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Gold’s Long March Upward Continues

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Despite gold’s recent run up to new historic highs, I believe the yellow metal’s price has far to go - both in future percentage appreciation and duration before the great gold bull market comes to its ultimate cyclical end.

Right now, there is no evidence of a buying frenzy to suggest we are anywhere near a long-term top . . . but there are plenty of rock-solid fundamentals that suggest the market is healthy with plenty of room to move higher.  Moreover, the world economic and geopolitical environment remains very supportive - and seems likely to remain pro-gold for years to come.

My forecast, published here on NicholsOnGold and in other speeches and reports, of $1700 gold by year-end 2011, now seems within easy reach.

And this is just the beginning of gold’s next great leap upward, a leap that will carry the metal to $2000 an ounce in 2012 - with prices heading still-higher, quite possibly to $3000, $4000 and maybe even $5000 an ounce by the mid-to-late years of the decade.

From a long-term perspective, gold prices near $1500, should we ever return to that level, $1600, or even $1700 an ounce will prove to be bargains.

As I have cautioned in the past, expect high two-way price volatility and periodic sharp corrections, corrections that some will mistake as the end of the bull market - but consider these opportunities for “scale-down” buying, opportunities to acquire additional metal at bargain-basement prices.

A Pause that Refreshes

Rising some $300 an ounce from its January 2011 low point and more than $120 in just the past few weeks, gold has scored a series of successive all-time highs.  Now, however, there is certainly some risk of a sharp short-term correction, particularly if the political-economic news on either side of the Atlantic looks less threatening to financial market stability.

A political compromise to raise the U.S. Treasury debt ceiling and agreement to narrow the Federal deficit in future years that avoids any downgrading of Treasury debt by the rating agencies would remove or reduce an important source of anxiety that has contributed to gold’s recent strength.  News of positive movement toward or actual completion of an agreement could trigger a swift - but temporary - gold-price retreat.

Speculative long positions held by institutional traders on world derivative markets have increased sharply in recent days.  Should the market lose upward momentum, speculative pressures could quickly turn negative.  Moreover, if the short-term news turn bearish for gold, liquidation of these long positions and/or institution of new speculative short positions could leave the market especially vulnerable to a swift correction .

Adding to my short-term caution has been a price-related relaxation of physical demand and the appearance of increased quantities of gold scrap returning to the market, especially from India and other price-sensitive national markets in recent weeks as prices rose above $1550 and approached $1600 an ounce.

I expect Indian and Chinese scrap reflows will diminish significantly over time, even at high price levels.   In the meanwhile, should gold approach or fall below the $1550 level, scrap supplies will quickly abate and price-sensitive demand, smelling a bargain, will re-appear.

Hot Summer, Hotter Autumn

Contrary to the view expressed by most serious gold analysts, we said in past reports that gold would not pause for its typical summer vacation — and it hasn’t!  Nor would we see this summer a seasonal relaxation in price volatility.  Indeed, it has been a very hot summer as gold moved up smartly to achieve new all-time highs with plenty of fireworks and price volatility both up and down.

However, come September, positive seasonal factors will kick in - and, other things being equal, give gold still more firepower. There are three distinct sources of seasonal demand, all of which will likely contribute to demand and higher prices as we move into the later few months of 2011:  First, jewelry manufacturers step up fabrication demand ahead of Christmas gift-giving late in the year; second, Indian dealers begin stocking up ahead of the autumn festivals and wedding season, and in expectation of good harvests and healthy household incomes in the gold-friendly agrarian sector; and, third, later in the year and in early 2012, we should expect a sharp rise in gold investment and jewelry demand associated with the approaching Chinese lunar new year.

For sure, irrespective of the season, price-sensitive Asian demand - principally from China and India - for physical metal will continue to underpin these markets and limit downside risks.

So too will bargain hunting by a number of central banks eager to raise their official gold holdings without disrupting the world gold market by increasing upward price volatility.

Central Banks Rediscover Gold

Official statistics published monthly by the IMF show that central banks, as a group, have been busy buying gold.  Russia, India, China, Saudi Arabia, Mexico, and Brazil have been among the big buyers in recent years and a number of other countries have added smaller amounts of gold to their official reserves.  One big surprise was Mexico’s purchase of some 100 tons earlier this year as a hedge against the possible decline in the value of their U.S. dollar reserve holdings.

Moreover, a recent survey of 80 central bank reserve managers predicted that the most significant change in their official reserve holdings in the next 10 years will be their intentional build up in gold reserves.  They also predicted that gold will be their best performing asset class over the next year and sovereign debt defaults will be their principal risk.

