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1. THE PRECIOUS METALS TUG OF WAR
When I get to the
bottom
I go back to the top of the slide
Where I stop and turn
and I go for a ride … - Paul McCartney, 1968
As if on the
playground slide, so aptly described 40 years ago by the Beatles Paul McCartney,
gold and silver buyers and the commercial shorts are now locked in a struggle
that will reveal whether we shall inflate out of our economic misery or whether
deflation headwinds shall continue to constrain the US and most economies
globally. For the past 18 months gold and silver prices have vacillated around
$1000 and $14 respectively. There are many cross currents in this struggle.
The outcome is uncertain in the short run. If gold holds above the $1000 per
ounce level and silver above $17 we shall have our answer shortly.
Cross
currents? First and foremost, the US Federal Reserve wants inflation. There is
no more important philosophical foundation of the Bernanke Fed than “inflation
targeting.” The belief in the Washington DC fishbowl, indeed most central bank
boardrooms, is that inflation is the lesser of the two evils. An omniscient and
independent Federal Reserve Bank has the necessary tools, according to monetary
policy makers, to control this lesser evil. The Fed believes that deflation,
once in control, will run its own price destroying course to exhaustion and then
renewal. This seems to be anathema to Central Bankers.
But there is
another major actor in this arms race. The grandiose fiscal plans of the Obama
Administration and the Congress will have an impact. Even Warren Buffet who
supported the new president recently noted,
“This fiscal
year, though, the deficit will rise to about 13 percent of G.D.P., more than
twice the non-wartime record. In dollars, that equates to a staggering $1.8
trillion. Fiscally, we are in uncharted territory.”
With
current spending plans, net debt will increase to 56% of GDP leaving the US
government no choice but to print (might I use the word, “invent”?) money – a
lot of money. Mr. Buffet reckons that even if Americans saved $500 billion,
Congress and the Administration would be forced to “find” another $900 billion.
Under these circumstances and with $1 trillion in health care reform on the way,
a much larger inflation fire will be lit.
Then, of course, we have China
and India and perhaps the rest of the newly emerging world. China’s policy is
to permit the purchase of silver in up to 5 kilogram bars by its citizens
recently. So we come to the key point in the rapidly expanding drama. Chinese
banks are requesting their gold, now stored in London, be returned to Hong Kong
there to be safeguarded – an unusual move but one we think presages a new Asian
gold repository for Asian Central bankers chastened by the recent turmoil in the
West.
Will the commercial shorts in gold and silver be overrun? It
has never happened in the past. Many investment bankers, viewing the
extraordinarily high levels of investors long the gold and silver futures, are
predicting a dramatic pullback in both gold and silver prices. They are warning
investors to take profits. The commercial shorts have always reigned in the gold
and silver spot markets in the past. One thing we are quite sure of - there is
not enough physical gold and silver to cover the massive commercial short
positions. At present gold producer Barrick is attempting to cover its naked
hedges (shorts) and finding the going rough. Even if Barrick committed all its
gold production for a year it would still fall far short of covering its hedge
positions. In short, Barrick is naked.
Given these competing cross-currents and the longer
term necessity / inevitability of inflation we think that the commercial shorts
will in fact be forced to cover. We are just not certain when that covering
might occur. Obviously the commercials do not see this
eventuality the way
we do – even as Barrick executives are trying to cover their shorts in some
degree of panic.
Perhaps the much beloved and at the same time reviled
John Maynard Keynes said it best in his seminal work, The Economic Consequences
of the Peace following World War I in
1920.
"But who can say how much is endurable, or in what direction men
will seek at last to escape from their misfortunes?"
"Thus the menace of inflationism described above is not merely a
product of the war, of
which peace begins the cure. It is a continuing
phenomenon of which the end is not yet in
sight."
Is
inflation ever a palatable solution? At present it seems to be the desired and
most likely scenario for the US economy. The alternative, deflation, is quite
out of the question. Yes Dear Discovery Investor gold is going much higher – it
is just a matter of time.
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