The Case for Gold Hasn't Lost Its Luster

At the end of October I made the case for gold, based on the rapid increase in government debt by the Treasury, and in money by the Federal Reserve, in response to the financial crisis. Since then, gold is up 5.8%, so I feel pretty good about that call.

Over the same period, oil is off 35.5% and stocks are down 12.7%. So we can't explain gold's rise by pointing to commodities in general, or by rising economic growth expectations. No, gold is doing its own thing.

And I think it's because of the reasons I've pointed out -- that gold, the most inflation-sensitive commodity, is coming to realize that when the Treasury issues as much debt as it is now, eventually the Fed will have to buy some of that debt to keep interest rates low, and ultimately that will lead to inflation.

Not everyone agrees. In an article here last week, my SmartMoney.com colleague Igor Greenwald raised some challenging counterpoints to my view. He noted that since I wrote my October article, "the yield on the 30-year Treasury is down 79 basis points…without the Fed so much as lifting a finger in the cause."

If Igor were writing his article today, he could make his case even more forcefully. Treasury yields have continued to fall, and at 3.06%, the 30-year is now off 126 basis points since I wrote my October article. But I think Igor is wrong when he says the Fed hasn't lifted a finger. That may be literally true. Instead, the Fed has opened its mouth. And when the Fed talks, markets listen.

On Nov. 25, the Fed announced a new program under which it would buy $600 billion of mortgage obligations from Fannie Mae (FNM) and Freddie Mac (FRE), and mortgage-backed bonds issued by those GSEs, in order to lower the costs of mortgage loans. Then in a speech on Monday, Fed chief Ben Bernanke talked about how the Fed could buy Treasury bonds as a way of stimulating the economy even when interest rates were near zero. Could it be any clearer? The Fed is committing to do exactly what I said it would do: Buy government debt to keep interest rates low.

True, it hasn't actually done it yet. But when the Fed announces it will over a matter of months acquire more than 5% of the entire U.S. mortgage market -- and then move on to buying Treasurys, too -- markets aren't going to wait for fingers to be lifted. A big buyer has just announced his intentions, so prices are going to go up immediately, and when bond prices rise, of course yields fall.

The same thing happened in early 2003, under similar circumstances. Remember Bernanke's famous speech in November 2002, when he talked about "helicopter drops of money"? That's what earned him the nickname Helicopter Ben. In that speech he talked about the same thing: the Fed buying Treasurys. And soon after he made that speech, bond yields fell dramatically just like they're doing now.

Igor raises a good point when he notes that yields wouldn't be falling like this if the bond market "were really worried about inflation. But bond buyers are focusing instead on the worst asset deflation since the Great Depression…." I agree that the market is indeed focusing on deflation. How could it not be, when a key consumer commodity like oil has seen its price fall by 70% in five months?

For that matter, why should it worry about anything when the Fed has announced its intention to make gigantic bond purchases? For the moment, that's the dominant reality. The market is going to make the Fed pay the highest price possible, and that's that.

But I do think that, in the end, all this will end up being inflationary. On Wednesday, the New York Federal Reserve posted a list of "frequently asked questions" about the $600 billion mortgage purchase program, in which it stated "these operations will be financed through the creation of additional bank reserves." In case you don't understand Fed-speak, that means they are simply going to print the $600 billion to buy the mortgages. Pure and simple.

How about the Treasurys the Fed is going to buy? That hasn't been codified in a formal program the way the mortgage operation has. But it's already happening, almost automatically.

Starting in September, the Treasury issued $558 billion of "supplemental financing" securities. It deposited the proceeds from this issuance with the Fed, and the Fed used the money to carry out various credit market rescue operations. The Treasury announced on Nov. 17 that it wouldn't issue any more of these bills, not even to replace the existing ones as they mature.

Think about what that means. Every week or so, something like $30 billion of these securities matures. By the end of this coming January, they will all be gone. That means the Treasury is taking back from the Fed all the money it deposited since September. When the Fed sends that money to the Treasury, that is the exact operational equivalent of buying Treasury bonds.

It's already happening. And I think it's going to be inflationary, too. That's because the Fed is probably going to have to keep in place all its rescue facilities for troubled banks, brokers, insurers, money-market funds, and commercial paper and asset-back securities issuers. To keep those in place at the same time as it sends $558 billion to the Treasury means only one thing: The Fed is going to have to print new money to replace the $558 billion. Pure and simple.

To be precise, none of that absolutely has to be inflationary. Igor is perfectly correct when he describes the torrent of deflationary forces currently besetting the economy. So probably the Fed has to do some money-printing just to stay even. That's why gold is up only 5.8% since my October article, and not 50.8%.

"Only" up 5.8%? In a world in which the price of every other risky asset is collapsing, 5.8% is a lot.

And what about when things calm down a bit, and those deflationary forces aren't quite so torrential anymore? Then if the Fed isn't pretty darn hasty about un-printing all the money it's printing now, we'll all definitely be talking about inflation again. Then we really will see gold up 50.8%.