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March 05, 2008

Bernanke's Gold Show Must Go On?
by Brady Willett

Ben Bernanke has attacked the threat of deflation with great zeal. We knew that he would. But what we don't know is how Mr. Bernanke will respond to today's stagflationary pressures, if at all, and/or whether or not the slumping dollar will eventually ignite a monetary policy response. Yes, Mr. Bernanke has assured policy makers and investors that fighting recession is higher on the Fed's check list than directly attacking inflation. However, if USD creation is the primary cause of the inflationary problem now rupturing through out the global economy Bernanke may have little choice but to eventually switch focus.

Suffice to say, Ben Bernanke is one of the major reasons why gold is hitting record highs today. Bernanke's Fed has aggressively cut interest rates in an attempt to liquidity a financial marketplace burdened by terrifying episodes of seizure and failure, but what they have not been able to do is disperse monetary stimulus with any degree of precision. Thus, during a time when investors do not want to buy stocks and they are not eager to bottom pick real estate, the commodities arena is attracting money flows. So long as the Fed keeps promising more rate cuts and flows to equities and real estate remain restrained, eroding investor confidence in the U.S. dollar has the potential to keep the commodity fires stoked.

Given that supply/demand fundamentals do play a key role in determining commodity prices, it may seem a stretch to blame Bernanke for the commodities boom now transpiring. To better illustrate some of the forces at work drawing on one of Bernanke's most famous quotes is applicable (bolds added):

Today an ounce of gold sells for $300, more or less. Now suppose that a modern alchemist solves his subject's oldest problem by finding a way to produce unlimited amounts of new gold at essentially no cost. Moreover, his invention is widely publicized and scientifically verified, and he announces his intention to begin massive production of gold within days. What would happen to the price of gold? Presumably, the potentially unlimited supply of cheap gold would cause the market price of gold to plummet. Indeed, if the market for gold is to any degree efficient, the price of gold would collapse immediately after the announcement of the invention, before the alchemist had produced and marketed a single ounce of yellow metal.

What has this got to do with monetary policy? Like gold, U.S. dollars have value only to the extent that they are strictly limited in supply. But the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. Bernanke. November 21, 2002

If the correlation is not otherwise clear, commodity prices - and precious metals in particular - are efficiently responding to Bernanke's pledge to keep cutting interest rates before such cuts actually transpire. Still not following? Well, the promise of more Fed intervention immediately hurts the dollar because no other major central bank is as dovish as Bernanke's Fed, and the slumping dollar immediately sends players into precious metals. Moreover, as the Fed's super-dovish words and actions fail to ignite a return of confidence in either stocks or real estate - the two major assets on the consumer's balance sheet - precious metals attract even more flows from investors too scared to hold traditional assets.

If this all sounds confusing fear not because when, and if, other central banks start trying to debase their currencies in response to Bernanke's ploy the plot thickens and gold goes superboom! Or so the story goes...

Goldscape IPO Launch at $1,000 an ounce?

Recall if you will the Netscape IPO in 1995. It was common sense back then that led to the conclusion that a money losing and nearly revenueless experiment should not be valued at $2+ Billion after its stock price nearly tripled (intraday) on its first day of trading. But, as the arrival of countless hot IPOs in the years that followed proved, common sense failed to produce results for some time.

Point being, the contrarian conditions that made precious metals a strong buy in the late 1990s have long vanished. Instead what we have today is a bull market in gold and other commodities that is being fueled, in part, by the greater fool theory. Akin to the IPOs that followed Netscape, investors have watched commodities perform well and many have decided that they want to participate. Higher prices beget higher prices as participation expands regardless of the fundamentals. The only question is whether or not even more inflows are around the corner.

In short, while I believe that $1,000 ounce gold will come to resemble a top more so than a launch pad, it may be important to remember that I regarded Netscape as pure mania only to watch the insanity continue for nearly 5-years afterwards. In other words, gold could continue to attract investors much longer than most think possible, and $1,000 ounce could be the headline grabber that opens the floodgates.

Needless to say, one of the major problems with definitively coining precious metals a bubble is that Bernanke appears far removed from the inflationary attitude his Fed has produced. Bernanke logic says that the Fed has the power to immediately restore some confidence in USD by credibly threatening to attack monetary inflation. Question is, when will Bernanke, fixated on stimulating, switch focus?

Brady Willett
FallStreet.com

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