Sovereign Debt Crisis Prompts Safe-Haven Demand

European Central Bank president Jean-Claude Trichet a few weeks ago raised the alarm level on Europe’s debt crisis to “red,” warning that the crisis is nowhere close to being resolved . . . and he also warned of the “potential contagion effects across the [European] Union and beyond.”

Meanwhile, Europe’s sovereign debt problems are worsening and the likelihood of sovereign default by one or another of the more vulnerable periphery economies is increasing, despite the past week’s patchwork aid package that avoided (or more likely postponed) a sovereign default by Greece.

Despite all the talk among finance ministers and the European central bank, it looks like the future fate of “periphery’ country debt is increasingly in the hands of the credit rating agencies who view any delay in full repayment as partial default.

Several factors suggest that the European debt crisis will continue to worsen:

Longer term, the more restrictive fiscal policies the periphery nations (Portugal, Ireland, Italy, Greece, and Spain - the so-called PIIGS) have been asked to accept will push their economies deeper into recession - and increase, rather than decrease, government deficits and borrowing needs for years to come.

More immediately, the downgrading of sovereign debt by the rating agencies raises interest rates and borrowing costs - and pushes these countries closer to the brink (a lesson that the United States needs to learn before it also finds itself with higher Treasury borrowing costs should we suffer a cut in our own debt ratings on U.S. Treasury securities).

As credit ratings decline for the peripheral countries, the rising cost of refinancing maturing debt make it all that much more difficult to keep their heads above water.  Reflecting the recent deterioration in credit ratings, Greek two-year bond yields last week were over 35%, Spanish 10-year bonds hit a record 6.3%, and Italian 10-year bonds were  also yielding around 6%.  Higher borrowing costs will increase government deficits and make repayment of past debt all the more difficult.

An important aspect of the crisis is that default on European sovereign debt, debt that is held by many European banks, will require the banks to write-down these questionable assets, leaving them with insufficient capital and effectively bankrupt.

The broader effect of bank failures on the European economy, capital markets, and banking system could be far more devastating than the Bear Sterns and Lehman Brothers debacle in the United States - and would likely result in the European Central Bank along with the U.S. Federal Reserve flooding financial markets with newly created money, depreciating paper currencies, inflating prices, and boosting gold.

I continue to believe that ultimately the euro, Europe’s single currency, will be replaced by a multi-currency system - with the core countries possibly retaining the euro while the periphery nations will revert each to their own monetary unit or a deeply devalued renamed euro of their own.

With no solution in sight, Europeans will continue to abandon the euro for “safe havens” including gold and, ironically, the U.S. dollar.  At the same time, the problems of the euro will discourage its acceptance as a reserve currency by some central banks - and make gold an even more attractive alternative.

Meanwhile, Back at the Fed

The U.S. economy is still mired in recession, or worse.  Nearly everyone knows it, even if the official statistics show some positive growth in real GDP.  Unemployment remains stuck at over 9 percent.  The huge inventory of foreclosed homes held by banks continues to weigh heavily on home prices.  Various economic indicators released in the past few days and weeks are pointing to the second dip in what may be called a double-dip recession.

So far, most Washington politicos and Wall Street bankers are in denial, refusing to see the worsening signs of renewed recession.  Instead, they are arguing for restrictive economic policies that, if enacted, would exacerbate the developing downturn . . . and which future history books will liken to the policy mistakes of the 1930.

The Fed also fails to see, at least publically, the writing on the wall.  Having ended its program of quantitative easing at the end of June as scheduled, it will - in my view - soon be forced by rising unemployment and sluggish business activity to resume monetary stimulus in one form or another.  Contrary to popular belief, the Fed can stimulate the economy and liquefy the financial system through open-market purchases of securities and even real assets, not just Treasury securities but stocks, corporate bonds, commercial paper, mortgages, credit-card debt, student loans and even real estate.

The resumption of quantitative easing (QE3) or some other program of monetary stimulus will be reflected in a swift and significant jump in gold prices.

As I have said in past reports and speeches, the only viable and politically acceptable means for America to dig itself out of its unbearable burden of excess debt - federal, state and local, housing, and other private-sector debt - is to pursue a pragmatic policy of higher inflation that will deflate the ratio of outstanding debt to nominal gross domestic product (GDP) to historically acceptable and manageable levels.  This is what we did in the 1970s, a decade of stagflation, and we’re already doing it again.  Indeed, under Chairman Bernanke’s lead, the Fed is quietly pursuing this policy of targeting somewhat higher U.S. price inflation.

