Bond Crash to Drive Gold

By Neil Charnock   Apr 19 2010 12:12PM www.goldoz.com.au

The gold market has been heating up and conditions are moving into an alignment which is ideal for a gold price rally this year. Fear and uncertainty will drive the price northwards even if the current CTFC saga does not eventuate in immediate disciplinary action or regulatory change.

The fact is that the lack of physical supply has been exposed and this will attract more investors to gold as rarity is again bought to the forefront for investors. If the issues raised at the enquiry are to be addressed we could see explosive short covering and gold price action. However this is a bonus I am not counting on at this stage.

Currency risk has escalated due to concerns over sovereign debt levels. Currency movements are now extreme and concerns over which currency one should invest in (if any) are warranted.  Gold is acting like a currency not a commodity. It is interesting to note that even though you cannot print gold as a metal the banks have somehow managed to print paper gold which they classified as “physical”.  Even the most innocent interpretation of this classification could be viewed as misleading.

I note that the warnings of a bond market crash have been growing over recent months. GoldOz has been talking about this for several months including articles discussing Greece and how their situation is neither unique nor sorted. Pimco has now announced that it has stopped buying all bonds. Therefore they will not be reinvesting any funds in this market when their current bond holdings reach maturity.

Given Pimco are the leading bond investor in the USA and in global bond markets I view this as significant. They generally get the markets right which is why they have grown to be the largest bond fund over their 39 year history. The reason for their stance of course is that interest rates are going up and the cost of capital is increasing. This is a serious problem because this removes the low interest rate tool from the Central Banking system as a stimulus measure.

Given the unsustainable nature of the current historically unprecedented debt load I see severe disruptions to the global economy from the subsequent and inevitable unwinding of this bubble. The key reason interest rates are going up is risk. Risk has to be factored into treasury rates or investors will not invest in them it is as simple as that.

Investors may have read that high interest rates are bad for gold. This comes from the fact that when interest rates are above the true inflation rate it is more attractive to hold cash than gold which does not provide any such return via interest payments. What we are talking about here in present time is somewhat different however. 

Then why am I stating that rising rates will be good for gold?  In this instance the rising rates will be increasing due to fear and will create fear and uncertainty which are both great for gold. Let’s face it an upward interest rate spiral is not what the world needs now.

As interest rates increase the repayment load increases for governments, corporations, SME’s (Small to Medium Enterprises) and private borrowers. This in turn increases the risk of default and so overall risk increases even further. As rates go up across the board more and more of the disposable income heads toward the banks instead of other consumption which constrains growth and therefore government and business incomes.

As income falls across the board outside the banking system we see greater risk factored into lending, bad news on bond offerings and higher rates. This leads to job losses (or business failure) which causes loan defaults and then foreclosures as we have seen in the USA and elsewhere. The defaults are not immediately acted on by the banks so this all takes time. You have to default on several payments before the bank will take this step and it takes a further 6 months to sell the asset.

Of course it takes time before employers lay off workers. Interest rates are still relatively low so this effect takes time to flow through the system which fights this decay every step of the way.

What I am describing is of course the pathway to GFC2 which will take some time. It starts with events like Greece and the contagion slowly spreads through the system. This is a decay so feared that you now see denial as nobody wants to see it but again I state this is great for gold and ultimately gold stocks.

In other words this can easily turn into a spiral forcing governments to just print new money rather than borrow it to keep things afloat. If they cannot secure funds via treasury auctions then they are forced to print. This causes currency upheaval and if the tipping point, which would be a loss of confidence in the currency occurs then this can develop into a hyperinflation.

Estimates vary however it would seem that the debt burden the world now faces is at least double the one that existed before the great depression of the 1930’s. Credit was completely removed from the system in the USA back in the 30’s which completely crashed the economy. The crash occurred at that level of severity despite there being excellent manufacturing capability, demand, skilled labour and infrastructure and the will to keep the game going.  

We may have learned from that disaster and there are now mechanisms in the tool chest of the banking system that most people are not aware of however my question is: who will be able to afford the new credit?  How many countries, institutions and individuals are not fully leveraged at present?  Imagine what will happen if interest rates hit 15% in a few years time. What happens to asset prices in that sort of environment? 

My interest as a gold analyst is what happens to gold and gold stock prices as current trends evolve. I am not here to warn people about other asset classes if they cannot see the writing on the wall they will, unfortunately have to face the consequences. I believe that gold investors have to get their head around the issues at hand however.

If bonds are unattractive and property is falling then investment choice is diminished across the asset classes. This makes any viable investment like cash or gold or gold stocks a rare thing so investment flows will be more concentrated forcing prices higher than might otherwise be expected.

