Getting “Real” about Gold

The odds of a long-awaited precious metals correction increased this week.

Gold and silver have been setting new high after new high. Gold is up $100 and silver’s up more than $10 since President Obama ruled out significant spending cuts in his mid-April budget speech and the Fed chairman noted inflation will be “transitory.”

The strong uptrend, however, showed its first signs of weakness in months this week. Gold has fallen for three straight days and silver is down nearly 20% from its highs.

If the downswing continues, it could be enough to send the hot money crowd running for the exits and set off a long-awaited (and healthy) correction.

It’s time like these, when pundits are itching declare the bubble over and emotions can quickly overcome rational decisions, the best move is to revisit what it’s going to take to pop the emerging gold bubble.

The Dollar’s Widely-Predicted Demise

The current “story” driving gold is a simple and very widely spread one.

Government spending is out of control. The federal deficit is well over $1 trillion and both sides are nowhere close to agreement on how to close it (and won’t be until after the next election or until the next debt crisis suddenly hits). China has stopped by U.S. government bonds. Bill Gross, a.k.a. the Bond King, has sold out of U.S. Treasuries. There’s nowhere to go but down for the dollar over the long run.

And any hopes of a return fiscal sanity have been quickly dashed. The last round of $38 billion in phantom spending cuts have done nothing to reduce the trajectory of federal spending growth.

The chart from Downsizing Government shows the trajectory of federal spending excluding TARP (which created a huge outflow in 2008 and one-time inflows in 2009 and 2010 as it was paid back):

In short, the dollar is doomed.

We, however, see the gold bubble as a much simpler financial phenomenon. As a result, our view on gold is a bit different and we’ll have a good idea of when the still-forming gold bubble is about to burst.

Getting “Real” about Gold

Gold prices have risen due to many factors. One catalyst, however, has outweighed them all.

The chart below from Gresham’s Law shows what happens when real interest rates (interest rates after inflation) are negative.

(click to enlarge)

As you can see, there have been three periods of sustained negative interest rates in the past 80 years.

Each period of negative interest real rates coincided with rising gold prices and/or extremely high inflation.

The first period came at the tail end of the Great Depression and throughout World War II. The price of gold was fixed. After World War II was over, however, a sharp recession followed and inflation increased more than 100% between 1945 and 1946.

The 1970s was the second period of inflation. After the gold standard had been lifted, inflation soared and nominal interest rates didn’t keep up. Real interest rates plunged and high inflation, economic stagnation, and a sharp rise in gold coincided. Gold prices didn’t drop until real rates turned positive in 1980.

The final period of negative real interest rates is the current one. Since the Fed dropped nominal interest rates in 2002 to counteract the tech bubble and spark the housing bubble, real interest rates have meandered in and out of negative territory.

Since the credit crunch, however, interest rates have stayed negative. The entire time, official inflation has been benign, but commodities prices have surged and gold and silver have lead the way.

And this period of negative real rates is not going to end anytime soon.

Bernanke’s Bind

The Fed chairman is in a bind.

He can raise rates, shut off the free money spigot, send stocks and bonds much lower, and let excess debt be cleared away during a deep recession. This would result in positive real interest rates.

Or he can keep the party going, allow the economy to continue to limp along, and let inflation continue to grow. This will keep real interest rates solidly in the negative.

During last week’s first ever Fed press conference, an example of how politicized the Fed has become, Bernanke signaled he’s firmly committed to the latter.

This is the most critical foundation to the coming gold bubble.

There’s no way to value gold. It could be worth $500 and $5,000. Either would be justifiable. The most important factor is real interest rates are negative.

A precious metals correction may be near. It may not be. But at this point, we’ve got at least another year and a half left (probably even longer) to go for gold prices as real interest rates are going to be held below zero. And if history is a reasonable guide, gold prices will continue their uptrend and any correction will be short-lived.

By Andrew Mickey

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