Pursuit of a mildly inflationary monetary policy will not however excuse the Congress and Administration from developing a responsible believable program of long-term spending restraint and deficit reduction.  However, now is not yet the time to impose these restrictions on an ailing economy - though articulation of a realistic bi-partisan plan for long-run deficit and debt reduction would help calm world financial and currency markets.

Whatever happens in the U.S. and European economies, it is hard to imagine a realistic scenario that won’t push gold prices significantly higher in the months and years ahead.

Other Pro-Gold Trends Continue

Meanwhile, other important pro-gold trends continue unabated.  These bullish trends include:

  • The growth in Chinese, Indian, and other Asian gold demand accompanying their expanding economies, growing wealth, rising inflation, and historic affinity to gold in jewelry and as a saving and investment medium.
  • The expansion of the gold investment infrastructure around the world - such as the development of gold exchange-traded funds and other forms of physical gold . . . or the implementation of gold distribution systems through banks and other retail outlets in China, India, and elsewhere).
  • The recognition of gold as a worthy asset class for inclusion in investment programs and portfolios of individuals; pensions, endowments and other institutions; sovereign wealth funds; and central banks.
  • The relative stagnation of new gold-mine production (certainly in comparison to the growth in gold demand) and the rising costs of discovery, development, and operation of new mines.

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Global Inflation Rising and Other Pro-Gold Developments

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Clients and readers of NicholsOnGold.com should not be surprised by gold’s recent rebound.

In late January, as gold was testing recent lows near $1,310 an ounce, we said “the fundamentals suggest much higher prices ahead” with “market activity strengthening the case for a surprisingly sharp snapback and new all-time highs later this year.”

Indeed, we anticipate gold will retake its all-time high near $1,432 an ounce in the months ahead . . . and reach $1,700 later this year . . . on its way to $2,000 an ounce in 2012 . . . and still higher prices in the next few years.

(Readers interested in frequent brief analysis, commentary, and insights are invited to follow us on Tweeter @ NicholsOnGold.)

Global Inflation Rising

One of the key forces contributing to expected gold-price strength is the acceleration in inflation now underway around the world.

It seems that almost everywhere - except here in the United States - inflation is on the rise.  We now read daily about the rise in agricultural, energy, and industrial commodity prices from one country to the next - and the consequential acceleration in consumer prices.  China, India, Brazil, the United Kingdom, and the Eurozone economies make the newspapers because these are the largest economies after the United States and they are the most populous, too.

But, less noticed outside their own borders, one country after the next, is suffering from higher prices, especially for food and energy - and the acceleration of inflation in some countries is beginning to have broader social and political consequences as we have seen recently in Tunisia and Egypt.

Today’s global inflation is largely a consequence of U.S. monetary policy and the unbridled flood of dollars into the world economy on the one hand . . . combined with an unwillingness among central bankers in the other big economy countries to allow upward appreciations of their own currencies.

Just as in the United States, central bankers in these countries prefer economic expansion and happy workforces to low inflation with higher unemployment.  And, although some - China, India, and Brazil, for example - are raising interest rates and restricting bank lending, these measures are intentionally insufficient to greatly restrain future economic growth and, therefore, insufficient to restore price stability in their respective economies.

It’s no wonder that smart savers and investors in China and India are buying hundreds of tons of gold a year - and will most likely continue to do so even as gold prices move significantly higher.

Anyone worried about inflation should be worried about the fantastic growth in the Fed’s holdings of U.S. Treasury securities.  Recently, the Fed surpassed China as the largest holder of U.S. Treasury securities - and by mid-summer the Fed will likely hold more Treasury securities than both China and Japan combined.

The explosive growth of U.S. Treasury securities - T-bills, notes, and bonds - held by the Federal Reserve is the flip side of the central bank’s policy of quantitative easing.  The Fed has now replaced foreign central banks as America’s financier, funding our Federal budget deficit by creating new money.

This is a policy that must eventually result in a significant erosion in the greenback’s purchasing power brought on through a depreciation of the U.S. dollar in world currency markets and an acceleration of inflation here at home - an acceleration that is bound to occur irrespective of continuing economic slack, high unemployment and low capacity utilization.

Other Pro-Gold Fundamentals

In addition to rising global inflation and inflation-fueling U.S. economic policies, other on-going trends in the world of gold will also contribute to higher prices later this year and beyond:

Continuing strong gold demand for jewelry and investment - even in the face of higher prices - from China, India, and other gold-friendly Asian and Middle Eastern nations.  Demand from these countries is driven by rising household incomes and rising inflation expectations - and these trends are likely to persist for some time to come.

