Submitted by Brian Rogers of Fator Securities
Macro Commentary: The Cost of Fiat Money and Gold
Markets are trading sharply lower this morning after yesterday’s late afternoon rally on the change in language in the Fed statement that will keep short interest rates essentially at zero until 2013. As I have stated before, I believe they will ultimately be forced to keep rates low forever, or at least until the bond market vigilantes eventually rise up and shock the world by demonstrating that indeed you can fight the fed. Which begs the question, who will be the George Soros that breaks the US Fed? We’ll see. In any case, by 2013, it’s highly likely that the US will have over $16tr in debt. If the average rate across the curve in 2013 is only 4%, which is low by any historical standard, then our annual interest payment will be over $600bn, or almost 30% of annual tax revenues. So the Fed faces problems on a number of fronts. They have to be seen as actively trying to do something so they continue to manipulate the price of money to artificial levels which only serves to send misleading signals throughout the economy. QE1 and QE2 have come and gone and yet unemployment remains sticky above 9%. Their balance sheet remains abnormally large and their policy tools to manipulate the market is dwindling. Now add to that the reality of the math of our huge fiscal debt and deficits. No matter which way you spin it, we have some tough times ahead that will involve some asset prices falling (commercial/residential real estate and other levered assets), other asset prices rising (agricultural land, commodities, gold/silver) and the façade that the Fed is all-powerful to come crashing to the ground.
Much ink (and binary 1s and 0s) has been committed to the topic of whether or not gold is in a bubble. For the record, my view is a clear and unequivocal no. There are a number of factors that help form my opinion, everything from the estimate of the ratio of paper gold to physical gold (45:1) to the amount of outstanding USD vs the total value of all gold currently above ground (hundreds of trillions vs. approximately $6tr). In my opinion, gold isn’t in a bubble, but rather is reflecting the largest bubble on the planet, US Treasuries. Over time, foreign central banks will hold fewer and fewer US Treasuries as Chairman Bernanke and company consistently devalue the dollar. As this process unfolds, many central banks will opt to own precious metals, commodities and commodity based currencies. However, with most foreign central banks holding over 60% of their reserves in USD, the flight out of dollars and in to other alternatives will cause bottlenecks and price spikes which could cause some assets to see their prices rise exponentially. Of course, this isn’t to suggest that gold won’t fall in price from time to time, it certainly will. In fact, given the recent price rise over the last few days, a correction in gold could be forthcoming soon. But given the strong demand for alternatives to the USD, gold will always be bought on dips. In my view, investors should not view gold as a commodity but as a currency. True, you can’t buy much with gold these days given our legal tender laws, but it will generally protect your wealth better than other fiat currencies and certainly better than the soon-to-be devalued US Treasuries once rates eventually start to rise. Further, as the world searches for an alternative to the USD as reserve currency, gold is almost certain to find some kind of role in that new economic reality.
Gold price sell target?
Given my views on gold, I’m often asked what price I’m using as my sell target. I actually don’t have an upside price target for gold. As I mentioned above, with the ratio of paper gold to physical gold somewhere in the neighborhood of 45:1, it doesn’t take much to realize that even a slight increase in the demand for physical settlement could bring the whole paper gold market to its knees and send gold’s physical price skyward. However, my view is that when this is happening, it’s very likely that real estate will also be tanking. Why? A rush to physical gold which could ignite a parabolic move will very likely be happening due to an extremely fearful economic environment. This means it’s likely that bank lending will be at low levels if not completely stalled. At the same time, the government is talking up the idea of defunding FNMA/FHLMC and removing the mortgage interest deductibility benefit. Some reports have shown that the US government is currently making somewhere between 90% and 95% of all new mortgage loans at relatively low equity levels (<10%). In other words, when we finally get the TBTF banking crisis that was delayed in late 2008/early 2009, the government won’t have the ability to safeguard the entire system as their own balance sheet will be called into question. Therefore, I can envision a not-so-unlikely scenario where gold will be rallying, interest rates rising, bank lending drying up and the government’s ability to backstop housing via FNMA/FHLMC severely limited. End result: most real estate tanks to cash levels. Americans will still buy and sell property, but they will only be able to afford to pay what they have in cash, which is already the case in many countries, as financing for a large swathe of the market will dry up. With real estate finally tanking, the endgame of the TBTF banks will be written. However, this will be the level where I sell my gold, regardless of its current price, and buy real estate with both hands. At that point, where we finally trade for cash in the majority of the market, real estate will represent an excellent value play as the price paid will be at multi-decades low and yet with the ability to receive rental income, you will be better off over the long run than if you simply held the non-interest bearing, non-dividend paying yellow metal. So holding gold isn’t the ends, it’s the means. But when you swap your gold for another asset, you must make sure you aren’t over paying. As long as mortgage financing remains abundant in the US, mortgage prices will remain artificially high. Once cash prices return to the US, however, real estate will represent the best way to create multi-generational wealth. However, for anyone buying now, caveat emptor. –Brian
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