The Bubble You Shouldn't Care About

07/26/2011 9:00 am EST

Focus: COMMODITIES

Boris Schlossberg

Managing Director of FX Strategy and Co-Founder of BKForex LLC, BK Asset Management

Gold’s near-term future is secure as investors, wary of the recovery and mounting debt problems, look for safety, so despite the bubble predictions, look for the yellow metal to continue to make new highs.

As gold continues to set daily record highs, it is encountering a rising chorus of criticism from skeptics who view it as the latest asset bubble soon due to burst. However, while the precious metal may be vulnerable to a near-term pullback in order to consolidate its latest gains, we believe the long-term case for gold remains bullish.

Contrary to popular perception, gold is not a hedge against inflation. Most traders make that association because the last time the yellow metal experienced a secular bull market in the late 1970’s and early 1980’s, US price levels rose at double-digit annual rates.

However, gold’s actual correlation with inflation is relatively weak. Indeed, in today’s economic environment, price levels in G-10 nations are at multi-decade lows and deflation, not inflation, is a far greater concern. Yet gold rises relentlessly.

Why then the sudden strength in gold? As its many critics point out, aside from wedding demand from India, gold is now a nearly useless commodity, replaced in industry by better, more efficient substitutes. Gold remains a strong psychological store of value, and more specifically, it is the primary asset for expression of no-confidence by investors in the fiscal policies of the state.

As traders and investors look ahead in 2011, the debate between the recovery bulls and the double-dip bears remains at a standstill, but markets are in near-universal agreement that fiscal deficits in the US, UK, and to a smaller extent, the Eurozone, will continue to mount as the gap between expenditures and tax revenues widens alarmingly even as GDP growth rebounds.

With the exception of Australia and Norway, governments in all other advanced industrialized nations are under enormous pressure to keep their spending policies in place in order to assure the sustainability of the recovery in 2011.

Furthermore, in an atmosphere of extraordinarily high unemployment rates across much of the industrialized world, politicians will find it exceedingly difficult to raise taxes next year, as they’ll face the full wrath of voters who are already pinched by stagnant wages and high debt burdens.

As long as the United States has an extraordinary amount of debt (regardless of any compromise on the debt ceiling), gold will continue to rise in price as faith in the US dollar diminishes. It really is that simple.

Traders and investors are clearly sensing that this dynamic shows no signs of improvement, and it is this realization that has been the primary catalyst behind the rally in gold.

Some skeptics have pointed out that while gold may continue to perform well during times of financial stress, it will be nearly worthless as an asset in case of true political turbulence (world wars, economic doomsday, etc.) as investors lose faith its real world purpose. We completely agree, however, before any real doomsday scenario takes hold, it is likely to be preceded by a protracted period of financial turbulence that will only enhance the yellow metal’s appeal in the near term.

There is no doubt that any rally in gold will ultimately end in tears as the asset goes parabolic and then crashes, but any concerns about such a move are premature. For the time being, the rally in gold is climbing a wall of worry, while the growing fiscal problems in the G-10 continue to raise doubts about fiat currencies.

If 2011 does not see a marked improvement in economic activity that quickly replenishes the tax coffers of G10 nations, the financial stress of the situation will likely result in fresh record highs for gold.

By Boris Schlossberg of BK Forex Advisors

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