Continuing official purchases by China, Russia, and other cash-rich central banks with “under-weighted” gold reserves.  Central banks tend to buy on dips when their purchases are least likely to disrupt the market - and official demand in recent weeks with prices near $1,320 helped stabilize and reverse the short-term price decline.

Expanding investment demand from a small but growing segment of retail investors in the United States and Europe who are worried about rising inflation and currency depreciation . . . and from hedge funds and other institutional investors who understand gold’s bullish fundamentals.

Given the relatively small size of the gold investment market relative to world stock and bond markets or major currency markets, a very small shift in portfolio preference away from conventional assets in favor of gold may have a negligible affect on the stock and bond markets - but will have a big affect on the price of gold.

Easier access to gold through new investment vehicles, especially exchange-traded funds, is promoting the growth in gold investment from one country to the next.  Even India and China are jumping on the bandwagon with new ETFs denominated in local currencies and weight units familiar in each country.

Imagining the Unpredictable

In addition to these somewhat predictable gold-positive trends, unpredictable geopolitical developments could, under certain circumstances, have an overwhelming affect on the price of gold.

What if Egypt sinks into a prolonged period of social and political chaos?

What if the Suez Canal is threatened or closed by political developments or by terrorism?

What if similar spontaneous revolutions erupt in Lebanon, Yemen, or Saudi Arabia, the world’s largest source of oil?

What if new governments in the region threaten Israel militarily?

What if Iran takes advantage of the political vacuum created by these popular uprisings?

Or, in other regions . . .

What if North Korea launches another, but more serious, assault on the South?

What if Europe’s sovereign debt problems erupt again, triggering a flight from the euro?

And, closer to home . . .

What if Congress and the Obama Administration fail to make any significant progress in balancing America’s Federal budget deficit, triggering a flight from the dollar?

Any of these events are certainly plausible - and there are many others we simply can’t imagine - but each has the potential to send gold skyrocketing.

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Looking for a Snap Back

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January has been a difficult month for gold, so much so that many market mavens - analysts and investors alike - are abandoning their bullish expectations.

From its year-end 2010 price near $1,420 an ounce to its recent low just over $1,320 gold has so far shed some $100 - about seven percent.  Measured from its all-time high just over $1,432 in early December, the recent decline is less than eight percent.  Either way, in percentage terms, this doesn’t amount to much of a correction in the metal’s 10-year old bull market.

Bright Fortunes

In contrast to gold’s naysayers and born-again bears, I believe gold’s fortunes remain very bright.

What’s more, recent market activity, rather than signaling an end to gold’s decade-long advance, strengthens the case for a sharp snapback in the metal’s price and new all-time highs later this year.

Indeed, with gold’s fundamental price drivers all remaining supportive, I expect another strong advance over months ahead - with the yellow metal rising to $1,700 an ounce by year-end 2011.  While this seems like a lofty target, it amounts to “only” 19 percent above the recent market lows and is dwarfed by last year’s 29-percent annual gain and the even bigger 32-percent advance registered in 2007.

Euro Trigger

Much of gold’s price action in recent months has been triggered by the ebb and flow of “safe-haven” funds into and out of the euro.

Whenever Europe’s sovereign debt problems worsened or the life span of the European currency seemed more uncertain, a flight of capital and speculative funds out of the euro into both the dollar and gold - perceived as “safe havens” - gave both the greenback and the yellow metal a boost.  And, whenever sovereign debt fears subsided, safe-haven demand for the dollar and gold diminished.

Historically, gold and the dollar have typically moved in opposite directions:  Think weaker dollar, stronger gold; stronger dollar, weaker gold.

But lately, the two have moved up and down together like Siamese twins - rather than in opposition as history suggests.  We can now see why: Both gold and the dollar are being driven up and down together as confidence in the euro waxes and wanes.

To the detriment of both gold and the dollar, a number of developments have come together in recent weeks to boost euro confidence and push the currency to a two-month high.  The list includes:

  • A spate of better-than-expected economic indicators,
  • The successful refunding of sovereign debt by Portugal and Spain,
  • Strong demand for the euro-zone rescue fund’s first-ever bond issue, and
  • Tough anti-inflation talk from European Central Bank President Jean-Claude Trichet.

This good news won’t last forever.  Instead, significant economic and social disparities between the stronger “core” economies (led by Germany and the Netherlands) and the weaker “peripheral” economies (such as Iceland, Ireland, Portugal, Spain, and Greece) will continue to threaten the viability of Europe’s common currency.

Sooner or later another funding crisis will trigger a new wave of capital flight seeking a safe haven in the dollar . . . and gold.

Who’s Selling . . .

