Inflation specter has some investors pining for gold


By John Parry and Pedro da Costa
Friday, February 6, 2009

NEW YORK -- Unease over a surge in U.S. government borrowing has some analysts nervous that, even as the immediate threat of deflation looms, hyperinflation on a global scale may be the eventual result.

A recent spike in both gold prices and the cost of insuring sovereign debt against default shows that investors worry an eventual meltdown of major currencies cannot be ruled out.

Economists emphasize that the prospect of a Weimar Republic-like crisis of confidence in money itself is not the most likely endgame to the global credit crisis.

They also note that, given the predominant risk of deflation, policy-makers have little choice but to flood the financial system with money, if only to counter the most rapid retrenchment in U.S. consumer spending in half a century.

Yet those investors who are less prone to taking big risks note that gold is the most obvious hiding place from the nightmarish scenario of vanishing trust in fiat money, or paper currency not based on a hard asset.

Indeed, its latest jump was triggered in part by massive government debt issuance, which some say threatens to undermine the value of the paper it is printed on.

"That sovereigns don't default because they can print money is technically true, but the big question is whether the money is worth anything," said Jay Mueller, senior portfolio manager with Wells Capital Management in Milwaukee, Wisconsin.

"In the movement of gold you are seeing the fear that the dollars that you could pay back in aren't worth as much," he said.

Spot gold has rebounded from a recent low in November around $710 per ounce to $914 on Thursday, a 29 percent rise. At the same time, credit default swaps on five-year Treasury notes have recently spiked to a record 85.9 basis points, up more than 80 times pre-crisis levels.

In previous periods of high inflation, such as the post-World War I years in Germany's Weimar Republic, precious metals are among a handful of hard assets that have been able to conserve their worth.

In that context, some analysts worry a huge expansion of the supply of money, which could run to about $8 trillion in the United States alone, will stoke a surge of inflation down the line.

This is not to say that gold investing is without perils of its own. "Price fluctuations in gold over the last 30 years don't tell me that's the place where I want to put the majority of my money," said Thomas Higgins, chief economist at Payden & Rygel in Los Angeles, California.

Nonetheless, the vulnerability of the U.S. currency has some experts recommending investors hold at least some gold in their portfolio.

"It is hard to understand why the dollar should continue to demand respect," said Tom Sowanick, chief investment officer at Clearbrook Financial LLC in Princeton, New Jersey. "We are in a much different geopolitical environment than 10 years ago or 20 years ago, with the U.S. being the largest debtor nation and China being the largest creditor nation."

China, the biggest foreign holder of dollar-denominated Treasury securities with some $681.9 billion or about 12 percent of Treasuries outstanding, might pare back its dollar holdings, a worry for the U.S. bond market and currency.

To be sure, such fears have often been overhyped and, to date, have proven premature. But as plunging house prices show, past performance may not be a great indicator of future returns. That becomes especially true as debt issuance begins to dwarf most historical precedents in the United States, excluding the period of World War II.

This year alone, analysts expect the U.S. government to issue some $2 trillion of debt on top of the nearly $6 trillion of Treasuries outstanding. Some have begun calling even this startling estimate conservative.

And there are few alternatives to the buck. The fiscal situation of governments around the world is deteriorating, as evidenced by ratings downgrades of Portugal and Spain.

Reflecting this deterioration, spreads on credit default swaps for European countries have experienced a similar pattern to those in the United States, rising to record wide levels. Some investors are also piling into inflation-protected bonds, against the advice of mainstream economists.

Dollar bulls note that, in the case of the United States, an actual default -- i.e., a missed payment -- is highly unlikely. Given the dollar's status as the world's leading reserve currency, the U.S. government could simply print unlimited quantities of money to repay its creditors.

But that could still open the door to a precipitous drop in the currency's value and, potentially, even hyperinflation, analysts warn.

And while a downgrade of America's standard-bearing AAA credit grade seems far-fetched in the near term, the rumblings from the ratings agencies were already emerging.

In a report on Thursday, Moody's Investors Service warned, "The U.S. government's financial position is projected to worsen considerably over the coming two years."

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