[A-List] Gold and asset price deflation

[Michael Keaney]

Gold tells a tale of asset deflation in the future
By John Dizard
Financial Times: May 21, 2007 

The dollar gold price would seem to have decisively broken down, with a
trend that appears sustainable for the next several months, probably at
least to the end of this year.

Anthropomorphising markets is not very sensible, but to indulge in that
for a moment, it looked as though gold wanted to break through $700 an
ounce, tried its very best, then failed.

Gold is telling a very different tale than the equity markets, but the
equity markets have hundreds of billions of private equity dollars (in
the US), and a huge, though less quantifiable, pot of domestic savings
(in China) to propel them beyond sensible levels.

Gold is telling us there is more asset price deflation ahead in the US,
principally through a housing market that will be weaker for longer, and
a commodities price peak later this year.

A big trend break in gold tends to precede one in other commodities
prices by at least six months. For the moment, commodity fund managers I
know are still finding large pools of institutional money washing
towards them.

Apart from trend-is-your-friend thinking, supported by five-year charts,
this seems highly dependent on the assumption that the Chinese
authorities will utterly fail to rein in real growth, and on the Federal
Reserve's assumption, based on its creaky standard econometric model,
that US growth will resume in the second half of the year. Gold thinks
otherwise.

Gold takes Ben Bernanke, the Fed chairman, other central bankers, and
their staffs, seriously. The central banks believe that their guide, the
Dynamic Stochastic General Equilibrium model, is giving them the right
signals.

They would disdain the simplistic trend-is-your-friend thinking of
half-educated traders, but there is a lot in common between believing in
trend charts and believing in the DGSE model.

Both serve you well most of the time, but are not particularly good at
calling turns in markets or economies.

The problem that traders have with depending on the trend to be their
friend is that by the time you can see that your friend has abandoned
you, you've burned through your original and variation margin.

The problem that central bank economists have is that at the turning
points in the economy, when correct judgment on their part is most
important, the data their models depend on are at their most unreliable.

As one economist friend of mine says: "There is a huge statistical fog
around the US economy. Every number surprises on the upside and on the
downside."

This is because behaviour patterns are changing. Builders know the bell
has rung on their industry, and are already preparing themselves for
long hard times. Invisible illegal immigrants who were working off the
books and buying goods are drifting back across the borders to their
home countries. You can't extrapolate from past behaviour, which is what
charts and models do, because that behaviour is changing.

Mr Bernanke is a man of unquestionable intellectual integrity. That's a
problem. Alan Greenspan, who was arguably a lesser theoretical
economist, was a far craftier Fed chairman.

While he always had a theoretical rationale for his actions, that "risk
management" policy was merely the public face on his more instinctive
reactions to obscure microeconomic data, the collection and perusal of
which was his main obsession.

This was not as consistent or theoretically defensible as Mr Bernanke's
inflation targeting, but it did serve him in avoiding the policy
overshoots that are the risk of the present Fed approach.

The Fed's models now tell it that the US economy's growth rate will turn
back up later this year. That means that it, and its counterparts in
Europe and elsewhere, will stick to tighter policies longer than they
probably should to avoid an asset price deflation soon.

But it has been the monetisation of asset price inflation in the US, in
recent years through home equity withdrawal, and now through private
equity buy-outs, that has maintained the balance sheet of the consumer.

The builders and buyers know, if the Fed does not, that the housing
market "correction" will be lasting a lot longer.

The private equity tribe knows it is dependent on the continued
availability of credit derivative liquidity. The credit derivatives
people are telling the private equity people that there is a limit on
the capacity they can provide.

I wish the Fed board could hear the open pessimism of many of the credit
derivatives professionals I know, many of whom are figuring how to best
position their firms and their own careers for a prospective bust.

Within a year, though, the gold bear market will have run its course,
and Mr Bernanke's other academic speciality, depression avoidance, will
be called on. He and his counterparts in Europe, Japan and China will be
called on to keep the global Ponzi scheme going, because the real
economies cannot stand a bust in the financial economies. In
anticipation of that rapid reversal, gold will take off as it hasn't for
a generation.

So sell gold now, but wait for it to begin a dramatic rally next year.


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