To understand where gold prices are headed this year, its important to recognize that most of the selling in recent weeks has come from U.S. and European short-term institutional traders and speculators - banks, trading firms, commodity funds, and hedge funds - operating mostly in derivative markets, some simply taking profits, others betting on the downward momentum of the market, and many reacting to the reversal of “safe-haven” funds that late last year sought security in U.S. dollar assets and gold.

These players have no long-term view of gold and certainly no allegiance to the metal as an inflation hedge, store of value, portfolio diversifier, insurance policy, and traditional savings medium.  They simply sense a profitable trading opportunity.  Today gold is in their sights.  Tomorrow, it may be petroleum, cocoa, rice, steel or long-term U.S. Treasuries.  And, one day they will be buying gold again.

. . . And Who’s Buying

In contrast, strong physical demand not only continues but may very well have picked up as lower price levels attracted bargain hunters.  Much of the buying has come from Asian markets - China, India, and other countries where gold has great cultural appeal as a store of value, savings medium, and harbinger of good luck and prosperity to those who hold it.

Big premiums (over New York and London prices) on gold bars in Hong Kong, Mumbai, and other gold-trading centers across the region indicate a shortage of physical metal as refiners struggle to meet strong demand for the various bar sizes popular in the Asian markets.

It is also likely that some central banks are taking advantage of the current price decline, quietly adding to their gold reserves or accelerating their purchases.  Likely buyers include the People’s Bank of China, the Bank of Russia, and possibly one or more of the reserve-rich oil-exporting countries.

In fact, all of the central banks that have bought gold in recent years today remain significantly underweighted in gold.  All still hold the lion’s share of their official reserves in U.S. dollar securities . . . and all have an incentive to buy gold on major price declines.

Strong Hands

Significantly, this dichotomy between buyers and sellers means that gold is moving into very strong hands and much of this metal is unlikely to come back to the market anytime soon.

Buyers in Asia are mostly long-term holders, often for a lifetime.  Similarly, many of the retail and wealthy buyers of bullion coins and small bars in America and Europe are motivated more by fear than by greed and are likely to retain their physical gold holdings for years to come.

As a result, when the current wave of selling abates, gold will have the potential for a swift and sizable recovery - all the more so if these same players view the metal as an attractive vehicle for trading and speculation on the long side of the market.

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GOLD 2011: Another Banner Year

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Gold began the new millennium under $300 an ounce . . . and under a cloud of pessimism among even many of its most ardent advocates.  To mainstream investors and central bankers around the world, its two-decade decline (from 1980’s all-time high near $875) confirmed the yellow metal was no more than a “barbarous relic.”

What a difference a decade makes!  Ten years later, gold had advanced to more than $1000 an ounce - to $1087.50 basis the December 30, 2009 London PM fix - for a gain of roughly 275 percent over the ten-year period.

Gold - By the Numbers

Gold’s steep ascent continued in 2010, finishing the year in New York at $1,420.75.  Though just shy of its all-time high of $1,432.50 registered on December 7th, gold nevertheless advanced some 29.5 percent from the prior year’s close and scored its tenth consecutive annual increase.

Despite a rocky start - with prices dipping briefly under $1,360 an ounce on January 7th - 2011 promises to be another stellar year as the metal’s bullish price drivers continue at full throttle.

I expect the price will very likely rise to the $1,700 level by year-end 2011.  This would be a “modest” gain of “only” 19 percent from last year’s closing price.  And, with the right confluence of events, gold could quite possibly rise to $1,850 or higher by next New Year’s Eve.

Over time and across currencies, bull markets in precious metals often last twenty years or more - so we should not be surprised to see the current decade-long advance continue for at least a few more years.

Indeed, I strongly believe gold will surpass $2,000 an ounce in the next few years . . . and I wouldn’t be at all surprised to see gold reach $3,000 or higher at the next cyclical peak.

Gold prices are likely to remain volatile, registering big short-term swings both up and down.  Although sizable intermittent price declines will lead some to question the bull market’s staying power, the long-term trend, as noted above, will remain positive for years to come.

Physical Demand Remains Firm

As we begin the New Year, physical demand in key world gold markets - especially China, India, and other Southeast Asian trading centers - has remained remarkably firm despite the record price levels prevailing in recent weeks.

In the past few years, each time gold prices reached for the big round numbers - $900, $1000, $1100, $1200, and $1300 - buying interest diminished and a return flow of price-sensitive old scrap weighed heavily on the market.  But now, even with prices once again at or near all-time highs, physical demand remains remarkably strong and only limited quantities of old scrap are coming back to the market.

