Seeking Alpha
Long/short equity, contrarian, special situations
Profile| Send Message|
( followers)  

It's Double Secret Devaluation, not Inflation, Stupid!

The Fed and the markets have been completely absorbed by the deflationary pressures of a soft economy. As such, Gold was summarily pummeled as an unnecessary inflation protection proxy. However, the other story to tell is that the Fed, the ECB, and the BOJ have been engaged in a Gentleman's Agreement to stimulate the global economy that has resulted in massive money supply expansion. Just because one currency is not falling apart relative to another does not mean that the world's paper currency in aggregate is holding its value as supply swells. To borrow a notion from Dean Wormer in Animal House, this is a time of "Double Secret Devaluation". The markets have not caught on yet that 'hard' currency purchasing power is leaking air. And that Gold (NYSEARCA:GLD) is the answer.

The Central Banks, of course, need low stated inflation figures in order to sell the case for cheap money. After all, with low inflation, at least a real return can be provided when they go to sell their sovereign paper - even at 3% in the case of the US. However, as is true with the US unemployment figures, there are lies, damn lies, and statistics.
This graph by looks at stated US CPI inflation (red line) versus inflation calculated based on the pre-1980 methodology for computing today's official CPI (blue line). With stated US CPI inflation now running at 2.2%, the differential looks to have grown over time to what now is 6%. (The same calculation using pre-1990 methodology has current inflation running at approximately 4.5%.)

In the course of the US quantitative easing (QE) program of the past five years, the adjusted monetary base grew by 24% per year (CAGR) from 2008 to 2013. Allowing for the fact that 80% of those funds were stashed away in the banking system's 'excess reserves' that never reached the economy, it grew by 8.5% CAGR. Well, that is considerably higher than the stated inflation figure for the period of 2.2% CAGR. This is admittedly an ethereal mental exercise. But there is a differential here of 6.3% CAGR for those 5 years.

Gold Correlates with Money Supply. Well, it did. And It Will Again!

So what about these faux inflation statistics and monetary bases? Well, the gold price correlates with money supply. Between 2003 and September 2011, the coefficient of determination (or r-squared) of the gold price and global liquidity was 98.4%. From September 2011 until December 2013, when the markets fell into the deflationary fear funk, it has been at 73%. For the 10 years from 2003 to 2013, it registered 90.5%.

(click to enlarge)

A return to the normal relationship between the global liquidity and spot gold gets the gold price back to approximately $1,800 per Au oz. The fact that such a strong correlation exists argues that gold was actually never on a hyper extended Bull Run - it was simply keeping pace with the printing presses. A few studies on true price increases within society point to significantly higher costs year after year. Gold was just holding its value.

A caveat or question that may give pause to this argument is: When is money supply not money supply? Given that much of the stimulus money never hit the economy and the dramatic & persistent slowdown in money supply velocity, does it count? The economic response to Central Bank stimulus has been weak (although it has created some pretty sensational bubbles in financial assets). They will unlikely to be a position to suck liquidity back out of the system. Beyond this, they have their own balance sheets, which have grown 67% to $9.4T since 2008, will to fund (and inflate out of). In sum, the likelihood of any slowdown of money supply growth is slight.

The other question would be: How much does it matter in the context of this exercise? If we look like without stimulus on the graph above and postulate that they never stimulated, global liquidity might be at US$12T versus its current US$15T. The gold price equivalent on that basis would still be approximately $1,500 per Au oz.

In today's economy, it is a stretch to envision demand-driven inflation driving a higher gold price. That part of the equation is very true. However, the other side of the coin is that: Inflation is understated and has been compounding while money supply swells, shrinking the value of printed currency. That trend is set to continue. There is a strong correlation that has been broken to the downside by the gold price, offering an excellent medium-term entry point into the yellow metal.

Source: Gold's Correlation To Global Money Supply Implies $1,800 Per Ounce