The Slippery Slope

The Bank of Japan has opened up the “quantitative easing” spigot with almost 3X the $85 billion a month that Santa Bernanke is providing in the United States. The Japanese plan involves buying the bulk of Japanese longer-dated government bonds, but also includes purchases of exchange-traded-funds (ETF’s) and real-estate investment trusts. Central banks are now investing in non-traditional holdings instead of currencies and bonds. They are buying equities. This is clearly market manipulation. As central banks continue to print money, what stops them from printing more money to take-over publicly held companies? Instead of buying $85 billion of mortgages this month, the Federal Reserve could buy all of Facebook with a current market value of $75 billion and have $10 billion left to buy a few smaller companies. An even scarier thought – what stops foreign central banks from buying publicly-traded US companies? The central banks’ manipulation will cause short-term volatility in the market. Despite this volatility, one must continue to look at their portfolio with a longer-term perspective. Longer-term, if central banks continue to print unlimited amounts of money, it is setting the stage for future inflation.

And with gold dropping today by more than 5%, we don’t believe the Federal Reserve will slow down QE3 any time soon. Why? Because the Fed perceives the drop in gold as a drop in inflation. However, the reasons for owning gold have become stronger over the past few weeks. Central banks continue to flood the markets with liquidity which will eventually lead to inflation, as stated earlier. The reason inflation is not hitting us hard right now is that the velocity of money – how fast money moves through the economy – is at its lowest point in more than 50 years – see the graph below. The Federal Reserve cannot raise interest rates significantly if velocity returns to normal. Why? One only has to look at our $17 trillion dollar deficit for the answer. Any increase in interest rates will add to our budget crisis in the U.S. As interest payments rise – for instance, a 2% rise in interest rates – is equivalent to $340 billion in interest payments, compounding our deficit problem. As a result, the Federal Reserve will have a hard time trying to raise interest rates in any meaningful fashion. Because of this, inflation will be much more difficult to fight back. The last gold bear market was in the 1980’s when the Federal Reserve raised interest rates above 20% to quash inflation. Today is different in that if the Federal Reserve did dramatically raise interest rates, our country would go bankrupt. Inflation is just around the corner.

What does this mean for your portfolio?

First, don’t sell gold! The drop in gold prices is not because fundamentals have changed. Gold has always been a hedge against currency devaluation. Many countries today struggle with huge debt problems because of the social spending that has gone on over the previous decades. Most politicians will take the path of least resistance to fight these deficits. As we have seen from the recent sequester, it is easier to print money than cut spending. Gold – and other commodities – are a store of value and the best way to hedge against future inflation. Inflation, in our opinion, is our biggest risk over the next few years. We believe owning hard assets in your portfolio remains appropriate at this time.

Sincerely,

Your THOR Team