This suggests not only a continuing price appreciation and revaluation of gold - but also a mental re-evaluation and upward shift in expectations among many gold-market participants about the metal’s future price. 

If physical buying remains fairly firm - as I believe it will - we can expect that gold will soon advance to new all-time highs.

Bullish Price Drivers

In brief, here are the seven fundamental reasons why gold’s long-term outlook is rosy:

Number One: Inflation-producing U.S. monetary policies, irrational U.S. fiscal policies, little if any progress reversing growth in Federal debt, and a depreciating dollar overseas all promise rising inflation at home.  Higher industrial and agricultural prices around the world and across currencies are a harbinger of things to come.

Number Two: No quick or easy solution to the Eurozone sovereign risk crisis, a widening economic schism across the continent, and possibly the demise of Europe’s common currency, the euro, as it exists today.

Number Three: China’s already huge and growing appetite for gold - both jewelry and investment - will continue in tandem with economic growth, rising personal incomes, worrisome inflation expectations, and pro-gold government policies.

Number Four: Rising long-term gold demand from India and other traditional Asian gold markets reflecting (as in China) growth in personal incomes and wealth, the maturation of local markets, and introduction of new gold investment vehicles and distribution channels.

Number Five: Increasing central-bank interest in gold will continue to underpin the market as countries (such as China and Russia) over weighted in U.S. dollar and euro currency reserves and under weighted in gold play catch-up - and as both the dollar and the euro continue to lose their appeal as official reserve assets.

Number Six: The continuing reevaluation of gold as a legitimate investment class is prompting greater participation from both retail and institutional investors in the United States and Europe, coupled with new products and channels of distribution (especially the growing popularity of gold exchange-traded funds) will continue to make gold more convenient, more attractive, and more accessible to more investors around the world.

Number Seven: Little or no growth of aggregate world gold-mine production for at least the next five years - with gold-mining nations absorbing more of their own production to meet domestic demand for jewelry, investment, and additions to central bank reserves.

Pro-Gold U.S. Monetary Policy and Fiscal Folly

Despite all the rhetoric to the contrary emanating from Washington in the past month or two, Congress and the American people simply are not yet willing to take the tough steps necessary to reign in an out-of-control budget, let alone shrink the country’s immense Federal debt.

Just consider the fiscal package passed by Congress and signed by President Obama late last year:  Showing no signs of restraint, it guarantees to add some $850 billion, give or take, to the Federal budget deficit - and possibly much more if, as I believe, the underlying assumptions about prospective economic recovery prove overly optimistic.

Where will the money come from if not from higher tax revenues and lower public-sector spending?  Well, obviously from America’s central bank, Washington’s financier of last resort, whose policy of quantitative easing is already financing America’s out-of-control government spending as it purchases U.S. Treasury debt with newly created money.

This policy is only just beginning to erode the U.S. dollar’s purchasing power - an important reflection of which will be rising inflation and a much higher future price of gold.

Had the recent fiscal package included a credible plan for significant long-term deficit reduction, institutional investors and foreign central banks, who have historically funded America’s deficit spending, might be more willing to continue taking on more U.S. government debt.

Instead, the growing reluctance of central banks and private investors to pour more good money after bad, to buy more debt that will someday be repaid with cheaper dollars, is already pushing up long-term interest rates in the United States, a trend that will retard the Fed’s accommodative policies - and prompt still-more stimulative monetary initiatives as the central bank tries to keep the economy from slumping back into a more painful recession.

Most conventional economists in and out of government see the recent rise in U.S. long-term interest rates through rose-colored eyeglasses - as evidence of a nascent self-sustaining business-cycle recovery.  In contrast, I believe this rise in long-term interest rates is the unfortunate consequence of investor and foreign central bank reluctance to accumulate more U.S. Treasury debt unless current yields include a bigger premium to protect against expected future inflation.

Persistent economic weakness and recession-like, if not outright recessionary, business conditions mean that the Federal Reserve will keep the pedal to the metal for some time to come.  And, as in the past year, continuing aggressive quantitative easing will push gold prices higher.

The recent retention of the so-called Bush tax cuts and extension of unemployment benefits to millions of long-term idled workers may, in the short run, lift consumer and investor optimism that the recovery is now on a self-sustaining path.

But, this is wishful thinking.  A significant increase in Federal budget deficits for years to come will be accompanied by higher long-term interest rates.  As a result, much, if not all, of the presumed fiscal stimulus will be offset by higher bond yields even as the Fed monetizes America’s rising debt.

Washington’s inside-the-beltway economists and most of their private-sector colleagues have not accounted for the economic drag arising from higher yields, drag that will require still-more monetary stimulus from the Federal Reserve.

