Editor’s Note: Today we launch what could be the most important financial advisory you will ever read. It’s based on a pretty simple premise — that the world is going through a re-ordering of its monetary system. How can you chart a safe course through the crisis this will cause? What investments will it kill…and which will flourish? Jim Rickards’ Strategic Intelligence sets out to answer these questions for you. Keep an eye on your inbox this afternoon for a special invitation from our publisher, Kris Sayce. In the meantime, check out Jim’s latest essay below…
Investors have long understood that gold is an excellent hedge against inflation. The analysis is straightforward.
Inflation is caused, in part, by excessive money printing. That’s something central banks can do in unlimited amounts. On the other hand, gold is scarce and costly to produce. It emerges in small quantities.
The total growth in global gold supplies is only about 1.5% per year…and has been slowing lately. Compare this to the 400% growth in base money that the US Federal Reserve has engineered since 2008. It’s easy to see how a lot more money chasing a small amount of gold can cause the dollar price of gold to rise over time.
But this is not the only driver of higher gold prices. There are at least three other catalysts — extreme deflation, financial panic, and negative real interest rates. A brief look at all three scenarios will give us a more robust understanding of gold’s potential price performance.
A central bank’s worst nightmare
Mild deflation might cause the nominal price of gold to decline, although it may still outperform other asset classes that go down even more. But extreme deflation, say 5% per year or more over several years, is a central bank’s worst nightmare.
This kind of deflation destroys tax collections because gains to individuals come in the form of lower prices, not higher wages, and governments can’t tax low prices.
Deflation also increases the real value of debt. That makes repayment harder for individuals, companies and governments. As a result, defaults increase and those losses fall on the banking system, which central banks and governments then have to bail out.
This lethal combination of lower tax revenues, higher debt burdens, and failing banks is why the Fed, RBA and other central banks will fight deflation with every tool at their disposal.
So far, the Fed has been trying to fend off deflation by using its inflation playbook. This includes rate cuts, money printing, currency wars, forward guidance, and ‘Operation Twist’. All of this has failed.
Deflation still has the global economy in its grip. But when all else fails, central banks can cause inflation in five minutes simply by voting to fix a gold price of, say, US$3,000 per ounce.
The Fed could make the price stick by buying gold at US$2,950/oz and selling it at US$3,050/oz — in effect becoming a market maker with a 3.3% band around the target price.
If the Fed did this, all other prices including silver, oil, and other commodities would quickly adjust to the new price level, causing 150% general inflation — problem solved!
Don’t think of this just as an ‘increase’ in the price of gold. It’s really a 60% devaluation of the US dollar measured in gold.
If this sounds far-fetched, it isn’t. Something similar has happened twice in the past 80 years — in 1933–1934 and 1971–1980.
From weak hands to strong
The second scenario for higher gold prices is financial panic. This does not rely on any technical economic analysis; it’s a simple behavioural reaction to fear, extreme uncertainty and investor aversion to loss.
When panics begin, gold often declines slightly as leveraged players and weak hands dump it to raise cash to meet margin calls.
But quickly, the strong hands emerge…and gold rallies until the panic subsides. It may then plateau at the new higher level, but the objective of preserving wealth when other asset classes may be in chaos has been accomplished.
Don’t fight the Fed
The third driver of higher gold prices is an environment of negative real interest rates. This is a condition where the rate of inflation is higher than the nominal interest rate on some instrument. I use the 10-year US Treasury note for this comparison.
Right now in the US, real rates are steeply positive since 10-year note yields are about 2.3% and inflation is slightly negative.
This is a headwind for gold, but the Fed is determined to cause inflation while keeping a lid on bond yields with financial repression.
The Fed wants negative real interest rates to encourage ‘animal spirits’. Investors know that it’s not usually smart to fight the Fed. In any case, the Fed will keep trying, which could make asset bubbles worse.
The fourth case
So gold does well in inflation, extreme deflation, panic, and an environment of negative real rates. Is there a scenario where gold does not do well? Yes. If the Fed brings the economy in for a soft landing, achieves trend growth of 3% or more on a sustained basis, avoids deflation, avoids inflation and engineers a positive sloping yield curve with positive real rates, then gold will have no immediate reason to rally. Is this possible?
Yes, but highly unlikely. Deflation is the immediate danger. Fighting deflation probably means overshooting on the inflationary side next. Bubbles are everywhere and could burst leading to panic at any time.
Trend growth will not resume without structural changes to the economy. A dysfunctional US political system prevents that.
Even if the Fed’s rosy scenario did emerge, gold could still rally based on foreign buying, diminished floating supply of physical bullion, and the potential for a short squeeze.
In short, a balancing of all of the possible financial outcomes from here argues strongly for including gold in your portfolio at this entry point.
There are many ways to own gold or have price exposure to gold. My Australian associate, Tim Dohrmann, has analysed these and found the best ways you can use gold’s features to protect your portfolio. You can access Tim’s tips immediately by signing up to our brand-new advisory service, Jim Rickards’ Strategic Intelligence. For more information on that, watch your inbox this afternoon.
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James G. Rickards is the strategist for Strategic Intelligence, the newest newsletter from Port Phillip Publishing. He is an American lawyer, economist, and investment banker with 35 years of experience working in capital markets on Wall Street. He is the author of The New York Times bestsellers Currency Wars and The Death of Money. Jim also serves as Chief Economist for West Shore Group.