What's Driving Gold?

How the price of oil and Dollars affects the bull market in Gold...

JUST BEFORE the collapse of Lehman's and the rescue of AIG, HardAssetsInvestor spoke with David Galland, chairman of Casey Research and publisher of Big Gold, the monthly gold advisory letter.

HardAssetsInvestor.com (HAI): Where is Gold and what are the factors driving its performance?

David Galland, chairman of Casey Research: I think you have to start from the perspective of where the US and global economy stand. And if there is a word to describe that, it would be "in transition." We are truly in uncharted waters here, and I think we are entering a period of violent volatility and unprecedented risk.

HAI: What's driving gold?

Galland: There's a very high correlation between oil and Gold and the Dollar and Gold. Oil was, by anybody's definition, overbought at $140 per barrel and more, and the Dollar was oversold. No markets go up or down forever, so those had to correct. They did at the same time, which is logical because oil is priced in dollars.

   So gold was suffering from association with oil, but the truth is that the reasons for owning gold haven't changed one bit. In fact, if you look over the landscape, the outlook is worse than ever, so gold will come back. In fact, it could come back much sooner than people expect.

HAI: How soon?

Galland: It's not inconceivable that you could see a $50 an ounce jump in gold tomorrow. [This interview was done just before gold jumped $110 an ounce in one session on Sept. 17th.] But it might be two months from now. We could still see $1,000 per ounce by the end of the year. Nobody knows because things are so fluid and we're in this transition period.

   In engineering, there's something called the "transit lag". That means, for instance, that when you turn on the hot water, there's a 20- to 30-second lag between the time you turn it on and the time when you actually get hot water. We've had a lot of loose monitory policy over the past few years, and there's a normal lag between inflating the money supply and it showing up in prices. We're in the transit lag period – everything that can go wrong with the economy is going wrong, but it hasn't yet worked its way through the system to its logical conclusion.

   We're going to see people talking about recession and even depression, because that's how it's going to feel. And what does the government do when faced with a monetary downturn when they have a fiat currency? They try to add liquidity. The government is trying to bail as fast as they can right now, and they're trying to be proactive, but if you step back and look at what you know about the economy, things get pretty clear pretty quick.

HAI: For example?

Galland: Let's see...We know there are more US Dollars in the hands of foreign investors than at any point in the history of the planet. There is no comparable to this; the reserve currency of the world is more in the hands of foreigners than at any other time in history. People literally have central bank deposits of US Dollars that are backed by nothing. That's a big factor in monetary policy – they have the ability to call the shot with US monetary policy at this point. That's a big problem.

   You also have the largest financial bubble in history that is now unwinding – the housing bubble. Even by conservative measures, that is now a $30 trillion bubble. This was the engine that was running the U.S. economy, but this engine is broke and the boiler has blown out.

HAI: So what do you do?

Galland: You currently have a situation where lenders don't want to lend and borrowers don't want to borrow. So the whole credit structure that built this bubble is now frozen and messed up. The US government is now standing behind – by taking over Fannie Mae and Freddie Mac...around half of the mortgages in the United States. A very decent percentage of those are no good. Twenty per cent of these mortgages, by reasonable analysis, could fail.

   Governments don't produce anything, so how are they going to cover those costs? They can't tax it -taxation past a certain point is counterproductive. They can either default on these loans or inflate them away.

   There's a lot more to it than that, but even with just that, you have all the stuff that you know is going on, and now you have this transit lag. What will come out the other side? One or two scenarios. Anybody with a reasonable perspective will say it's not going to be business as usual. You're not going to have a small recession and have everything end up okay. It will either be a deflationary crisis or an inflationary crisis.

   Our take is that it will look like a deflationary crisis for a while yet, which will give the government the permission to do what it normally wants to do anyway, which is to inflate, which will then materialize and dissolve itself into a very significant inflationary crisis.

HAI: Aren't they already inflating the currency and adding lots of liquidity into the market?