Optimistic forecasts are also underestimating the effect of state and local government budget problems on the country’s overall economic performance.  Many of the 50 U.S. states, not allowed by law to run budget deficits, are also entering a year of substantial cuts in public-sector employment and wages, social services, and grants to local governments and school districts - and substantial increases in income taxes, sales taxes, and user fees.

These steps to balance state and municipal budgets will have a significant negative effect on economic activity - not only cutting public spending but also spending by households and businesses to an extent that is not fully accounted for in the more optimistic forecasts of a self-sustaining recovery.

Across the Atlantic - Breaking Up Is Hard To Do

Meanwhile, across the Atlantic, some European countries are slashing government spending so deeply that economic activity will slow or, worse yet, contract, forcing unemployment rates still higher.  And, despite spending cuts and higher tax rates, government revenues will fall, blunting the hoped-for reduction in government deficits and perceived sovereign risk.

As a result, rather than improving their creditworthiness, some countries may see their credit ratings marked down still further, forcing the European Central Bank to bail out its most-endangered members yet again by its own program of quantitative easing through the purchase and monetization of member-country sovereign debt.

Meanwhile, the growing disparity between the stronger “core” economies (led by Germany and the Netherlands) and the weaker “peripheral” economies will further threaten the viability of Europe’s common currency, the euro, with capital flight and speculative money flowing into both the dollar and gold - contributing over time to the metal’s expected appreciation and masking the greenback’s inherent weakness.

Recent developments, especially the difficulties of a number of countries to finance their existing deficits and refinance their maturing debt, illustrate the lack of political and social cohesion necessary to maintain a single currency.

What is missing is a shared sense of common statehood.  The disparity in inflation rates, fiscal policies, employment markets, and economic productivity that separates the poorer peripheral nations from the wealthier core economies is a gap that is proving too wide to bridge with a single currency.

Many of the weaker economies are simply not competitive versus their stronger neighbors.  To become more competitive, wages and living standards must fall . . . but electorates will not willingly accept this path.  In the old days before a single currency, countries could regain their international competitiveness by depreciating their own currencies - but, in Europe’s single-currency regime, this is no longer an option for individual members, all of whom now lack their own currency and exchange-rate policy.

A voluntary reduction in living standards by the populations of the poorer countries is not a politically acceptable social burden.  In a few countries it is likely that right-leaning political leaders will be replaced by left-leaning politicians who are unwilling to pursue the extreme austerity programs required by the single-currency system.

The only thing now holding the European single-currency monetary system together is the high cost and seeming impossibility of managing a break-up.

While the euro may survive another year or longer, periodic funding crises will push its exchange rate lower - possibly to parity with the dollar in the next few years.  Meanwhile, its role as a second-string reserve asset and international numeraire has been irreversibly damaged.

A tarnished euro, periodic funding crises, and fears of a euro break-up will benefit gold in the year ahead and beyond - even if the lion’s share of scared money and safe-haven demand find shelter in U.S. dollar financial markets.

Chinese Liberalization Promotes Rising Demand

Private gold investment was banned and the market was tightly controlled for more than five decades following the Communist Party takeover in 1949.  Ever since the legalization of gold investment and the gradual liberalization of the market beginning in 2002, the Chinese appetite for gold has been growing by leaps and bounds.

Much of the growth in China’s gold demand over the past few years has been a result of the government’s liberalization of the domestic gold market, its encouragement of private gold investment, and the development of new investment vehicles and channels of distribution.

As a result, China has become a powerful driving force in the world gold market, alone accounting for a few hundred dollars in the thousand-dollar price advance in the years since liberalization.

China’s gold investment demand rose by roughly 75 percent last year to an estimated 170 tons while gold jewelry purchases rose by some ten percent or so to 380 tons - putting total consumption in 2010 around 550 tons.  While the country has seen a significant rise in domestic mine production, so much so that it is now the world’s biggest gold-mining nation, imports are necessarily rising to fill the supply-demand gap.  China’s legal and illegal gold imports may have totaled as much as 250 tons last year - giving the country an increasingly important price-setting role in the world gold market.

These trends are likely to continue, if not accelerate, in the next few years reflecting demographics, strong economic growth, rising personal incomes, worrisome inflation, and the continuing development and maturation of the gold-market infrastructure.

China’s first gold exchange-traded fund (a hybrid that invests in overseas gold ETFs) was launched this past December and was quickly fully subscribed.  I anticipate several other gold ETFs (or similar exchange-traded products) will be launched this year giving Chinese investors - both households and institutions - greater access and choice.  I suspect Chinese-listed gold ETFs will grow rapidly in the next few years, just as they have in the West, possibly with a profound effect on the world market and the U.S. dollar gold price.

