The Precious Metals Gang Gathers

The stock market has almost become a sideshow to the story playing out in the bond and precious metals markets. But that's okay. The stock market is so divorced from reality at the moment that we believe it is failing to tell us anything really useful about what's ahead in 2009.

So what's ahead in 2009? Let us turn to the world's reserve currency and the last great bubble of the Bubble Epoch for answers.

First up, a U.S. dollar crash. Or should we say another U.S. dollar crash? In 2008, the dollar managed to trim some of its losses over the last five years. But with U.S. President elect Obama telling the world America will have trillion dollar deficits "for years to come," the greenback has an unprotected flank.

That flank is the bond market. With the supply of dollars and dollar-denominated debt set to explode, you'd expect the appetite for U.S. bonds to fall. And yesterday, it began to do just that. In December, 30-year U.S. bond yields were hovering at 2.51%. By the close of yesterday's action, they were above 3%.

Everyone and everyone's dog (and everyone's dog's feline foes) is calling for the popping of the bond bubble. Every fibre of our contrarian nature says to go against the crowd. After all, it seemed fairly obvious that the Nasdaq was in a bubble when tech stocks were selling at average price-to-earnings ratios of 100. And then the ratio doubled!

The point? A real bubble worthy of the name exceeds your expectations and just keeps going up. This prompts us to conduct a brief thought experiment. What could keep the Treasury bond bubble rising? Fed buying!

That's right. We know the Fed is trying to bridge the gap between government bond yields and mortgage rates. The Fed wants to make it easier for Americans to refinance into lower-rate mortgages, and thus heal the mortal weeping wound at the heart of the American economy. So it's been hacking away at the short-end of the yield curve, trying to bring mortgage rates down by proxy.

It follows that if ten-year and thirty-year yields start creeping up in response to the increase in the monetary base, the Fed will kick into action and become a buyer of U.S. government securities. Now we know what you might be thinking. At least we know what that makes US think.

When the Treasury issues bonds, it's borrowing money from the world's savers. That crowds out private investment, but is not really money printing. True, it steals from future income and sends interest and principal payments to bondholders outside the U.S. But that is a kind of monetary time travel, rather than monetary alchemy.

If the Fed, on the other hand, moves to keep a lid on Treasury yields by buying them in the open market, it will likely do so with money in wishes into existence. There's no place like credit! And don't think this will go unnoticed by the precious metals gang loitering on the corner, and its leader, Gold.

Analysts at Societe General predict an average gold price of US$650 for this year. That seems stupidly low to us. But gold has given ground the last three sessions in the face of a slightly stronger U.S. dollar, so maybe the financial institutions are right and 5,000 years of monetary history are wrong.

Or maybe not! Here's a prediction for you: gold and its precious metals brothers in arms (silver, platinum, and palladium) will absolutely ambush the dollar this year if things keep playing out the way they are.

Others agree. Former Bank of England policy maker Willem Buieter writes on his blog that, "There will, before long (my best guess is between two and five years from now) be a global dumping of US dollar assets, including US government assets. Old habits die hard. The US dollar and US Treasury bills and bonds are still viewed as a safe haven by many. But learning takes place."

We recall reading in a journal or paper last year that learning actually produces pleasure in the human brain. This must be nature's way of helping is survive, by turning learning into a pleasurable experience. Buieter is right. Investors learn quickly, pleasure or not. When the risk of ignorance is insolvency, it pays to learn quickly.

And if all else fails, you can simply pay attention to what the Fed said in its December meeting notes. Not that we put too much stock in the central bank's forecasting (missing the credit bubble and later, the bust). But the Fed is telling us what it thinks will happen, and that indicates what it will probably do (hint: print money like mad!).

In the meeting notes made public yesterday in New York, Fed officials said that, "Real GDP was projected to decline for 2009 as a whole and to rise at a pace slightly above the rate of potential growth in 2010. Amid the weaker outlook for economic activity over the next year, the unemployment rate was likely to rise significantly into 2010, to a level higher than projected at the time of the October 28-29 FOMC meeting."

Got that? Economy...shrinking...unemployment...not shrinking.

Inn other words, the Fed fears a deep, deep, deep recession in 2009. It is also hyping up the fear of a deflationary spiral in order to pre-emptively justify its inflationary (if unorthodox) policy measures. Thus always the Keynesians.

A world that could use more savings and thrift, and the increase in purchasing power that comes when people choose cash over consumption, is going to be kicked into poverty and submission by fiscal and monetary policy. The government will spend. It will ask you to spend. And it will borrow to spend...all under the illusion that spending creates wealth.

But only real increases in productivity create real wealth. If spending were the easiest way to get rich, why...we'd all be rich! Of course, paper money doesn't make you rich either. And many people are beginning to get that in 2009. Watch that precious metals gang on the corner. They're looking like they're ready to make a move any day now.

Dan Denning
for The Daily Reckoning Australia

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