There was more tension on the geopolitical front this month, and there are few signs this is going to end soon. That's especially true in the Middle East where one event after another has been making headlines. The situation is intensifying and this will continue to affect the markets, particularly gold and oil.

Complications in a Bad Situation

Iraq, for instance, is on the brink of civil war. Fighting and bombings have spread as the death toll grows daily. Iran remains a wild card and it's holding firm on its nuclear stand, despite worldwide disapproval.

The entire situation is turning into a quagmire. Many of the Iraqi insurgents are believed to be from Iran but there are ever growing groups from other countries too. Roadside bombings are averaging 1000 per month while Bush is warning of a long war. Intelligence chief Negroponte says terrorism may spread to other Asian nations, while Rumsfeld admitted the U.S. is losing the propaganda war to al Qaeda.

This was illustrated in surprising poll results several months ago. When asked, how much confidence do you have in bin Laden, over 50% of the respondents in Pakistan and Jordan said a lot... and these are countries friendly to the U.S. The results were also high in Indonesia. Unfortunately, this sentiment seems to be spreading.

Gold Loves Uncertainty

Wars often don't work out as planned. The Vietnam War was one example that hit close to home. Iraq has become another example and U.S. opinion has changed as a result.

Bush's approval rating has declined steadily and more than 60% of those polled feel the U.S. is seriously off course. Second term presidents have often had a hard time and it looks like Bush is not going to be an exception. But he's determined to carry on with his policies, which is bullish for gold because it'll mean ongoing deficit spending and ongoing global tensions.

When gold's bull market started in 2001 it wasn't yet clear what might fuel the rise. But as these factors have evolved, they nearly guaranty a continuation of gold's bull market for years to come. Let's look at the money alone...

Repercussions of an Expensive War

The war in Iraq is now costing more than the Vietnam war, per month adjusted for inflation. Plus, the U.S. has already spent almost as much as it did in Vietnam, even though that war lasted 13 years. The U.S., however, can't afford it. So it's cutting social spending and other programs as it pours more money into military spending, which will be nearly half a trillion dollars in the year ahead. It's also creating money out of thin air to cover these expenses and that's why the budget deficit keeps hitting new all time highs. Very simply, the government keeps spending money it doesn't have.

Fueling Inflation

As a result, all of this deficit spending and booming money supply is also fueling inflation, which has been on the rise for a while now. In other words, a loose money supply is the cause and price inflation is the effect. That's always been the case and it's happening again. And since gold is the ultimate inflation hedge and it reacts to world tension, that's why it's rising too.

The situation was very similar in the 1960-70s. As the war in Vietnam drug on, the government adopted a guns and butter policy it couldn't afford. Monetary policy was irresponsible, which almost always happens during times of war, and that eventually resulted in soaring inflation in the late 1970s. Gold also soared, hitting $850 in early 1980.

We don't think we're exaggerating when we say the situation today is more serious than it was then. The spending is bigger, the deficits are larger and U.S. debt as a percentage of Gross National Product (GDP) is now at the highest levels since 1916, and probably ever (see chart). Currently, for every dollar of GDP, there are three dollars of debt.

That's downright scary. It's even higher than during the Great Depression of the 1930s, and with the economy and housing now slowing, along with record high bankruptcies, you can bet the Fed is on the alert. It knows this debt is dangerous and if the economy were to really slow down, deflation could take hold. The Fed definitely wouldn't want that to happen and it would do everything it could to avoid it, including cranking up the printing presses as Bernanke has said in the past. That would add more coal to the inflation fire.

The historical cycles tend to reinforce deflation is not in the cards. Mega trend upmoves generally last about 22 years on average, going back to the early 1800s. This coincides with bull markets in tangible assets and since the current mega upmove started around 2000, it could continue for another 10 to 15 years, based on these cycles.

And while we don't enjoy saying this, increasingly it looks like this mega upmove is going to coincide with the clash of civilizations, the ongoing religious wars or whatever some are saying is happening in the Middle East. We hope we're wrong but the evolving oil situation tends to suggest this as well.

Demand for oil is soaring worldwide while supplies are being depleted. Oil producers have become the big men on campus and some are behaving that way. Just look at Ahmadinejad in Iran or Chavez in Venezuela as examples.

Oil Producers are Making the Rules

Iran is a real case in point. Today they're scheduled to open their new oil bourse, which will only accept euros for oil and not U.S. dollars. Based on Ahmadinejad's actions on other issues, he'll probably go ahead. If he does, it'll be a huge economic slap to the U.S. because U.S. dollar world dominance would begin to unravel, both as the global pricing mechanism for oil and as the world's reserve currency. Plus, Norway is now saying its oil should be bought in euros too.

This would seriously hurt the dollar, but it would be good for gold since gold generally rises as the dollar falls. In the past five years, the dollar has already lost a large portion of its value in terms of gold and that would certainly accelerate if the dollar/oil relationship starts coming apart.

For now, we don't know how this will all work out. But gold's mega trend is poised to continue in the years ahead and based on what's happening in the Middle East, events there will likely be an important reason why, both financially and geopolitically.