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Morning Gold Fix: August 16

Commentary courtesy of

Gold booked a small gain on Friday, rising $2.10 from its opening price of $1212.80 per 100 troy ounces to $1214.90. After trading higher electronically over the weekend, gold is kicking the week off with a bang, with the October contract pushing as high as $1228.80 all ready, an increase of more than $7 on the day.

Monday Morning Comment
Deflation talk has the markets spooked during these last couple weeks. Since Bullard's comments (preparing the ground for QE2) and Bernanke's promises to combat deflation through treasury purchases, even the CNBC talking heads are discussing it. Editor's Contrarian note: Probably time to consider unwinding your bond longs if T.V.'s equivalent of your shoe shine boy is telling you deflation is coming. 

In deflation, Gold should be the tallest pygmy. Even If it drops 40% in a deflationary depression, it will still stand tall among the financial wreckage that is defaulted debt and worthless equity.  But, if the Fed succeeds in combating this event (preemptively or after the fact), Hyperinflation becomes a high risk and we know what that portends for fiat currency.

"Do not seek to follow in the footsteps of the wise.  Seek what they sought." 
~Matsuo Basho

During the U.S. Great Depression, there was a high demand for Dollars as thelast refuge for safety.  "WHY were Dollars so valuable during the Great Depression?" is what you have to ask yourself before you go plowing any more of your money into long-dated bonds or the DX. Our own analysis sees a lack of counterparty risk and scarcity as the two reasons Dollars were coveted back then. Hardly an original idea, but relevant when you compare today’s greenback with depression era dollars.

No Counterparty Risk- Dollars were backed by Gold then, now they are backed by GDP. Some would even say that Fiat money is debt... so there goes the counterpartyrisk argument. Meanwhile, physical Gold has no counterparty risk.

Scarcity- there are plenty of dollars out there in the mattresses of foreign governments and scared people. Fractional reserve banking is not the issue it was during the 1930s, especially in an age of e-money. The Fed is also printing in advance of a deflationary debacle, it is not playing catch-up this time. So, scarcity is not a reason to buy dollars now. Inflation remains in check thus far due to a lack of monetary velocity, not a lack of money supply. Gold is scarcer than Dollars with an annual growth rate of only 1.7% . This time Fractional Reserve Bullion Banking might be a catalyst for more scarcity motivated Gold buying.

Risk: Short People, Long Things
If depression economics kicks in again, you will see a flight to assets with little to no counterparty risk... this time the Dollar doesn't have the monopoly on safety. Gold will compete with it, just like it did when the Europeans ran for cover during the Greek debacle. Finally, if you are long dollars looking at Deflation coming prior to Inflation does,we think you are most likely right. But Hyperinflation is a function of money velocity, not just money supply. And money velocity can turn on a dime if the public loses faith in its government.If a quick increase in velocity occurs, you will have to be a market timer extraordinaire to not get caught long fiat currency when the devaluation panic hits. You'll be right until you are wrong, with very little time to reverse when the rubber-band snaps.

Why we're Long Gold on a relative value basis:
We're regression traders trading M3, not Gold. And M3 will revert to the mean, but only after a volatile pendulum correction in the other direction. We believe the reasons for buying dollars during the Great Depression were: scarcity and lack of counterparty risk. These qualities reside this time in Gold, not the Dollar, and therefore limit downside in a deflationary depression.


What we are worried about:

Market timing- timing exit of a Gold market where 1 Trillion dollars can corner it (or crush it) is a recipe for an exit liquidity problem.

Gov't intervention- special taxes, stepping in and forcing liquidation on the Comex during a rally under the guise of special circuit breakers (see the Hunt Brothers), and generally managing the market until the cycle turns can cap the upside. And do not give me the London Bullion story of how that would fail. Governments can remain irrational longer than you can remain solvent, to paraphrase.

What we've done about it:
We hope to avoid these pitfalls by not being market timers and by diversifying assets to mitigate political and sovereign  risk without diversifying ideas. Gold, U.S bonds under 5 years, Real Estate in underleveraged countries, and financial companies that will benefit from rising bid/ask spreads on the yield curve without all the balance sheet baggage. Rolling maturing bonds into Tips, and Gold and BRIC Bonds.

Bonds: Illusion of Safety
All this talk about Bonds being a flight to Safety is a little erroneous we think.They are safer than many things right now. But we feel more and more that U.S Bonds are a flight to liquidity, not safety. Many buyers are "parking" their money there in the hopes that the next wash out in stocks or any other risky asset will give them the ability to sell the bonds and buy into the risk asset classes again. Hot money needs liquidity on demand, and U.S. Bonds seem to offer that. Look for bonds and the DX to go down simultaneously if the deflationary trend is reversing. If that happens, look for more liquidity gaps to begin appearing in previously liquid markets, a la the flash crash.


Black Swans and Fat Tails
We prefer to call them Fat Tails and have used that phrase long before recent fascination with semi-aquatic foul came to the fore. Although we admit Taleb is much sexier and smarter at this stuff. Buying wings in hedge of a Black Swan event is a valid approach, but it seems to be morphing into a dogmatic philosophy.  Black Swan event probabilities are not the same as Fat Tail valuations. At some point it just might be better to buy skew call spreads and put spreads when the leptokurtosis gets too fat. We're seeing that in commodity options everywhere as people are buying speculative insurance and driving down 5 delta option Gamma/ Theta relationships to silly levels on the curve. In short, there are lots of longs in the Fat Tail portion of the Gold curve.

Dear Gold Bugs

It’s a trade, not a religion.  What happens when someone can synthesize gold atoms? Or aliens land on earth that eat dollars and crap Gold? Those are pitch-black swans for sure, but stuff we think about. Try to "know what you do not know" is our hedge. It's just a trade, one whose time has come, but a trade nonetheless. Make money, take profits, and find the next trade. Try not to expect PMs to go up during a depression, and you might be pleasantly surprised.
Good Luck.

-Elizabeth Thawne