Gold versus debt-based dollarmania

There is a reason why gold has survived centuries as a monetary asset without paying a dividend. It is nobody's liability.

Gold is debt-free (image: Fuu J)

The broad overhang of sovereign liabilities over the economy is something that many in the modern investment management industry have never had to confront on the scale that confronts us now.

The great financial crisis was driven by private debt, primarily housing. Once the debt bubble popped in 2008, central banks came to the rescue by bailing out the wealthiest of the G7 via QE and other monetary tricks. When the pandemic hit, central banks doubled down on their asset inflation strategies, but this time governments joined in with massive fiscal stimulus. That stimulus transferred risk from the private sector to the public purse.

However, some governments are now finding out that there is a limit to how much money they can borrow at cheap rates. The United Kingdom found that out this month after Chancellor Kwasi Kwarteng unveiled a financial energy subsidy and an economic stimulus package that was long on planned spending but short on details on where he would get the money to pay for it all. The result was a selloff in U.K. Gilts which spilled over to other major bond markets including the US Treasury market.

Because there was no transparency around the UK spending plans, it is a bit of a guessing game as to how much it will push up the deficit. We estimate that the spending, which includes 45 billion pounds in tax cuts, will push the UK budget deficit to at least 5.0% of GDP given that the deficit is already expected to be 3.9% for 2022/23. However, while the UK is getting all the attention, soaring interest rates are not leaving the US budget deficit unscathed.

Here comes the US budget deficit (image: Zoë Reeve)

The Congressional Budget Office (CBO) which provides non-partisan forecasts for the US fiscal situation, assumed in its May 2022 outlook that 3-month T-bills the next fiscal year would be 1.8% and the 10-year yield would be 2.8%. These projections will clearly need to be revised higher. That will have a significant impact on the expected US deficit next year. Based on early week levels, the current 3-month rate is 1.5% over projections and the 10-year is 1.1% over.

According to the Brookings Institute, the duration of the US Treasury issuance is about 5 years. A reasonable approximation for the jump in funding yields facing the Treasury is an average of the overshoots of the 3-month and 10-year yields. Based on that very rough math, we would not be surprised to see net interest expense next year jump from $442 billion to $708 billion. That could push the US budget deficit to $1.25 trillion next year, taking it to about 4.8% of GDP, a full percentage point higher than the current CBO base case projection. Obviously, there are many other variables such as tax revenues that will determine the ultimate deficit.

 

US budget deficit on the rise

 

Nevertheless, nobody is talking about the prospect of the US budget deficit hitting 5% of GDP next year. The higher the deficit goes, the riskier US debt becomes.

That brings us back to gold.

There is no government deficit associated with gold. There is no credit associated with gold. It is just gold, a mineral that is extremely hard to find. Unlike British pounds and their associated gilts, or greenbacks and their associated Treasurys, gold has no associated liabilities. As such, it does not need to pay a dividend because once you hold gold, it will not default, and only a thief can take it away from you.

Of course, it is very hard for a sovereign nation to default outright on its debt because it can always print more pounds or greenbacks. So far, the US dollar has soared against other currencies because investors have assumed that the US will be able to manage its debts better than the rest of the world. The US has also benefited from its strong domestic oil & gas industry which the Biden Administration hates.

We believe that bullish US dollar assumptions are about to be tested. On the Energy front, the Administration has been actively trying to dismantle the oil & gas industry. As such, energy companies are being cautious about expanding production. US oil patch insider sentiment remains very depressed. Meanwhile, over the past decades, America has been able to run its deficits thanks to foreigners investing in its debt. Now, as countries around the world struggle to finance their deficits and defend their currencies, they are becoming sellers of Treasurys.

Will foreigners keep selling treasury bonds?

To fund its rising deficits, the US is going to have to either raise taxes, cut spending or debase its debts via a debased currency. Further tax increases are unlikely short of a surprise Democrat sweep in November. Reduced spending is nearly impossible given mandatory outlays and the need to fund the war effort. That leaves some form of money printing as the only option. The Fed and Treasury can resist, but not for long. As investors start to realize that debasement is the only game in town, they will come to understand that the US dollars they hold are someone else's liability.

Investors will look for hedges.

Precious metals are likely top of mind for many investors, particularly the professional money management crowd who will need to come up with some solutions for their clients. Once the mainstream start to understand that gold is nobody else's liability, the big asset mix shift back into precious metals should start.

Bitcoin is a bit of a dark horse in this environment. It is still perceived as a risk asset thanks in no small part to the SEC's approval of a futures ETF instead of a spot ETF, all in the name of consumer protection. Could BTC shake off its correlation with the S&P 500? It is possible, but we will wait for some proof before trying to anticipate such an outcome. At this point, we are seeing few signs of encouragement from the crypto-equities area where the top-ranked stocks in the universe have the benefit of legacy financial businesses to help them through the current dangerous investing environment.

These comments originally appeared in the INK Edge September Top Mining & Crypto stock report: Gold versus debt-based dollarmania. The full report is available on Canadianinsider.com and inkresearch.com.