Gold and CDs: What Can Disrupt the Rally?

 |  Includes: GLD
by: Econ Base

After I wrote an article recommending gold and CDs, the two sectors skyrocketed. Gold went from $1512/oz on July 5 to a high of $1663/oz on August 3, a 10% gain in one month. As the media misread the markets and continued to scare the public about the US debt crises, the real pros made more money in July by buying US debt than in any other month this year. The bull market raged in US treasuries as the 10-year yield plunged to 2.45% on Aug. 4, the lowest since October 2010. As the media prepared the public and politicians for higher interest rates, the world was literally ignoring the news and rushing to buy treasuries.

US debt downgrade and why it does not matter (for now)

S&P downgraded US debt from the best AAA rating to a lower AA+. It is possible this downgrade was anticipated since the bond market ignored the event. There may be volatlity in the bond market next week, but in the end sovereign credit ratings do not matter nearly as much for large GDP economies. Let's compare the top GDP countries and Greece, the whipping boy of the bond market.

Public Debt vs. GDP and Credit Rating
Country Debt % of GDP 2010 Credit Rating S&P Outlook 10 Year Interest Rates (Bloomberg)
Japan 225% AA- Negative 1.01%
Greece 130% CC Negative 15.51%
Germany 74% AAA Stable 2.35%
UK 76% AAA Stable 2.69%
US 92.7% AA+ Negative 2.56%
Click to enlarge

Sovereign interest rates of large economies do not seem to be impacted by the credit ratings. SImilarly, debt to GDP ratios have no significance for Japan, while matter too much for smaller Greece. Interest rates may or may not follow the credit ratings.

The US debt downgrade did not matter, simply because the rest of the world is in even worse shape. The eurozone's problems are represented by poster child Greece. Japan's problem is deflation that started 20 years ago and is now unbelievably entering its third decade. That leaves the world with not many choices, the US dollar and treasury debt being one of the less rotten options. It is quite likely interest rates will continue to stay low due to the strong demand of US treasuries.

Gold continues to go up. Let's understand the reasons.

  • The debt ceiling was raised past $14 trillion, but only $2 trillion was going to be cut over 10 years. This was interpreted as kicking the can down the road, and the key reason of S&P's debt downgrade. Business as usual is good for gold.
  • As the stock market declined in the last two weeks, demands for QE3 grew louder. This is also good for gold.
  • To spur economic growth, there is a downward spiral, a kind of race to the bottom by currency devaluation. More paper currency is bullish for commodities worldwide, especially gold.
  • Sovereign countries have joined in to buy gold. South Korea, Thailand, Mexico and Russia all bought gold this year.

What can disrupt the rally? This is a very important question. Let's analyze the scenarios and the probabilities.

  • The economy starts doing well on its own, such that unemployment goes down to the full employment rate of 5%. In this scenario, the pressure for easy monetary policy goes down, and that will be bearish for gold. This scenario is unlikely in the near future at least. The economy added 117k jobs in July and unemployment went down to 9.1%. But as I noted in this article two years ago, these kinds of numbers are needed to absorb new entrants into the job market. A lot more jobs are needed to bring unemployment down. Therefore the Fed will be tempted with more dollar debasing and another round of quantitative easing to boost growth.
  • The politicians solve the deficit problem and balance the budget, either through cuts, new taxes or both. This will be very bad for gold, since there will be no need for dollar debasing or QE. Given the attitude and credibility of politicians from both parties, this is highly unlikely. As proof, take a look at a question I raised two years ago in that article, in regards to shovel-ready projects. We got an answer: Shovel-ready was not as shovel-ready.
  • Per the compromise to raise the recent debt ceiling, the enforcement mechanism triggers across-the-board cuts. But these are not going to be triggered until 2013. In between, there is a presidential election cycle. Probability of this happening is low.
  • The economies of rest of the world no longer require the crutches of currency devaluation because their economies are now robust. This is unlikely. The currency wars of devaluation have only just begun. This means both gold and US treasuries will be in demand worldwide.
  • Central banks worldwide start selling gold. This is also unlikely. They have just started to buy. The buying is likely to accelerate unless the US gets its financial house in order.

It is just possible that had the debt ceiling deadline of August 2 breached without a deal, and automatic cuts in spending had happened, gold would have tanked. But now we will never know if that would have happened.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Additional disclosure: Long gold and 10-year treasuries