Default Fears Boost Gold Prices

Gold generally thrives amid disruption and instability, as a safety play in times of uncertainty. Yet on October 1^st, the first day of the U.S. government shutdown, gold investors awoke with the price of gold down nearly $40 in the overnight session. Why the surprise move down?

It was mostly a case of “buy the rumor and sell the news.” For nearly three weeks leading up to the government shutdown, gold had been climbing on the possibility of a closure. When it happened, the smart money decided to take some profits.

Yet the very next day, gold rose $35 to $1,320 and has been holding more or less in that low $1,300 zone throughout the first 8 days of the shutdown. But why is gold rising now?

It’s another case of “buy the rumor,” only this time the rumor is of a potential government default on October 17^th if Congress doesn’t get its act together to approve a debt limit increase.

So what’s next for gold? Are we going to see another “sell the news” plunge in the gold price come October 17^th, just as we saw on October 1^st? Or might gold surprise everyone by continuing to climb even if default is averted, thanks to growing expectations of continued U.S. Federal Reserve stimulus?

Default Tension Mounting

As the drama plays out in Washington – with Republicans refusing to allow a debt limit increase without some tax-reduction incentives and Democrats refusing to offer any – the music in the background of this “game of chicken” is moving through a crescendo, along with the gold price.

“Gold is getting some bids because of the uncertainty,” Frank McGhee, the head dealer at Integrated Brokerage Services LLC in Chicago, relays to Bloomberg by phone. “It will be a very big deal if the U.S. defaults.”

Why? Because any missed debt payments would hurt the U.S. dollar, giving a lift to commodities and foreign currencies which trade opposite to it. We should expect traders to continue buying gold all the way up to the 17^th, unless the government reopens by then.

But many economists are not sounding very alarmed. Even if the credit limit is not increased in time, the government can still avoid defaulting on its debts simply by reallocating its revenues to cover its debts first. Remember, the government has money rolling into its coffers throughout each and every month. All it would need to do if the debt ceiling is not raised is cut lower priority spending in favor of debt repayments. And voila – default is averted…at the expense of other things of course.

And this is the reason gold may continue rising even without a government default, because of that “expense of other things” – namely, the U.S. economy.

The Real Risk is Economic Growth

It has been estimated that the U.S. economy is losing some $300 million dollars of government expenditures each and every day the shutdown persists; that’s $2.4 billion to date. If we go all the way to the 17^th as we are, the toll on the economy would total $5.1 billion.

The toll would be even higher if we go through the deadline without a limit increase, as revenues are shifted away from employee paychecks and contractor payments toward covering foreign debt. Thus, even if the government manages to avoid a default through some last-minute reshuffling of its funds, the U.S. economy would still suffer.

But what would happen next? All eyes would turn to the U.S. Federal Reserve. It’s funny how so many traders and economists were so perturbed with the Fed when it decided last month to not reduce monthly bond purchases. Soon we will all be turning to it for more help.

Word is already circulating that we can forget about stimulus tapering for a while, possibly well into 2014, given the damage being inflicted on the economy by the shutdown. To make matters worse, while government offices are closed, no economic reports are being compiled for release, meaning that the Federal Reserve is going to have insufficient data to base any decisions on.

Judging by what few non-government reports there are, the economy is still weak, new jobs are still sluggish, and the housing market is cooling. We might thus expect current monetary policy to remain unchanged for a while.

Why Gold Won’t Stop

The gold price, therefore, is likely to continue climbing well past the October 17^th credit limit deadline – with or without an actual government default on debt payments – on the back of economic weakness and continuing easy-money policies.

Then there is the continued buying of gold by central banks around the world, which the World Gold Council expects to reach 350 tons this year. The reason? Preservation of buying power. Inflation erodes the value of money, with emerging markets especially susceptible to rising prices and falling currencies. Central banks thus purchase gold to counter any adverse moves in their money.

And this is the reason many money managers are advising investors to hold on to their gold in America as well, thanks to highly accommodative monetary policies that expand the money supply and weaken the USD, giving rise to inflation.

The latest consumer price data released before the government shutdown showed inflation is slowly beginning to appear in the U.S., with consumer prices rising for the last three months in a row to 1.2%. The Federal Reserve has repeatedly emphasised that interest rates will remain unchanged at near zero until inflation reaches as much as 2.5%.

This is good for gold either way you look at it: if inflation is low, more easy-money lifts gold’s prospects; if inflation is high, that will lift gold’s prospects all the more.

Marc Faber, publisher of the Gloom, Boom and Doom Report, speaking at the recent Precious Metals Round Table web conference, reiterated that expectation. “The Fed is well on the way to creating a situation where the sh.. will hit the fan,” BDLive diplomatically transcribed.

John Embry, a regular keynote speaker, elaborated on the point during the conference. “We are in the early stages of a classic monetary debasement. We are seeing more and more instances of where the physical gold does not seem to be available.”

With still aggressive buying of physical gold in Asia and elsewhere, the shortage of gold is further compounded by suspicions of central banks leasing gold to multiple buyers, as Sprott Asset Management CEO Eric Sprott confirmed at the conference:

“Our analysis of the physical gold market shows that the central banks have most likely been a massive, unreported supplier of physical gold, and that strongly implies that their gold reserves are negligible today.”

In view of this, Embry forewarns, “Demand for gold will explode at a time when the supply is not available, and the price will reflect this dramatically.”

Expect Surprises – Both Ways

Given gold’s quintuple personality as a commodity, currency, inflation hedge, speculative vehicle and personal adornment all rolled into one, its price movement is much too difficult to predict. Even Federal Reserve Chairman Bernanke admitted before the Senate Banking Committee in July, “Nobody really understands gold prices, and I don’t pretend to really understand them either,” Bloomberg transcribed.

Count me in on that; I don’t know what it will do either. Even experts are divided, with investment bank Goldman Sachs Group (NYSE: GS) predicting gold will fall to $1,110 in 12 months, French bank Societe Generale calling for an average of $1,125 for 2014, and the array of speakers noted above predicting it will soar.

Perhaps the wisest approach is to follow the widely accepted practice of allocating 10% to 15% of one’s portfolio to gold and simply rebalancing as the price moves, adding a little when it falls and selling a little when it rises.

We do know this much… the markets will turn to gold in times of uncertainty. In more ways than one, we have been in uncharted territory for a few years already, with a few more still to come.

Joseph Cafariello

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