Debtflation

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Recently
by David Galland: The
Long Road to Recovery

 

 
 

We recently
received the following comment in our Q&A Knowledge Base.

Investors
should be prepared to sell gold as either increased inflation
expectations or doubts around debt sustainability force a sharp
increase in US Treasury bond yields. Simply put, in an environment
of high real interest rates, the allure of gold could disappear
as quickly as it did in the early 1980s when Paul Volcker took
control of the Federal Reserve.

My response…

First off,
I want to congratulate the reader for trying to anticipate the conditions
that might mark the end of the gold bull market. Because, make no
mistake, the gold bull market will come to an end – and when
it does, it’s not going to be pretty for those who stubbornly
stay too long at the party.

As to the possible
triggers for gold’s big sell-off, the reader’s contention
is directionally correct when he points out that this could occur
when real interest rates (T-bill rates minus CPI) become high enough.
At that point, as a non-yielding asset, gold will become less attractive
to investors looking for income. And, gold will fall.

However, the
situation today is significantly different than during Volcker’s
term as the head of the Fed.

The first difference
can be seen in the chart here that I just dredged out of the archives
of The
Casey Report
. Besides painting a picture that many of you
will think obvious – that inflation is the biggest driver of
interest rates – you can also see that gold’s stunning
rise in the second half of the 1970s occurred during a period of
strongly rising interest rates. So, rising interest rates and rising
gold prices are not mutually exclusive.

The second
difference between now and then becomes clear in the next chart
showing that while there certainly was an inflation problem during
Volcker’s reign, there definitely was not a debt problem.
At least not compared to today.

The implications
of the nation’s current debt load loom large in this discussion.
Aggressively raising interest rates, as Volcker did back in the
day, would not just dent today’s U.S. economy, it would destroy
it. As it would evaporate a significant amount of the trillions
of dollars now sitting in government debt, much of it held by pensioners.

Put another
way, Volcker raised interest rates as energetically as he did because
he could. Today, that couldn’t happen – at least not without
pushing the U.S. economy into a death spiral. That’s why we’ve
long compared the scenario faced by today’s policy makers to
being stuck between “a rock and a hard place.”

While the smoking
ruin solution
I wrote about a few weeks ago – where the
government steps aside and lets the free market do its worst, so
that it can then do its best – is certainly possible, the more
likely scenario is that the Treasury and the Fed will keep reacting
to each new chapter in the crisis by further degrading the currency
in the hopes that at some point the debt becomes manageable. Of
course, there is the real risk that at some point along the path,
our creditors will lose faith and demand higher interest rates.

But what happens
if interest rates begin to move up based on credit concerns, and
not in response to a noticeable uptick in price inflation? At that
point, couldn’t we see positive real interest rates relative
to CPI – therefore reducing gold’s appeal?

If interest
rates begin to rise for any reason – including concerns over
creditworthiness – the obvious damage to the economy and to
the government’s ability to service its debts will only heighten
concerns over repayment. Almost overnight, creditors will begin
to fear either overt debt defaults or the covert default of yet
more inflation, and demand even higher rates.

At that point,
with interest rates beginning to spiral, few people will be looking
to buy bonds but will remain fixated on the return of capital, versus
return on capital.

Being repetitious,
debt is the single biggest economic challenge facing the U.S. –
and much of the developed world. In time this debt will get resolved,
it always does, but it’s not going to be pretty.

As I see it,
unlike the inflation of the 1970s that could be treated with a strong
dose of tight monetary policy, the debtflation we now face can only
be resolved through default. Given that no U.S. government will
want to join the ranks of history’s sovereign deadbeats, the
inflation option remains the most likely course.

And in that
scenario, gold is still a solid investment and so should be a core
portfolio holding.

The
Casey Report
focuses on big-picture investing – analyzing
emerging mega-trends and their effects on the economy and markets…
and recommending the best ways to profit from those trends, whether
they’re positive or negative. To learn more about the editors’
favorite investment of 2010, click
here
.

David Galland
is the managing editor of Casey
Research
.

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