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  • The gold price and the debt ceiling: possible scenarios 0 comments
    Jul 28, 2011 7:26 AM | about stocks: PHYS, PSLV, EGO, GLD, AEM
    Gold bullion Why should the US debt situation affect people’s willingness to buy gold? A superficial answer might point out that gold is a traditional safe haven in times of economic uncertainty, that it is a good currency hedge and that it is negatively correlated to other asset classes. However, there are other traditional safe haven assets, like cash and Treasury bonds. Why shouldn’t investors park their money there?

    Clearly with the latter the debt arguments and default risk directly threatens Treasuries’ safety credentials. But what about cash? In times of trouble isn’t cash supposedly “king”? Not all cash is made equal though. There is such a thing as “sound money” and the soundness of money is determined by how well it performs its extremely valuable functions as a store of value, medium of exchange and unit of account.

    Gold is arguably the best form of money known to man. It was the world’s leading form of cash, together with silver, for thousands of years. It was what gave the dollar value until very recently. More importantly it is better money than the dollar, outperforming it as a store of value and unit of account ever since President Nixon took the US of the gold standard in 1971. Despite its demonetisation, it is still viewed as a legitimate medium of exchange by people all over the world. If doubts grow about the US dollar, gold will be one of the first places that people look for an alternative.

    In Voltaire’s words “Paper money eventually returns to its intrinsic value – zero.” Is the dollar likely to suffer this fate anytime soon? What will trigger the final collapse of the fiat dollar? A Treasury bond panic might be one potential trigger, the relationship between government debt and money printing is well established historically. This is why this debt-ceiling episode is so important.

    US government debt has grown exponentially over the past 40 years, as can be seen in this chart from The Economist. This is simply not sustainable. Moreoever, the higher the debt balloon rises, the bigger the eventual fall. But in democracies, politicians have little incentive to try selling harsh medicine to the voting public – an appropriate cue for Churchill’s dictum that “democracy is the worst form of government except all the others that have been tried.”

    If an agreement is reached, the immediate crisis will be averted and the pressure to flee US Treasuries and the dollar will be reduced. The price of gold is likely to then correct and test support levels at $1,600 and $1,580 per ounce. Perhaps we’ll even see a sharp correction to $1,500. However, market participants would see this as a buying opportunity and given the pent up demand and supply constraints, the uptrend would resume quickly. Especially if the agreement looks anything like the proposed “deficit reduction” plans which all but guarantee that overall government debt will continue to grow at a brisk pace.

    If in the unlikely event that there is no deal, or in a show of brinksmanship the players on Capitol Hill allow a “temporary” default, the flight from the dollar and from US sovereign debt would begin in earnest and the gold price would soar; $2,000 per ounce before the end of this year would be well within reach. The market fallout would pile immense pressure on US politicians to reach an agreement.

    However, by then it might be too late to stop the beginning of the end for the US dollar.



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