• Debtflation

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    by David Galland: The
    Long Road to Recovery



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

    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.

    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

    David Galland
    is the managing editor of Casey

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