The global monetary system rests on a fragile foundation of trust. Thanks to the actions of central banks, pressure on the system will keep growing.
Paper U.S. dollars sit at the heart of the global monetary system. Dollars are liabilities of the Federal Reserve. Just as houses are collateral for mortgages, Treasuries and mortgage bonds are collateral for U.S. dollars.
A central bank’s balance sheet is essentially a self-reinforcing feedback loop: Government bonds are the collateral for dollar liabilities, and bonds are streams of future dollar payments. So the dollar is backed by the promise of more dollars…
As more dollars are printed, their value inevitably falls. As the dollar falls, the Fed responds with more printing. The Fed uses weak excuses to explain higher prices; it blames anything but itself. Weather, geopolitics, and emerging market growth are classic scapegoats for higher prices. Few bother asking how those events would impact consumer prices without the influence of a swelling money supply.
Now introduce permanent zero interest rates into this system and the system becomes even more fragile…
Central banks are gambling with the trust of savers. They’re printing and buying bonds at the fastest pace in history. Zero interest rates also undermine confidence in the monetary system. Central banks’ most powerful tool to keep savers in the system is imposing positive real interest rates. Interest rates incentivize you to save. With zero interest rates — and little chance of positive rates for years into the future — there is no incentive.
Central banks have been bailing out bankrupt governments. Zero rates allow governments to fund budgets very cheaply. Of all governments in the world, Japan is the most bankrupt, with a debt many times the size of its GDP. A tiny rise in its government borrowing costs would usher in the same conditions we see in Greece.
How might the so-called “solutions” to slow global growth evolve when the current bout of printing fails?
A “reset” button could strengthen the fragile global monetary system. It involves reintroducing gold. Holders of gold own the crucial ingredient for a reset. And holders of gold mining stocks own in-ground gold supplies that could form the foundation of a future monetary system.
Since the end of the gold standard, debt has skyrocketed. Public- and private-sector debts amount to tens of trillions of dollars. Debt weighs down the economy. Pushing interest rates down to zero for years and years is no real solution. Look at Japan! Its economy has been half-alive for 20 years.
Writing off debt is the only way to restore solvency. The economy would be unshackled from its burden of servicing debts.
There is a way to slash debt without resorting to a deflationary collapse. It involves restoring the gold standard at prices of $10,000 or above. This high price is crucial, because returning to the gold standard at today’s gold prices would result in a devastating deflation.
In a recent investor letter, QB Asset Management explains how an inflationary reset button could slash the real value of the rapidly growing U.S. national debt:
“Using the U.S. as an example, the Fed would purchase Treasury’s gold at a large and specified premium to its current spot valuation. The higher the price, the more base money would be created and the more public debt would be extinguished. An eight-tenfold increase in the gold price via this mechanism would fully reserve all existing U.S. dollar-denominated bank deposits (a full deleveraging of the banking system).”
QB maintains a chart of the shadow gold price (SGP). The SGP uses the Bretton Woods calculation for determining the exchange rate linking gold to the U.S. dollar. The calculation is base money divided by U.S. official gold holdings. Here is QB’s latest chart. It includes projections of the base money supply through June 2015, assuming the Fed prints $85 billion per month. The SGP soars to $20,000 per ounce:
If the ratio between the SGP and actual gold prices stays constant, gold could be $3,400 per ounce by 2015!
If gold rallies anywhere close to $3,400 by 2015 (QB Asset Management’s scenario), quality gold mining stocks could rally by several hundred percent.
Of the bunch, I urge you to consider midsized gold miners.
Capital costs for new mines have skyrocketed at large gold mining companies. For example, the doubling of development costs for a project high in the Andes Mountains sent investors fleeing from Barrick Gold (ABX).
Investors will pay a premium for gold miners with consistent execution and low, stable cash costs. That’s why I suggest you consider the midsized players. One company I’ve suggested to my readers is Agnico-Eagle Mines (AEM) but there are plenty others in the midsize field (including, Yamana Gold, Eldorado Gold, New Gold, Randgold Resources, IAMGOLD Corp and more.)
Let’s assume QB Asset Management’s scenario: a steady doubling in gold prices over the next three years. Many midsized miners would produce vast amounts of free cash flow in 2014. Any rise in gold prices above cash costs flows straight to the bottom line. The most shareholder-friendly companies, will return this cash to shareholders, rather than reinvest in the ground when project costs are too high.
Such a scenario would grab the attention of mainstream investors. Investors who now ignore gold stocks would fall in love with them. High-quality gold stocks remain very cheap and will one day become expensive. Meanwhile, dividend yields pay you to wait.
Dan Amoss, CFA
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