suggest that gold is now again being considered a currency within the global monetary system. As we said before, it is all about relative scarcity and a well-defined supply curve – fiat currency at this juncture does not share that quality. As a good friend reminded me yesterday, when the Fed was created nearly a century ago, it was acceptable to have at least 40% of the money supply backed by gold reserves. The US now has 8,133 tons of gold in reserve, which equates to $285 billion at this year's pricing.

"Meanwhile, the Fed has spiked the punchbowl to such an extent that the monetary base now stands at $1.7 trillion. Do the math – under the old regime (which indeed hamstrung the Fed), the US alone would need to buy an incremental $400 billion of Gold Bullion or the equivalent of what would be nearly four times the typical level of annual demand. We could do the same calculation based on M2 but we don't want anyone falling off their chairs..."

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