Gold Lied, Inflation Died

Includes: BOM, GLD
by: Matthew Cowie

What happened in the gold market? The destruction of inflation expectations. The gold trade is crowded with people making a similar mistake to the Keynesian economists who completely missed the 2008 disaster because their models do not account for debt. The inflationists are not incorrect in their fundamental analysis, extremely far from it, but they are ignoring the role of credit in the economy with a narrow focus on money supply. Ultimately, I believe the gold bulls will be proven correct (and there is a deflationist case for gold too), but they are missing an intervening step.

Inflationists point to this as evidence for inflation...


...but offsetting this rise in money supply is a drop in velocity:

Instead of looking at only base money, or even the $10+ trillion M2, I prefer to watch total credit.

Economist Steve Keen has shown that banks are in the business of creating money first, and finding reserves second. One of the Federal Reserve's main jobs in the banking system is to create the reserves that sustain credit creation. The Federal Reserve itself doesn't "print money," in fact all the Fed does is swap debt-for-debt. It issues Federal Reserve notes backed by the Treasuries or MBS it buys. Thus, the Fed lags the market, it doesn't lead it.

At the end of 2008, the U.S. had total credit of $53.3 trillion. (Source:L.1 Credit Market Debt Outstanding) At the end of 2012, total credit stood at $56.3 trillion, an increase of $3 trillion. That is less than 6% growth in 4 years, when normal growth is 5% and high inflation comes when credit growth exceeded 7.5%.

At the end of 2008, total federal debt in the credit market stood at $6.4 trillion. At the end of 2012, it stood at $11.6 trillion, an increase of $5.2 trillion. Thus, on net, the credit market ex-federal debt contracted by $2.2 trillion. If it were not for the massive federal deficit, total credit would be contracting. We can see this change in the makeup of the credit market:

This is not the picture of a healthy credit market. Instead, it is the picture of a credit market where the federal deficit is the only thing preventing a full on depression. There is no inflation in the total supply of credit without the obscenely large annual federal deficit and the outstanding amount of credit dwarfs money supply.

How much does the Federal Reserve need to "print" before credit creation will begin again? I don't have an answer, but a ballpark guess is somewhere in the neighborhood of $3 to 8 trillion (today), give or take a few trillion (see "Why QE3 Will Fail"). That's because all bubbles return to their beginning, and in the case of the credit bubble, it will return to a point where the ratio of credit to fiat began. Using M2, it is 3 to 1 ($8 trillion print) or using M1, about 10 to 1 (a $3 trillion print).

What is gold telling us? It is telling us that the Federal Reserve isn't doing nearly enough to create inflation, and a move to taper off QE will be bad news for the economy. It is telling us that "austerity" in Washington, D.C., mild cuts in the growth of the deficit, are enough to derail the economy. Ironically, the inflationists have more faith in the Fed and the government than I do at this point. The Fed has failed for 4 years to do the only thing the one thing almost everyone is sure they can do: inflate.

What everyone looking for massive inflation is missing is that the inflation already happened. During inflation, debt levels soar. After the inflation, they either repay or default. The growth of the financial sector accompanies an inflation (with Wiemar Germany the most prominent example) because people are taking on debt. In the early 1990s, after the S&L crisis, financials were 7% of the S&P 500 Index. They peaked at 22% in 2008 and are down to 16% today. I expect they to will return to the single digits as a percentage of the S&P 500 Index.

For the past four years, The Fed has been backfiling the massive debt creation from the previous two decades and it has a long way to go before it shores up all the existing credit. Unless there's a massive deflationary event that destroys trillions in credit (which would dwarf 2008), at the current rate of monetization the Fed could continue for several more years, perhaps as much as a decade or more if nominal GDP remained stagnant.

Gold is not alone in signaling weakness: nearly all commodities are sending a similar signal. On top of this deflationary force, the Chinese leadership appears ready to rebalance the economy towards the consumer sector, something that will dry up demand for many raw materials. Copper faces a far darker future than gold.