Assets that require borrowings for purchase have to fall in value because at 15% the amount you will be allowed to borrow will be smaller due to the servicing cost.  In other words if the maximum debt you can afford to service is a $1M loan at 6% then you will only be able to afford to service (repay) a $500k loan at 12%. If the bank then tightens the equity requirements (deposit) on the borrowings then the maximum amount you can borrow also decreases.

Decreasing borrowing cost has driven certain asset classes much higher because people could “afford” to borrow more. Easy credit conditions have enabled more buyers to enter the market which has increased demand. Now unwind all that and see the future for yourself. The one thing banks fear is deflation of their investments and this is what they face. Their investments include all our borrowings as well as their own hard assets.

Fear is the most powerful driver of any investment mania and there is nothing like a gold mania. What I am pointing to is that fear will be increasing as denial gives way to reality.  Investment choices will be growing more and more limited. Currencies will appear to be more and more risky and hence gold as the ultimate currency will be more attractive. 

Cash creation in the absence of the ability to sell ludicrous amounts of treasuries will appear like the only way out for many governments as this crisis deepens.  Facing reality is not a strong point of governments as they face immense pressure to pull rabbits out of their hat. Pressure groups lobby and push and pull, advisors advise on how to get elected apparently without much attention to fiscal restraint. Paying off the debt and tightening the belt is not palatable under the vast majority of economic systems we have in place around the globe.

Many Australian gold stocks are selling at a deep discount below their intrinsic value, particularly some of the smaller emerging producers and mid tier producers. As the gold price increases the marginal high cost producers will become significantly more attractive however this is not an investment case until this occurs.

Given the emerging trends on the interest rate front I prefer to select the stocks with zero or insignificant debt.  The potential of a rising gold price is also significant so hedging will again become a problem area on the balance sheets of gold companies that are forced into this practice. I do appreciate that borrowings have to be hedged at times so there is a place for a small forward position if kept to a minimum. 

One of our newer producers has a hedge book at nearly $1600 UD per oz which will not be a problem. Fortunately many of the gold producers have reduced or eliminated their hedges over recent years.  The real kicker for the sector is that over recent weeks we have seen strong, across the board share price rises yet we are still well below pre-GFC1 levels. 

Progress has never been stronger for the sector and I also note a report just landed on my desk about an exciting new float. I came across an emerging mid tier polymetallic producer with a PE of 1.6 and market cap of about $30M today and updated it but this is just the tip of the speculative end of this sector. The emerging producers and some of the mid tier producers are already in bargain territory and I hope to see some downside price action soon to enable even more attractive buying conditions.

We have ASX listed gold stocks operating in all corners of Australia the across the globe including several in Africa and Asia making some interesting finds.  There is no shortage of value, latest mining techniques, excellent management and growth opportunities in this gold sector.  I am now starting to update all the news in the GoldOz Members areas ready for a complete review ahead of the buying season over the coming weeks.

Leading investment funds have become more active in recent years Down Under supporting my view that global investment flows are headed this way. Australian gold stocks have long been viewed as a bit out of the way however the globe is shrinking with information flowing across the WWW in mere seconds. This gold sector is probably the most undervalued anywhere when compared to the low sovereign risk we enjoy in Australia.

I have been saying this for over three years across the worlds leading gold sites – the Australian gold sector will play catch up on the global gold stock valuation scale.  This is slowly happening as these leading finds begin to take positions. I think they must agree with me that the whole global gold mining complex will benefit from the coming gold mania.  

I was talking to a fund manager in the US the other day who has been really pleased with my services and his investments in Australia. His view is that we are going to have a lively 2010 for the gold stocks around the world. We either follow on from here if he is right or we take off a little later after a pause; I don’t mind either way as investors will preserve or grow their capital.

Good trading / investing.

Regards,

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GoldOz has developed a basic Member area (news only) and a Gold Members area with substantial investment tools.  GoldOz web site is a growing dynamic resource for investors interested in PGE, silver and gold companies listed in Australia, ASX share quotes, Aussie Gold Index charts, brokers, bullion dealers in addition to the company research via our paid Membership services.

Neil Charnock is not a registered investment advisor. He is an experienced private investor who, in addition to his essay publication offerings, has now assembled a highly experienced panel to assist in the presentation of various research information services.  The opinions and statements made in the above publication are the result of extensive research and are believed to be accurate and from reliable sources. The contents are his current opinion only, further more conditions may cause these opinions to change without notice. The insights herein published are made solely for international and educational purposes. The contents in this publication are not to be construed as solicitation or recommendation to be used for formulation of investment decisions in any type of market whatsoever. WARNING share market investment or speculation is a high risk activity. Investors enter such activity at their own risk and must conduct their own due diligence to research and verify all aspects of any investment decision, if necessary seeking competent professional assistance.