What’s Up With Gold?

I often listen to CNBC’s Fast Money on the way home from work. Over the past year, one of the announcers has repeatedly stated that she does not “believe in” gold. Gold today is flirting with $1900/oz. On October 7, 2007 gold was at $730/oz. That’s a gain of over 150%. If you had your savings in the S&P 500 during the same time period you would have lost about 28%. I don’t “believe in” the stock market. I don’t “believe in” gold either. Gold will not save me. However the rise in the gold price is telling us something that we should be listening to very carefully.

As of late gold’s rise has been especially fast and furious. Since August 1 it has risen sharply, over $250/oz. This has not been as many assume, because of inflation. There is no significant inflation. Click here. What then is the reason?

On August 2 the United States government announced that it will raise the debt ceiling another 2.1 trillion dollars. Subsequently on August 5, Standard & Poors downgraded the U.S. credit rating to AA+ from AAA. On August 9 the Federal Reserve Bank painted a gloomy picture of our economic situation and vowed to keep interest rates low for 2 years. Following S&P’s downgrade the Dow Jones Industrial Average has dropped almost 1300 points and economic situation in Europe has worsened.

These events seem to have given rise to what financial analysts call a “fear trade”.

“Fear is breeding fear now,” said Nader Naeimi, a Sydney- based strategist for AMP Capital Investors Ltd., which manages almost $100 billion. “There’s a total lack of confidence in policy makers’ ability to defuse the situation.”

When volatility in the markets reaches a point where people feel their money is at risk they tend to place it into safe haven assets. Traditionally these have included treasuries (bonds, notes, bills), dollars and gold.

As I have noted gold has surged. Indeed treasuries have also surged. Click here. But the dollar has not.

This suggests that this is no ordinary fear trade. Something else is going on. Lets look at an S&P quote on the U.S. credit downgrade,

“the U.S. was downgraded based on the “current level of debt, the trajectory of debt as a share of the economy, and the lack of apparent willingness of elected officials as a group to deal with the U.S. medium term fiscal outlook.”

Translation: The U.S. debt is too high, it is rising too fast and the U.S. government is not willing to do anything about it.”

The Government Accounting Office anticipated S&P’s concern with the federal debt when they announced in March,

The timing of the debt build up varies depending on the assumptions used, but the overall picture is the same: the federal government is on an unsustainable fiscal path.

Note the GAO’s use of words. The U.S. is on an unsustainable fiscal path. An unsustainable fiscal path points to a crises. The United States is in the midst of a debt crises. The government cannot continue its rate of borrowing. Yet raising the debt ceiling did nothing to solve this problem. In fact the logic of taking on more debt to pay off debt is ludicrous and will only make the situation worse.

To solve this problem the government would have to raise taxes or revise the tax code and severely cut spending or default on its obligations. The Economist wrote in May 2009:

Having spent a fortune bailing out their banks, Western governments will have to pay a price in terms of higher taxes to meet the interest on that debt. In the case of countries (like Britain and America) that have trade as well as budget deficits, those higher taxes will be needed to meet the claims of foreign creditors. Given the political implications of such austerity, the temptation will be to default by stealth, by letting their currencies depreciate. Investors are increasingly alive to this danger..

The recent debt ceiling fiasco showed us that there is no political will to raise taxes or cut spending. Right now currency devaluation seems to be the only acceptable option. A devalued dollar makes it easier for the U.S. to service its debt. As we saw from the dollar chart above this is what is apparently happening. Unfortunately, this lowers the purchasing power of the dollar. Your dollars will buy less.

To safe guard ones money one could chose to invest in other currencies. However the U.S. is not alone in this debt crises.  The choice would be one deteriorating currency versus another. Expect other countries to suffer downgrades.

No currency today is backed by anything except a promise to pay. Investors are beginning to lose faith in government’s ability to honor their promises. To avoid a loss in real value they are fleeing to something that has retained real value for 5000 years. That something is gold. Click here to see chart of gold versus the dollar.

If the dollar continues to fall gold will continue rise. Can gold fall. Absolutely. Governments are not happy with rising gold prices. It reveals that their policies are causing a destruction of wealth. They still still have significant tools at their disposal to manipulate markets. But gold’s trend is up. If the government prints money its climb will be higher and faster. Below is the national debt and its rate of increase.

What does this mean for those who “believe in” dollars? A decreasing standard of living. What does it mean for those who “believe in” governments who back their money with nothing but promises?  Higher taxes, less services and possible default. What does it mean for those who “believe in” what gold is? Safety against financial destruction.

To learn more about what gold is and how it functions Click here.

To see what central banks think about gold Click here.