The Yajnik Letter

If you have been investing in gold (bullion, mining company stocks, ETFs, etc.) based on my prior postings, well, you are sitting on some nice gains. For the record, a year ago you could have bought an ounce of this yellow metal for $778. It has traded as high as circa $1200 but retreated about $50+ yesterday. Doing the simple math, year-over-year gold has now risen about 50%. There is nothing wrong if you choose to take some of the profits off the table. Personally, I am not selling because, even though we are in for a needed correction (come on, everyone from CNBC to your mother is saying, “buy gold!”), I still feel the fundamentals are still very much intact for gold to reach $2000/oz.

Emotionally, all of us must feel to some extent that gold is running too far, too fast. That inclination is supported by considering that, over the same period, the dollar index (DXY:IND) has fallen by 14%. When it comes to first-world currencies, that’s a major move!

Even so, that data point is suspect, because all it really tells us is that the dollar has fallen less against other fiat monies than it has against gold. If you view gold as the only honest currency (a currency backed by gold would also be viewed as honest…really it’s the only way gold can be a currency since we can’t buy bread with a gold coin), then the dollar has fallen about 35%. (Think of it this way… each dollar could purchase 1/778 or 0.001285 ounces of gold last year and now can only purchase 1/1192 or 0.000839 ounces, which reflects a decline in the value of the dollar relative to gold of 34.7%.) This is a significant move that screams big for the need to double check one’s premises about what’s next for gold.

When I step back from the emotional reaction to gold’s stunning rise and look strictly at what’s actually going on in the world, I have to think that gold will go to at least $2,000 in this cycle, as I mentioned earlier. And there are very credible scenarios in which it could go to a multiple of that number.

Why so bullish for the yellow metal? There are a number of reasons, but one in particular I’ll focus on today: Interest rates. At the peak of the last great U.S. inflation and corresponding gold bull run in the late 1970s, the government had a simple yet very effective tool to deal with the then prevailing problem of runaway inflation: aggressively raise interest rates, thereby contracting the money supply. Once inflation was tamed, the Fed was then able to steadily reverse course by lowering interest rates, effectively rebooting the economy and setting the stage for a protracted bull market.

In the current scenario, with everyone and every government up to their eyeballs in debt and interest rates already near 50-year lows, the problems the economy faces are distinctly different. And far more intractable.

Simply, there is no conceivable way the government can raise rates without destroying what’s left of the economy. Besides, in the absence of price inflation, why would it want to? Quite the contrary, using the lack of price inflation as its cue, it is going to great lengths to keep rates low in order to encourage yet more spending and more debt.

I suppose the hope is that, over time, the Fed will be able to manage the inevitable rate increases so they occur very slowly. That mindset cements in the cheap-money policies for as far as the eye can see, or at least until – again, it hopes – debt levels fall to the point where an increase in interest rates won’t be so devastating.

But there’s the rub because at the same time the U.S. government is pursuing some of the most aggressive easy-money policies in its history, it is simultaneously engaged in historic levels of deficit spending as in year-over-year deficits more than 3X higher than any seen since WWII.

Thus, when interest rates ultimately start rising, they’ll be rising on an even larger pile of debt. Which, of course, the government will be even more anxious to avoid because at that point they’ll only have one option: default on the debt. Either suddenly or over time, with an even more aggressive dollar debasement.

All of which is to say that we are now in a classic negative feedback loop in which one outcome is most likely – a lot more currency depreciation. But depreciation against what? Well, pretty much anything tangible. But as far as money is concerned, it’s gold that comes out the winner.

Here are some articles for your reading pleasure:

• Click here to see how the mighty are falling and that fall is happening quickly!
• Here are 10 brands that may disappear in as early as 2010.
• I can say, due to recent events, my view of Tiger Woods has diminished. Here is an interesting take on Mr. Woods.
• China’s appetite for gold is increasing and you can read out it here. Keep in mind that US currently holds over 70% of its reserves in gold, Italy has over 60%, India has between 4-7%, and China has less than 2%. With growing uncertainty around the US, more and more easy money flooding the global marketplace, growing economies (China and India, in particular) will seek ways to diversify their reserves by incorporating real assets (i.e. gold).

-Samir