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« Silver Wheaton Corporation: A Takeover Target? | Main | Silver Wheaton Corporation Call Options Update 25 September 2010 »
Tuesday
Sep282010

Debtflation

Chart 1 Inflation is the Biggest Driver of Interest rates 29 Sep 2010.JPG


By David Galland, Managing Editor, The Casey Report

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



U.S. Debt Outstanding by Sector 29 Sep 2010.JPG

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.
----
The 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 here.


Over in our options trading den they have updated the chart to show all the closed trades as of today, so you can see exactly how it is going, please click this link.




OptionTrader Profits





Stay on your toes and have a good one.

Got a comment then please add it to this article, all opinions are welcome and very much appreciated by both our readership and the team here.

On Friday, 27th August 2010, we closed another successful trade banking a profit of 79.46% on Call Options on Silver Wheaton.

The latest trade from our options team was slightly more sophisticated in that we shorted a PUT as follows:

On Friday 7th May our premium options trading service OPTIONTRADER opened a speculative short term trade on GLD Puts, signalling to short sell the $105 May-10 Puts series at $0.09. On Tuesday the 11th May we bought back the puts for just $0.05, making a 44.44% profit in just 4 days, with more positions opened yesterday. Drop by and take a look.


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Reader Comments (3)

As informative the outstanding debt graph is the more misleading it is. The numbers are presented as absolute debt levels which makes it less usefull as opposed to pct of GDP in order to evaluate real significance and eliminating inflation. Tnx.

September 29, 2010 | Unregistered Commenterdonprizzi

If rates go up sharply, it'll be because of a "sudden" loss of confidence in the currency and bonds denominated in the $...exactly the same thing that will make gold go up.

What they call "money" is headed toward a brick wall at 120 mile per hour. It's not a bad ride till impact ... and then, it'll be over in the blink of an eye.

Here's how this is gonna play out . Things seem fine. Things seem fine. Things seem fine. Uh o...kaboom. World monetary scheme in shambles. There won't be any time for finely-tuned maneuvers at that point.

We aren't there yet, but we're close. We've played multiple rounds of Russian roulette with a six shooter. What's next? Do the math.

September 29, 2010 | Unregistered Commenterfallingman

Donprizzi makes a good point - can anyone at Casey Research produce one of those charts?

Personally, I think that chart *may* look uglier!

September 29, 2010 | Unregistered CommenterTJ

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