5/25/09 Do Precious Metals Perform Better Under Inflation Or Deflation?

Precious Metals Market Analysis, By Michael Pennington (Copyright 2010 Pennco Coins)

Gold is exhibiting all the classic signs of being in a structural bull market. On fears of inflation in early 2008, it rallied. Then, on fears of deflation in late 2008, it rallied again. So does gold perform better during inflation or deflation? The real rationale for owning gold, as it once again approaches the $1,000 an ounce level, is the prospect of mounting monetary disorder.
The US Federal Reserve, having flooded the market with liquidity by more than doubling its balance sheet in less than six months, may be unable or unwilling to withdraw it in time for fear of precipitating a secondary relapse in economic activity. Other central bankers will also face intense pressures to “support” their domestic economy by weakening the currency, leading to competitive currency devaluations.
The race to the bottom in fiat currencies has begun and hard assets, particularly gold and silver, should be the primary beneficiaries. Gold is a prime candidate to become a “mania asset” once its demand becomes chiefly financially driven where no price is too high.
In fact, gold is currently one of the few remaining major asset classes where a case could be made for it to rise in a parabolic fashion. Once the psychologically significant $1,000 an ounce is breached convincingly, the speed of the move beyond that level could accelerate sharply. One precondition for a mania is there must be uncertainty about how the asset is properly valued which allows “new era” thinking to take hold. This is very true for gold.
The long-term story for gold, however, is as a demonetization play as investors lose faith in fiat currencies. Keep an eye on gold lease rates; a spike would be a good lead indicator that gold is about to punch higher as this would reflect a shortage of lendable bullion. Rising lease rates prefigured the last big move in gold back in the spring of 2007 just as the two Bear Stearns hedge funds were blowing up. Central Banks feared counterparty risk for the first time in 20 years and substantially curtailed gold lending and sales. This led to a 40 per cent rally in gold from $700 to over $1,000.
I cannot say with any confidence that gold will not be without risk and volatility but at least it offers early participants plenty of upside reward to compensate them for the wild ride.
Recently, the central bankers have become more supportive of higher gold prices as it would suggest that their attempts to stave off deflation were starting to work.
Central bankers in favor of higher gold prices? Things really have changed.


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