Gold's Rally on Economic Weakness Is Perfectly Intuitive

 |  Includes: GDX, GDXJ, GLD, PHYS, SGOL
by: Henry Reach

Most official government estimates for GDP growth over the coming quarters are exceptionally robust. The Fed, the CBO, and others foresee upwards of 4% real growth stretching out over at least the next six quarters. It should be obvious that they have no choice other than to be exceedingly optimistic for a number of important reasons.

First, the only way to justify the massive fiscal hole that the US finds itself in today is to assume that we'll "grow our way out of it". Mathematically, the CBO's estimates of ~4% real growth for the next several years are about the lowest possible number they could solve to justify their conclusion that US public debt to GDP will level off at credible ratios. In contrast, a more reasonable 2% real rate makes the US look increasingly insolvent over the very near future.

Second, pom-poms and cheerleading exercises are one of the only tools left at the government's disposal. Policy rates are already at zero, making further reductions literally impossible. At the same time the recent reemergence of the bond vigilantes in Europe and the growing clamor of the Tea Party movement in the US have very definitely reduced the potential for incremental domestic fiscal initiatives.

Thus, aside from an economic pep-rally, the only remaining weapon in the government's arsenal is more money printing. This is likely the reason that gold is rallying to record highs today in the face of highly disappointing US economic data. That logic tracks the following sequence: A) Simple math reveals that ~2% real growth in the US for the next four quarters will RAISE both the unemployment rate and the domestic debt to GDP ratio from already high levels. B) A deteriorating labor market will raise the volume on the discussion for incremental job-creating stimulus. C) With Fed funds tapped out and new fiscal initiatives not possible, the Fed will resort to more of what worked during the recent crisis - the printing press. D) The relative scarcity of gold compared to the seemingly bottomless supply of fiat currency leads to a flight to the yellow metal.

Ergo, this week's price action in gold is simply a logical game of connecting the dots between the inevitability of weaker growth leading to even more quantitative easing.

Disclosure: Long GLD, SGOL, GDX, GDXJ