Analysts and pundits provide various reasons for the bull market in gold. This includes emerging market demand, low interest rates, QE/money printing, central bank accumulation, central bank policies and falling gold production. These are all good reason but there is one reason which stands apart and will drive precious metals to amazing heights. It is the impending sovereign debt default of the Western Europe, led by the great USA.
If this happens you will remember me:
Quantitative Easing will go global. I can guarantee you. Japan will buy bonds, ECB will start buying bonds and UK will do the same thru QE to keep the economy moving.
Government Debt
Government finances have reached a point where default and/or bankruptcy is unavoidable. After all, they have already started to monetize the debt. The inflection point is when total debt reaches a point where the interest on the debt accumulates in an exponential fashion, engulfing the government’s budget. When this occurs at a time when the economy is already weak and running deficits, there essentially is no way out.
Significant runaway inflation and currency depreciation result from a government that essentially can no longer fund itself. It starts when the market analyzes the problem and moves rates higher. The government then has to monetize its debts to prevent interest rates from rising. Let me explain where and why severe inflation is unavoidable and likely coming in the next two to three years.
In FY2010, the US government paid $414 Billion in interest expenses which equates to 17% of revenue. When you account for the $14 Trillion in total debt, that works out to be 2.96% in interest. In FY2007, total debt was $8.95 Trillion, but the interest expense was $430 Billion and 17% of revenue. That accounts for an interest rate of 4.80%. Luckily, rates have stayed low for the past two years. Zero rate policy will continue till 2011. QE2 will give way to QE 3 and QE will get global while entering into Japan, Europe and UK very soon.
However, in the next 24 months the situation could grow dire. At least $2 Trillion will be added to the national debt. At an interest rate of only 4.0%, the interest expense would be $600 Billion. Even if we assume 7% growth in tax revenue, the interest expense would total 22% of the budget. An interest rate of 4.5% would equate to 26% of the budget.
As far as what level of interest expense is the threshold for pain. Once interest payments take 30% of tax revenues, a country has an out of control debt trap issue. When you clearly think about it, this just makes sense, as the ability to dodge, weave and defer is pretty much removed, as is the logic that it will be repaid in a low-risk manner. The world is going to be a different place when the US is perceived to be in a debt trap.
Is there any way out of this? Either the economy needs to start growing very fast or interest rates need to stay below 3% until the economy can recover. Clearly, neither is likely. Interest rates are now the most important variable. If rates stay above 4% or 4.5% for an extended period of time, then there is no turning back.
In 2011 and 2012, the Fed will have two new problems on its hands. First, the Federal Reserve will be fighting a new bear market in bonds. They will be fighting the trend. They didn’t have that problem in 2008-2010. Furthermore, the interest on the debt will exceed 20% of revenue, so the Fed will have to monetize more as it is. US dollar will stay weak due to QE2. It wont fix the economy. Ironically, the greater monetization will only put more upward pressure on interest rates, the very thing Captain Ben and company will be fighting against. According to citigroup latest report.
The dollar may drop 11 percent versus the euro next year as investors shun U.S. assets and drive bonds lower. It’s a bearish U.S. asset dynamic led by the bond market. This period has a set-up that is amazingly like what we saw in the ‘70s, and is similar to what we saw around 1993.
The dollar will follow trading patterns from the 1970s, when the housing market experienced a decline similar to the recent drop, and the 1990s, which also saw a slump in the bond market. U.S. two-year yields doubled from a low of 3.7 percent in September 1993 to a high of 7.7 percent in December of 1994, pushing bond prices lower.
The US Dollar/ greenback will follow Treasury lower next year as investor concern mounts the housing-market recovery will remain constrained and as the Federal Reserve pumps $600 billion into U.S. debt to help a slowing economic recovery. According to Kansas City Fed President Hoenig, the recovery simply cannot be sped up and that Fed Chief Ben Bernanke’s efforts to avoid a double-dip by printing money are nothing less than “a bargain with the devil.”
He has been a sometimes lonely dissenter on the Fed’s rate-setting committee, fears that the latest foray into easy money, the $600 billion bond buyback plan announced in November, is an unusually risky move.He also believes that the repeated promises to keep rates at virtually zero for “an extended period” are a mistake. It is widely believed that the Fed has kept rates too low for too long before. It is my concern that, by understandably wanting to see things move more quickly, we create the conditions for repeating the mistakes of the past.
Even so, Hoenig couches his warnings in caveats: “I don’t want to say that I’m right and someone else is wrong, “Only time will tell whether I’m correct.”
The US economy is stuck in a rut of very high unemployment, yet a bill to extend the Bush tax cuts for two years could prove a shot in the arm. Even so, it’s not enough to warrant a shift in Fed policy for now. The potential changes in fiscal policy will almost certainly be discussed at the meeting, but the statement will likely shy away from any mention of this contentious topic.
As you can analyze, there is really no way out of this mess which also includes the states, Europe[ PIIGS], England and Japan. This is why gold and silver are acting stronger than at any other point in this bull market. They’ve performed great when rates were low but are likely to perform even better when rates start to rise. This is why I urge and implore you to at least consider gold and silver.
Disclaimer:
This is just a research piece and not an investment advice. Investors are encouraged to perform their own due diligence for any investment and decision making as per their risk profile.
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