The Final Reckoning?

One look at Gold and you know something is very different this AM. This is definitely a lower left to upper right dynamic over the past three years. The appreciation from $650 to $1242 this AM is 91.1% or about 30% per year for each of the past three years. Even more surprising yesterday was the move in gold and silver (to $19.50 per ounce this AM) while the US dollar strengthened.

This is quite an unusual move and can only signal that gold and precious metals are being viewed as money substitutes. Even the resolute non-gold bug and friend Dennis Gartman said yesterday,

“The decision by the ECB to buy government debt, even though “sterilized” as the

Bank’s leadership says that those purchases shall be, will prove inflationary… or at least detrimental to the integrity of the currency itself. That process shall tend upon gold as gold becomes every day to be seen as the 2nd reservable “currency,” supplanting the EUR which had assumed that rule until quite recently on balance to put upward, perhaps relentless, pressure”.

It is true, of course, that gold and silver could correct. In fact it is inevitable that they will end in a parabolic crescendo. All assets correct at some point. Neither appears particularly extended here.

The reasons for the currency volatility, US dollar strength, Euro weakness and gold strength are obvious. All that debt in the OECD economies that has been used to save those “Too Big To Fail” is now finding its way to the sovereign debt level. Greece is, of course, the case study de facto. Greece’s plight is relatively small compared with debt and deficit ratios of Spain, Britain or the US. There really is no supra national authority that Greek defaulting sovereign debt can be pushed to. Furthermore, in the EU, it’s one for all and all for one if the union is to survive. It seems possible this AM, that the European Union and its currency the Euro may actually be disassembled.

The IMF/ EU rescue package is $970 billion. But where will this debt come from? Who will be the lenders of last resort? We see little Asian inclination to participate with the rescue of the Euro. The IMF seems loaned out. The Federal Reserve has extended US dollar swap lines, all this for the relatively small economy of Greece. One ramification is, of course, that a subset of the world is moving to gold and silver. Even more worrisome, this trillion dollar bailout is not nearly large enough to do the job except perhaps postpone the inevitable. As austerity measures begin to squeeze lifestyle in Greece, as they must, a nasty deflationary spiral will occur. Germans do not seem predisposed to a total Greek rescue. It does not seem possible that Greek public debt can be saved from ultimate default and that country can then grow out of its entitlement- induced torpor. Gold dynamics are simply recognizing this inevitability. However there is another dross lining to this event. It is the contagion that may ensue. Spain is a much bigger problem. Perhaps the UK and the US can inflate out of their self-induced debt by devaluing their currencies. Perhaps not.

To date the unwinding of the dollar carry has had somewhat the opposite affect, that of pushing the dollar higher and the Euro lower. Who wants Euros today? Hence the need for the Fed’s recent swap lines to supply the world with US dollars. As long as the Bernanke Fed keeps overnight rates low bubbles will be spawned through the dollar carry trade. Unwinding this carry will also be painful. Would raising US rates be more or less painful than the course now charted by our central bank and the Obama Administration? I do wonder if anyone in Washington really sees the likely outcome of this mess.

I am predisposed this AM to make a call. For the past two years I have been neutral on the inflation / deflation call. I’ve called it a tug of war. The US Fed (where I lectured last week) cheering for an inflation.

I think deflationary forces will now have the upper hand in the world. That would carry with it all sorts of implications. The barbell strategy is one to consider along with the discovery approach. As growth slows and sovereign defaults approach numerous austerity programs will be necessary. Owning cash and gold/silver (the barbell) will be an excellent way to counter the coming deflation. Of course I could be wrong. But there does seem to be an overwhelming potential for dissolution of the EU and a painful deflationary scenario that could last, as Rogoff and Reinhardt contend, for several years..

Gold is not reacting to inflationary expectations. Yesterday Goldcorp, my large cap pick, was up significantly.

Could Goldcorp be the Homestake of the new millennium?

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