China - Continuing Growth Despite Monetary Tightening

The recent and prospective monetary tightening by China’s central bank, the People’s Bank of China (the PBOC), will not diminish the country’s growing appetite for gold jewelry and investment.

PBOC policy actions - raising interest rates and some bank reserve requirements - are in response to super-strong economic activity and accelerating domestic price inflation.  But, real interest rates (after adjustment for inflation) are actually falling . . . and have become more stimulative and supportive of gold.  Moreover, Chinese monetary authorities would like to see more, not less, private gold investment.

At most, Chinese authorities are trying to cool a hot economy and slow the annual rate of GDP growth from around ten percent to a more sustainable pace around seven percent.  I have long argued that the country’s long-term bullish influence on the world gold market would continue as long as China’s economy continues to chug along at a moderate rate with or without worrisome rates of consumer price inflation.

If inflation accelerates, as it has recently, led by rising food and commodity prices, that’s just icing on the cake, boosting gold demand still more.

While news of monetary tightening by the People’s Bank of China may occasionally trigger brief short-lived reductions in gold purchases, China’s gold demand is likely register strong growth this year and beyond . . . and is likely to have a powerful influence on the future price of gold.

Indian Demand Heats Up

India’s appetite for gold is once again hot as curry.  As in China, economic growth has been strong with GDP up smartly last year - and inflation has been showing signs of heating up too.  Good summer monsoons brought healthy autumn harvests . . . and, as a result, income to the agrarian sector has been the best in years.  Importantly, the agrarian sector accounts for a lion’s share of the country’s gold consumption.

Imports of gold surged during the third quarter, so much so that total 2010 imports could reach 800 tons or more, up from 595 tons last year - putting India, for now, far above China as the biggest gold-consuming nation.

India has historically been a very price-sensitive market.  Typically, buying interest falls off as prices rise . . . and, at higher prices, India women are known to take profits, cashing in their bangles and chains, so much so that Indian gold scrap can be an important short-term source of supply to the world market.

In the past, Indian gold buying and re-selling often locked the U.S. dollar price of gold into trading ranges with low prices triggering more buying and higher prices triggering more selling.

In contrast, we are now seeing much less price sensitivity of demand.  Even at recently prevailing prices around $1,400 an ounce, Indians now seem eager to continue buying - suggesting a psychological reevaluation of gold’s future price prospects.

As in China, Indian gold investment is being securitized by the growth in gold exchange-traded funds. First introduced in 2007, there are now 10 gold ETFs with physical gold held on behalf of investors totaling more than half a million ounces (about 15.5 tons) - and holdings could easily double this year as more mainstream stock-market investors participate.

Central Banks Buying More

After net sales of roughly 400 to 500 tons a year over the prior decade, the official sector (central banks, the International Monetary Fund, and sovereign wealth funds) became a net buyer of gold in 2009.  Last year, net official purchases continued as a number of central banks, principally in Asia, added to their official reserves while sales by European central banks continued to diminish.

Net official purchases may have totaled as much as 100 to 200 tons in each of the past two years, even allowing for the IMF’s 403 ton gold sales program.

I don’t believe the officially published data on central bank gold transactions . . . and data on sovereign wealth fund investments in gold are, for the most part, unreported.  So, it’s not possible to get an exact reckoning of net annual purchases or sales by the official sector.  In short, we don’t know what we don’t know when it comes to central bank gold purchases.

That said, central banks are continuing to buy gold for additions to official reserves.  China, for example, announced last April that its central bank had purchased 454 tons in the prior six years - but chose not to report these purchases until more recently.  Many observers, myself included, believe that China continues to buy significant quantities on a regular basis, some if not all from domestic mine production.

Saudi Arabia also added significant quantities of gold - 180 tons, in fact - to its official holdings over the past few years - but did not report these purchases until this past June.  It is likely that the Saudi Arabia Monetary Authority also continues to buy . . . along with some of the other oil producers with dollar-heavy, gold-underweighted official reserves.

What we do know is that the list of countries that have bought gold beginning in 2009 continues to grow.  Some of the names on this list include: Russia, Kazakhstan, India, Sri Lanka, Mauritius, Venezuela, the Philippines, Thailand, and even Bangladesh.  And, South Korea recently announced it is considering adding to its official reserves.

We also know that the IMF gold sales program, which commenced in 2009 and promised to sell 403.3 tons, has already run its course.  One must wonder how the market will react now that the IMF is no longer supplying gold to the market.

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