Why own gold if prices are set to fall? Let 2008 be your guide, with a dose of Cyprus. Gold tumbled from a peak of above $1000 in March 2008 to below $800 in autumn 2008, before rebounding and finishing the year with a slight gain. Stocks are going to follow gold lower, but gold has already taken a big chunk of losses from its high and will rebound first.

Furthermore, this round of deflation will likely have more bank failures than 2008. Investors who held gold may be down more than 20% from $1900, but that beats the losses in Cypriot savings accounts above $100,000. Cash and U.S. Treasuries (not money markets) may be the best bets, but gold is going to shine once again in the midst of a deflation because it will survive bank failures.

Eventually, after the next round of deflation, there's going to be another round of money printing and the government is going to get its inflation-in this the inflationists are correct in their observation of the trend. To oversimplify, imagine a massive hole into which the Fed is pouring money: my argument is that the hole is far larger and deeper than the inflationists realize.

I do not see a coordinated central bank beatdown in the gold market, rather a short-seller raid, the capitulation of leveraged inflation bulls, combined with incorrect "all is well" sentiment created by the stock market highs. Investors can trade ETFs such as SPDR Gold Shares (NYSEARCA:GLD) or use paper trades to hedge physical holdings, but if 2008 is a guide, physical gold will trade at high premiums during a global financial market panic. There's already evidence of heavy retail buying all over the globe, and anecdotal reports of tight supply. Physical gold will likely trade at higher premiums, and be harder to acquire, if the next round of deflation exceeds that of 2008, therefore I would not be a seller of physical gold, even if it falls all the way to $400 as some Elliot Wave practitioners forecast. If gold even came close to that number, I predict there would be no physical supply and the price would only exist on the paper market.

Opportunities to short will also be greater in other assets, possibly including gold miners. Assets positively impacted in a deflationary crisis: U.S. dollar, cash (not money markets), Treasuries. Negatively impacted: equities, high yield credit, emerging markets, commodities.

Investors shouldn't bet on a deflationary crash today, but they can raise cash if they feel overexposed to equities. Some trade ideas:

  • PowerShares DB Base Metals Double Short (NYSEARCA:BOM). Volume is very low now, but it peaks when base metals tumble.
  • For China, short iShares FTSE/Xinhua China 25 (NYSEARCA:FXI) and be long Global X China Consumer (NYSEARCA:CHIQ).
  • Emerging markets should underperform Europe, since Europe has already seen several major markets decline. ProShares Short Emerging Markets (NYSEARCA:EUM) is one way to go.
  • Resource exporting countries and companies will likely be hit hardest: they are threatened by a stronger dollar or weaker commodity demand. Brazil and Australia are two countries to underweight or avoid. Companies without sufficient capital to fund their operations will likely go bankrupt, and many commodity producers and explorers could go bust if they have insufficient capital heading into a crisis.
  • More conservative plays: iShares Barclays 1-3 Year Treasury (NYSEARCA:SHY), iShares Barclays Short Treasury (NYSEARCA:SHV), PowerShares DB U.S. Dollar Index Bullish Fund (NYSEARCA:UUP), ProShares UltraShort Euro (NYSEARCA:EUO).

All of these trades require varying degrees of timing. Simply raising cash and making a shopping list is the best strategy for most investors. Be mentally prepared so that when others are panicking, you are calmly buying and anticipating the eventual rebound. This will be critical because another deflationary crisis could lead to exchange closures and major bank failures that will have people talking about the total collapse of the economy. Fear will exceed 2008 by an order of magnitude, and if you aren't prepared for it, you may be swept up in the hysteria.

As for inflation, I do not deny it is possible, but at this point I believe it requires an extreme political act that exceeds the will of the people. I expect a major deflationary crisis will come first and that will have most people (including nearly all of today's deficit hawks) calling for extreme measures. If bank loans take off or the current uptick in the Billion Price Project turns into a major trend, then I will revise my forecast. I don't believe the deflationary scenario is inevitable, but I believe the odds still favor it based on the current data.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.