Inflation Not a Valid Reason to Own Gold

Includes: GDX, GDXJ, GLD, IAU
by: Jason Schwarz

There are three recent developments that have the potential to burst the gold bubble:

Development #1- Instead of European debt woes escalating, they have retreated. Investors are now confident that the Ireland situation will be stabilized. Euro stability is not good if you’re looking for a continued gold surge. In addition to the expected Ireland bailout, the eurozone is showing tremendous discipline in sticking to its rigorous plan of austerity even as its citizens revolt. An environment of cost cutting and fiscal restraint is not conducive to a gold rally.

Development #2- China is raising its reserve requirement ratio for banks by 0.5% in an effort to combat inflationary pressures. This is the third tightening enacted by China since September. This policy is viewed as a moderate measure to control inflation without killing growth. These actions are enough to qualify as a negative for gold when considering the asset as a speculative play on inflation.

Development #3- Ben Bernanke set the record straight in his speech to a conference at the European Central Bank in Frankfurt when he lashed back at critics of QE2 by making it clear the United States is nowhere near an inflationary environment. In fact, the contrary risk of deflation still outweighs it. He mentioned that sluggish U.S. growth, falling inflation and an unemployment rate that has hovered near 10 percent for months convinced Fed policymakers they needed to add more stimulus to the economy. "On its current economic trajectory, the United States runs the risk of seeing millions of workers unemployed or underemployed for many years," he said in his speech. "As a society, we should find that unacceptable."

As I mentioned in this week’s CNBC interview, the gold rise that began at the end of 2007 was driven by hedge funds that utilized gold as an investment vehicle of fear. Since that time, we’ve feared a systematic collapse of the banking system, we’ve feared a Great Depression, we’ve feared currency chaos caused by a potential collapse of the eurozone, and we’ve feared a double dip recession in the U.S. Each of these reasons provided gold with a legitimate reason to climb. However, because of the decisive actions taken by global leaders, none of these worst case fears have materialized. The banking system didn’t collapse. We avoided a Great Depression. The eurozone supported one another and brought stability to the region.

The Federal Reserve’s QE2 was the right move at the right time to boost confidence in the U.S. economy as we worried about a double dip. This message of optimism was expressed by Warren Buffett in his NY Times op-ed, and I wish it could be expressed to every talk show host, both on the right and left, who spreads the gospel of fear. None of our fears have materialized. The system has worked. The greatest thing about America is our ability to quickly react and adapt in times of trouble. This trait is being successfully adopted in Europe and China as well. The future of the global economy has never looked better because of it.

For those who now fear inflation, I would tell you that we haven’t had an inflation problem since the 1970s because the Federal Reserve has done such a great job of controlling it. For those who fear the high debt levels in the U.S., I would tell you that we are at the tail end of a physical war as well as a financial war. Debt levels should be high right now. The government has had a full plate. As we continue to move deeper into recovery mode, the deficit will turn toward surplus and the cycle of prosperity will continue. Certainly the political mood has shifted in this direction, and I expect government excess will be reined in because of the prevailing negative public opinion. There is a time and a season for all things.

I’ll conclude with a personal anecdote that made me laugh. As I was leaving the studio after the CNBC segment on gold, a guy in the building came running after me yelling, “Jason, Jason, Jason! Let me walk you out to your car.” It turns out he was watching the Kudlow Report in the next room. This guy is in charge of collecting money in the parking lot whenever there is a downtown event. He goes on to tell me that he watches the Glenn Beck show and was persuaded to buy bars of gold just last month; but after watching my segment he felt he had just made a huge mistake. We discussed the irony of a conservative talk show host urging people to buy the most speculative, zero fundamental asset that there is as a way to protect wealth. This guy actually told me that one of the reasons he bought gold was because of a demand spike coming from Indian weddings and gold rings. I don’t think I need to write any more. You get the point. When the parking lot attendant is buying bars of gold it’s pretty safe to say we are near the top. If I could offer any advice to Republicans and Democrats alike, it would be to turn off the television or the radio when you are listening to a talk show host trying to boost ratings by spreading the gospel of fear.

Warren Buffett said it best when he mentioned in his op-ed that speculative bubbles arise out of delusion. Investors reached a state of delusion with Internet stocks, then with real estate, then with oil, and now with gold. There is no imminent threat of currency collapse and there is no real threat of inflation. The investment vehicle of fear is ready to take a breather.

Disclosure: Short GLD with puts

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