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(click to enlarge)Weimar

Contrary to conventional wisdom, gold is not trading over $1,600/oz because of fears of inflation, it is trading at such lofty levels due to a much more logical reason, one that is supported by objective market data. Ask any economist and they will tell you that it is unlikely to get sustained inflation without low unemployment. With unemployment bumping up against 8.0%, sustained inflation is highly unlikely. The current Consumer Price Index CPI has prices changing at a modest 1.7% over the last 12 months. The measurement often used by the Federal Reserve, the Personal Consumption Expenditures PCE Deflator is demonstrating disinflation with the current rate of 1.3% being less than 1/2 the 2.7% from last year.

What inflation we do have is largely artificial and manufactured through fiscal policy. Ethanol policy has us burning 44% of our corn production, and biodiesel has us burning up about 1/8th to 1/4th of our soy bean oil production. This article highlights the impact biofuel policy has over in Europe demonstrating the global impact these laws have on food prices. Other policies like hindering drilling in the Gulf of Mexico, blocking the construction of the Keystone Pipeline, and heavily regulating coal to the brink of bankruptcy have all contributed to higher prices. This artificial inflation policy was outlined by Al Gore in his book Earth in the Balance. I call it reverse supply-side-economics. The government deliberately implements policies that make using conventional energy sources so expensive, that it makes alternative energy sources economically viable while providing the government a new source of revenues. This artificial inflation isn't the kind that financial markets generally fear because it is focused on a few items, is artificially created and can be reversed with a stroke of a pen or election.

This reverse supply-side-economics approach effectively repeats the economics of the 1970's, only this time the US Government has replaced OPEC. By creating a supply-shock, the government is able to drive conventional energy prices higher. In the 1970's it resulted in a drilling boom and energy prices eventually collapsed. The "drill baby drill" free market approach worked. Today the hope is that it will result in a technology boom that will make electric cars, wind farms, solar panels and alternative energy sources commercially viable. Ironically the technology boom that has proven effective is in horizontal drilling, which has flooded the markets with cheap natural gas.

Fortunately, unlike the 1970's we don't have extensive cost of living adjustments (COLAs) that resulted in the spiraling inflation and stagflation. Today, wages have remained stable or even gone lower while prices have gone higher. The other big difference between today and the 1970's is that China has emerged as a manufacturing giant that pegs its currency to the $US at a discount. That effectively allows the US to export much of the inflation we should be experiencing to China. That along greatly reduces the chance of inflation, at least in manufacturing good, will be a threat any time soon. There appears to be a whole lot of excess capacity in China.

Arguments that we will get inflation because the Federal Reserve is "printing all this money out of thin air" don't hold up under examination either. The historical references are all wrong. There are infinite differences between our current Federal Reserve System that is constrained by a duel mandate of low inflation and low unemployment and the unconstrained printing press of the The Weimar Republic and Emperor Nero. In Germany the government would print money, buy goods regardless of their price, and hand those goods over to the French for war reparations. Nero would debase the currency to buy good and services needed to build and maintain his palaces. In all cases of hyperinflation there is actually buying of goods and services with the new dollars, taking them off the markets and creating shortages. The level of currency isn't tied to the level of production, it far exceeds it.

Sure the Federal Reserve has greatly increased its monetary base M0, but that money has gone mostly to recapitalize banks and simply sits at the Federal Reserve as excess reserves. M1, the money that is actually in the hands of spenders, has increased, but the velocity of money and money multiplier have collapsed. Put all those factors together and you have a recipe for deflation, not inflation. The current monetary situation is like riding a bike and having the gear jump to a lower level. The rider can peddle faster (print money), but won't go any faster (inflation) because the faster peddling is just compensating for the lower gear (bank lending and consumer spending). Also, if there is one thing the Fed knows how to do, it is fight inflation. Taking money back out of circulation is just about as easy as putting it into circulation. Fighting inflation is the Fed's strength.

The markets themselves aren't signaling inflation. Bond rates discount future inflation, yet the long-term bond rates are at or near record lows. Critics may say "yea, but the Fed is buying the 10 Yr." That may be true, but the entire yield curve is near a low, including corporate rates, and the Fed isn't buying corporate bonds. The Fed balance sheet simply isn't large enough to impact the entire bond market. The Fed only holds a fraction of the total outstanding debt, both public and private. Other indicators like Treasury Inflation Protected Bond rates aren't signaling inflation either.

What then is causing a wheat thin sized piece of essentially worthless metal to sell for over $1,600/oz? Safe haven buying. With government bond rates at or near zero, gold is a substitute for safe haven investments like government bonds. Investors logically conclude "why buy a bond that isn't paying anything, when I can buy gold and at least it isn't made of paper." Gold is essentially trading like a leveraged long bond fund. This chart shows the correlation between The Gold SPDR Trust (GLD) ETF and the Proshares Ultra 7-10 Yr Treasury ETF (UST).

(click to enlarge)Bond

While it isn't perfect, it certainly has a better correlation than gold does with inflation.

In conclusion, if my safe harbor theory is correct, gold investors should not be holding gold in anticipation of inflation, they should be prepared to sell their gold if interest rates start to increase. If bond rates increase, they will provide a better alternative than holding gold. People will sell their gold holdings and buy the alternative safe harbor that also pays a decent yield. Inflation ironically will drive gold prices down from here not up, as it lifts interest rates higher. Higher interest rates will also strengthen the $US, which will also work against gold. The worst thing that can happen to a gold investor is that confidence returns to the markets and the economy starts to grow at a non-inflationary sustainable rate. In that case, gold investors should be prepared to either go long interest rates through short long bond funds like Proshare Short 20+ Yr Treasury (TBF) or short gold through ETNs like Deutsche Bank AG DB Gold Short ETN (DGZ).

Disclaimer: Opinions expressed herein by the author are not an investment recommendation and are not meant to be relied upon in investment decisions. The author is not acting in an investment advisor capacity. This is not an investment research report. The author's opinions expressed herein address only select aspects of potential investment in securities of the companies mentioned and cannot be a substitute for comprehensive investment analysis. Any analysis presented herein is illustrative in nature, limited in scope, based on an incomplete set of information, and has limitations to its accuracy. The author recommends that potential and existing investors conduct thorough investment research of their own, including detailed review of the companies' SEC filings, and consult a qualified investment advisor. The information upon which this material is based was obtained from sources believed to be reliable, but has not been independently verified. Therefore, the author cannot guarantee its accuracy. Any opinions or estimates constitute the author's best judgment as of the date of publication, and are subject to change without notice.

Source: Gold Is Behaving Like A Leveraged Long Bond

Additional disclosure: My Mother has TBF in her retirement portfolio which I manage.