Ambrose Evans-Prtichard: Gold bugs at last have their perfect trinity


By Ambrose Evans-Pritchard
The Telegraph, London
Saturday, May 23, 2009

The world's top hedge fund manager, John Paulson, has built a gold position of at least $5.5billion, the biggest such move since George Soros and Sir James Goldsmith bet on Newmont Mining in 1993.

Britain has become the first of the Anglo-Saxon "AAA" club to face a downgrade. As feared, the cancer of bank leverage is spreading to sovereign cores.

Gold prices tend to slide in late May and languish through the summer, because of the seasonal ups and downs of jewellery demand. The trader reflex would be to short gold at this stage after its $90 vault to $959 an ounce over the past month. They may think again this year.

Paulson & Co. has bought $2.9 billion in SPDR Gold Trust, the biggest of the gold exchange-traded funds (ETFs), which now holds 1,106 tonnes -- three times the Brown-gutted reserves of the United Kingdom.

Mr Paulson has also built up a $2.3 billion holding of Anglo Ashanti, Goldfields, Kinross Gold, and Market Vectors Gold Miners. The fact that he is launching a "Paulson Real Estate Recovery Fund," reversing the bet against sub-prime securities that made him rich, tells us all we need to know about his thinking. This is a liquidity-reflation play.

He may be wrong, of course. In his early 50s, he belongs to the baby-boom cohort most psychologically vulnerable to the 1970s "paradigm error." And perhaps he has never lived in Japan.

It is striking how many of those most alert to the deflation danger are either veterans of Japan's Lost Decade or close students of it: Albert Edwards at Societe Generale, Russell Jones at RBC Capital, Nobel laureate Paul Krugman, the Fed's Ben Bernanke, and Athanasios Orphanides, who helped draft the Fed's study on the Japan trap.

"People always thought Japan's bond yields had to rise, but they kept falling and Japan is still not really out of deflation," said Mr. Edwards. Indeed, 20 years after the Nikkei peaked at over 39,000 it stands today at 9,280. Interest rates are 0.01 percent. The yield on two-year state bonds is 0.34 percent. Still there is not a whiff of inflation.

A number of readers have written to me in tones of polite reproach asking why I fret about deflation when governments everywhere are spending and printing as if there was no tomorrow. I admit to being tortured by self-doubt, like others grappling with this extraordinary situation.

What we know is that inflation is already negative in Ireland (-3.5 percent), China (-1.5 percent), Thailand (-0.9 percent), Korea (-0.5 percent), U.S. (-0.7), Japan (-0.3), Switzerland (-0.3), Spain (-0.2). The eurozone may be negative by July. Alistair Darling said Britain's retail RPI inflation used to set wage deals will be minus 3 percent by September.

Does this constitute deflation in a meaningful sense? Not yet, perhaps. But it is moving too close for comfort in a world stretched by extreme leverage. The economies of the U.S., Japan, the eurozone, and Britain have been contracting in "nominal" as well as "real" terms -- which smacks of the 1930s.

The "yen GDP" of Japan has shrunk by 10 percent in one year; the "euro GDP" of Germany has shrunk 6.2 percent, and Italy's by 4.7 percent; the "dollar GDP" of the U.S. has shrunk 3.3 percent. Debts are not shrinking, however.

GMO's Jeremy Grantham says in his latest note, "Last Hurrah And Seven Lean Years," that the market value of equities, houses, and commercial property in the US reached $50 trillion in the boom. This "perceived wealth" sustained $25 trillion of debt.

The crash has cut this wealth to $30 trillion, but the debts are still there. America's debt-gearing has exploded, as it has in the U.K. and Europe. This looks awfully like Irving Fisher's "debt deflation" trap of 1933. It will be a long slog for households to bring their debt-to-wealth ratios down to manageable levels.

You can argue -- as do UBS, Merrill Lynch, ING, and Capital Economics, to name a few -- that massive global stimulus is merely struggling to offset a massive deflationary shock.

So how will gold fare in a "Japanese" stalemate world where neither inflation nor deflation gets the upper hand? The eight-year rally that has lifted gold from $254 to $959 may lose momentum for a while.

"The air is getting thin up here," said John Reade, precious metals guru at UBS. "Rich investors are no longer rushing out to buy gold bars as they did after the Lehman collapse. Still, we think it is highly significant that both China and Russia -- two of the biggest holders of foreign reserves -- are both buying gold," he said.

Personally, I remain a gold bug out of fear that the most corrosive phase of this crisis lies ahead. There are two more boils to lance: Europe and China. As the International Monetary Fund keeps telling us, Europe's banks are still covering up their vast toxic debts. Nor has the G20 begun to address the root cause of the global crisis, which lies in excess exports from East (aided by currency manipulation) to an overspending West. China is putting off the day of reckoning with its crisis response, which is to build yet more plant to flood the world with yet more overcapacity.

For "political bears" the risk is that the EU polity fragments under strain and that governments restrict basic markets to defend themselves -- whether by imposing exchange controls to stop bond flight, or shutting derivatives markets used as hedges, or putting up trade barriers. We will find out if and when unemployment hits 10 percent in America, 12 percent in Germany, and 20 percent in Spain, or if migrant workers rampage in Shenzhen.

Some call this the "Armageddon case" for gold. That is going too far. However, gold has outperformed Wall Street's S&P 500 index by 500 percent so far this century, as if able sniff out trouble in advance. Such runs tend to finish with a "parabolic" blow-off before they die. Mr Paulson may yet make another fortune, whatever his reason.

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