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This “Bond King” Just Telegraphed Gold’s Next Move…

Posted By Dan Amoss On January 9, 2012 @ 3:29 pm In Gold,Precious Metals,Resource | No Comments

Here is a prediction for 2012: Despite the best efforts of government statisticians, the CPI will rise by more than 3%. This will surprise most investors and surprise mainstream Keynesian economists, who cling to the false precision of output gap models.

Economists define “potential GDP” as the maximum output that an economy can sustain without creating inflationary pressure.

This number is squishy and arbitrary; it’s remarkable that anyone takes it seriously. One might be able to draw useful conclusions from this sort of calculation at the company level, or even at the industry level. If the refining sector is running below capacity, you can calculate it with a reasonable amount of precision and draw valid conclusions.

But to estimate the potential output of today’s (largely service and intellectual capital-based) U.S. economy is an exercise that can only lead to errors. The U.S. economy results from an incalculable, complex web of household- and company-level decisions; it’s not a factory with easily measured capacity and output.

Yet potential GDP estimates lie at the core of many Federal Reserve economist calculations. These potential GDP estimates rise uninterrupted into the future. But any student of history knows economies move in violent cycles, not in a linear fashion. Unfortunately, many down cycles, like the one we’re in now, are inevitable after a period of unprecedented credit growth (promoted heavily by the Fed and Congress).

The blue line in this chart is the Federal Reserve’s estimate of potential GDP. The red line is actual GDP. And the difference between the two is the “output gap”:

The latest annualized nominal U.S. GDP for the second quarter of 2011 is $15.2 trillion. This is just 94% of the $16.1 trillion in potential GDP, making the output gap roughly 6% — among the widest in the postwar set of data. Many Fed governors look at this and actually believe that printing a lot more dollars and injecting them into the banking system will speed up the process of GDP re-converging onto the mythical potential GDP.

In fact, the minutes of the Fed’s last meeting, released last week, hint that the Fed will extend its zero rate pledge another year or two beyond mid-2013. Or perhaps the Fed will be bold and reckless enough to “target” the unemployment rate. This would involve printing more and more money until the unemployment rate falls to a more desired level.

What about oil prices and food prices? Well, increases in those prices will just be “transitory” because “our output gap models say so.” Keynesian economists will say we can keep running deficits and stimulus packages until the red line closes in on the blue line, and there will be no serious inflation or stresses in the Treasury bond market until that happens.

It would be nice if reality were that simple and tidy, but it’s not.

The reality is that we’re suffering from an imbalanced post-bubble economy. The nebulous idea of “demand” won’t drive the rebound in inflation; too little investment in an uncertain environment (including radical government spending and money printing) is more likely to lead to higher prices.

The academics at the Fed will always view higher prices as transient, and therefore printing even more money will have no impact on inflation. They either don’t understand or admit to the impact that their radical policies have on inflation expectations. The impact of their own actions on their preferred measure of inflation expectations — the 10-year TIPS break-even rate (the bond market’s expectation of average inflation rate over the next decade) — will give them a false sense of comfort about how the public really views the dollar’s integrity. Lately, the Fed has dominated the bond market, either explicitly or implicitly through its communications with primary dealers and bond investors.

Five years after the credit bubble popped, we still suffer from an imbalanced economy. Rather than recognize this, “policymakers” are trying to puff the economy back to the way it was in 2007, and the result will be disastrous. The Federal Reserve and Treasury Department have wasted vast resources propping up a failed financial system. A necessary part of this bailout plan is keeping interest rates near zero, so both the banking system and government can borrow at low cost.

Zero is, obviously, not the market-clearing price of money. As lenders and savers have slowly realized that zero interest rates are essentially a permanent fixture of the investing landscape, they’ve not offered as much of their capital as loans in the real economy as they would have if rates were higher. We’ve seen this play out as institutions continue to follow a defensive, barbell investing strategy: a hefty allocation to:

  1. U.S. Treasury bonds, and
  2. Inflation hedges like precious metals, energy and farmland.

This preferred menu of investment choices among institutions should continue until we see tighter Fed policy (which will be several years in the future). Bill Gross of PIMCO is one of the thought leaders of the institutional investment community. He just published an excellent article on the transition from the “New Normal” to the “paranormal.”

The article suggests that PIMCO is finally losing faith in the Fed and other central banks to engineer Utopia with money printing policies. Other institutional investors, who are the whales in the sea of stock market investing, will follow Gross’s lead with the typical lag. And yes, bond king Bill Gross, longtime member of the Keynesian/Fed establishment, mentions gold favorably. I checked twice, so this is not a typo: “Gold at $1,550 seems pricey, but it has upward legs if QEs continue.”

More QE (printing money to buy Treasury debt) is a matter of when, not if. You need only consider the imperative to keep interest expense low for the biggest borrower of all: the U.S. government. The Fed’s zero rate policy has led to lower interest expenses, despite exploding Treasury debt. Since late 2007, debt held by the public has doubled from $5 trillion to $10 trillion, yet interest expense on the debt has declined from $230 billion to $190 billion:

More investors will come to understand that everything they learned in college about Keynesian economic policies is invalid unless total systemic debt grows eternally. They’ll start to design portfolios for an environment of inflation or deflation, not a happy, “Goldilocks” scenario. Given the macro backdrop, and how governments and central banks are dealing with the limits of sovereign debts, I’m expecting inflation to get steadily worse.

The Fed/Treasury bailout policy has left capital stranded in banks and businesses that now have incentives to defend their existing positions, rather than grow and innovate. These businesses are slowly merging with the state.

As a result, we’re left with excess capacity in most areas of the economy (like finance and construction) and insufficient capacity in others (like agriculture and energy). This is especially true if you view these sectors in the context of the global economy, not just the U.S. economy. Persistent strength in oil and food prices — despite persistently high U.S. unemployment — is evidence that these sectors still suffer from shortfalls in investment.

For example, one company I’ve recommended to readers will benefit from central banks’ zero interest rate policies when it issues high-yield bonds to fund its oil field acquisitions (click here to learn more ways to cash in from this scenario [1].) Indeed, some borrowers can benefit from the subsidies that central banks are giving them, but the sectors suffering from long hangovers (like residential housing construction) have not availed themselves of cheaper rates.

This is not just a matter of financial capital, but also human capital. Most of the productive, experienced professionals in agriculture and energy are near retirement, and will not be easily replaced by the glut of unemployed finance and political science graduates. This is another way to consider the absurdity of “potential GDP.” How do you measure changes in generational productivity, habits and culture?

These macro considerations matter because it’s the environment in which investors must operate. Ignoring these factors runs the risk of getting blindsided by risks like owning companies that can’t function properly in an environment of rising inflation.

As investors, you can profit from this by owning stocks that will earn high returns on capital in sectors that still require heavy capital investment. Also, you can profit by selling short stocks that are earning falling or negative returns on capital in glutted industries.

Best Regards,

Dan Amoss, CFA

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[1] click here to learn more ways to cash in from this scenario: http://agorafinancial.com/reports/SSR/am2012/SSR_america2012_050311_c_vp.php?code=ESSRN100

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