Galland: There has been some data that suggest that they've done a little bit, but it's been more conservative than people would have expected.

   I have a personal theory. You've heard that history is just a series of accidents. A few years ago, Ben Bernanke made a speech where he talked about dropping dollars out of helicopters. He picked up the moniker "Helicopter Ben".

   He doesn't want to go down in history as being Helicopter Ben. I think it weighs on his mind. I'm convinced that, as a result, the government has been very creative to avoid the outright airdropping of dollars. If they go there, the foreign holders of the dollars will get out. Why would the Middle East and China want to hang onto the Dollar when it's such a depreciating asset?

HAI: What's the telltale sign that the inflationary period has started?

Galland: You can watch money supply, and you also see it in the fact that there could be $500 billion in losses on Fannie Mae and Freddie Mac. Where does that money come from? That new Administration in 2009 will also have lots of plans. How will he afford those plans? The deficit will be $500 billion this year? How does an eager new group of champions come in and change the world without having any way to pay for it?

   Cuts will have to be made and inflation will have to be created. We may see a default, or we may see people throw in the towel on the dollar. It's a big unknown. You don't know when you cross a line and foreigners dump real dollars.

HAI: Where should investors be right now? Gold? Gold Mining companies? What's the best play?

Galland: The best move to make right now, I think personally, is to skew towards bullion. No question. After that, I would wait until the end of the year and start picking up the big gold mining companies. On the juniors, we would probably wait until more like April/May of next year. Having said that, we own a lot of good juniors in our portfolios. But we are very careful in our research to ensure that they are more than just hope on paper.

   The juniors are going to have to survive a hostile takeover environment from the big companies, and if they're not careful, they're going to be sold for a lot less than they are worth. If your company does not have all the attributes of a good quality junior, they may not exist by March. If you have a company that was high on hope but not a lot else, you're done. But there are some terrifically run juniors, and they will come out OK. If we say wait until next year to buy them, it's only because people are extraordinarily defensive. Why pay more now when in six months from now you could pay less?

HAI: What about speculation in the gold market? Some people have said that Gold has become a speculative tool, and that it's lost some of its value as a safe haven.

Galland: The gold and silver markets are really determined in the commodity futures markets, and in that regard, gold and silver are actually very small markets. For example, foreign currency exchange on the futures markets trade $3.5 trillion per day. Silver trades $4 billion. I think gold is about $35 billion. They are little tiny markets. So they can be pushed around - a lot of people like to think the government pushes them around, and there is probably some truth to that, but as much as anything, it's just the trading herd.

   If they feel Gold is out of favor because the Dollar is strengthening, they'll exit gold and short gold and they can create a lot of pain in the market.

HAI: How could Buying Gold today not pay off over the next five years?

Galland: Well, I'll tell you something. There are only rare period in history where you can look ahead and see what's coming. This is one of those periods.

   I can't for the life of me imagine a likely scenario. What could happen, I suppose, is that over the short term, the Federal Reserve could fail to respond to current situations quickly enough – there could be a mistake made – and the Treasury might try to get too cute and things could go seriously, seriously wrong. We could end up in a depression.

   But during the last Great Depression, the government didn't have the ability to print money. Now they do. The only way to dig the country out would be to turn on the printing press full-speed.

   This is one of the scenarios where, looking down the road, the scenario of serious inflation – which is already going on – is highly likely. You have to look at the transit lag. The government will do what it takes to hide the true extent of the problem...

   So people are going to have a little mental fortitude and be defensive for quite a while. I would also say that the common man is going to be in for a very rough spot here, but the uncommon individual has the potential to make a fortune over the next year or so, because people are going to be so gun-shy and they're going to sell anything and everything.

   There are a number of companies, for instance, that are advancing enormous deposits of Gold, and nobody's paying attention. At the right time, and this is still early, those companies are going to make people a lot of money. But it's not going to be an easy road.