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Prepared by Philip Gotthelf

To Inflate or Not to Inflate?

(February 11, 2016) Once again, the Federal Reserve Bank (FED) has become skittish about normalizing interest rates. As I have maintained, the FED hasn’t a clue about how to intervene in the current economy. This is because there has never been an economic parallel in modern history to provide guidance. Although there is a saying, “There is nothing new under the sun,” reality paints a different picture. In particular, economics is evolving in conjunction with a rapidly changing world. A perfect example is the emergence of “stagflation” as an economic circumstance. Prior to this phenomenon, it was believed that there was an inverse relationship between inflation and employment. In other words, we could not simultaneously see high inflation with high unemployment. Wages were presumed to drive price levels.

The simplistic inflation assumption was toppled way back in the 1970s when commodity prices soared in response to scarcities resulting from natural and political influences. To be sure, the 1973 OPEC Oil Embargo sowed the seeds of part of the stagflation phenomenon, but El Nino contributed by adversely impacting crops around the world and inflating food prices to unprecedented levels. Nixon was confused as were all of his advisors and Arthur F. Burns, the FED Chairman in 1973. The presumed solution was price controls which failed to work.

In 2007 I warned that inflation would trigger a financial crisis. At that time, no one was concerned about rocketing energy prices and rising food costs. Uncle Sam conveniently reports inflation without the “volatile” food and energy components. I appeared on CNBC and actually argued with anchors about the inflation rate because they were claiming the Consumer Price Index (CPI) showed no inflation. This has been the government’s position since the Great Inflation of the New Millennium. Of course, denial is one of the fundamental governmental principles.

Fast forward to 2016 and ask yourself the question, “Why is the FED so anxious to inflate?” The excuse used is the correlation between inflation and economic growth. Drawing upon old principles, the FED presumes that price levels are indicative of economic health. I fear the incentives are more insidious from a consumer’s standpoint. Inflation is a toll to repudiate debt. Governments borrow in valuable money, paying back in inflated (devalued) money. There is absolutely no advantage to the public in any form of inflation. There is no argument from the public’s interest that supports rising prices. Yet, a 2% annual inflation rate is our FED’s target. Your government wants to devalue your purchasing power by 20% per decade.

The problem with this policy has become painfully apparent to the middle class all the way down to low income workers. A dollar is worth appreciably less today, savings are worth less now than a decade ago. In effect, inflation steals from regular wage earners all the way up the ladder to the executive class. Only hard asset accumulation protects against inflation. This is why Donald Trump is a self-professed billionaire. Real estate reflects the “real value” of currency. Yet, even real estate is subject to hiccups along the path of paralleling inflation. The economic contraction we have been seeing around the world has left wages flat even as inflation ripped through middle class wealth.

I have decided to label the Janis Yellen tenure the “Lost FED.” Neither she nor her Board of Directors knows how to manage her inherited situation. The economy is out of her control. This is because the massive $20 trillion debt we will have by yearend has no potential offset. Despite all the Treasury’s printing, capital is tight because one hand called Congress doesn’t know what the other hand called the FED is doing. Congress has passed Dodd-Frank to restrict capital while the FED tries to expand. If this was not so serious it would be laughable.

Small businesses that drive employment are under siege. From general regulations and taxes to Obama Care, there is very little a small business can do to escape the wrath of disjointed government regulation and imposition. Of course, Bernie Sanders would have us believe that we can afford paid family leave, college tuition, and universal health coverage. Hey, who doesn’t like that message? Be careful what you wish for… You just might get it! If small businesses are forced to pay for family leave, they will compensate by hiring less and paying less in wages. There is nothing the FED can do to compensate for this foolishness. So, let’s add a 2% target inflation rate on top of all the plans for income equality.

If the FED fails to normalize interest rates and continues emphasizing inflation, life insurance contracts will default. Fixed income earners will perish. Debt markets will eventually deteriorate into chaos. There will be no liquidity to absorb government paper and Treasury borrowing power will run dry. Going negative on short term interest rates for the sake of inflation sends a signal that there is nowhere to safely run and hide.

In my opinion, the FED’s inflation fixation is misplaced and represents a recipe for disaster.

Take a Hint from Gold!

April crude oil is trading under $30/bbl. It is down 80¢ today as I write. The DOW is making new interim lows, crashing more than 350 points this morning. March T-bonds are up 2’25. Under normal circumstances we would expect gold to tumble right along with stocks and oil as Treasury yields reach effective zero after inflation. Well, gold is up more than $69/oz; above $1,260/oz this morning.

I have been progressively long gold and we are enjoying our current April futures position that we bought at 110150. Unfortunately, we were stopped out of our long March silver position, albeit with a $2,020.00 per contract profit. This is a market to chase. With the FED claiming inflation is too low, gold appears to speak differently. If you believe gold is the inflation bellwether, something is wrong with the picture. In my book, The New Precious Metals Market and my subsequent Trading Precious Metals I point out that gold’s best performance occurred during the Great Depression. An ounce of gold climbed over 1,000% in purchasing power from 1930 through 1933. In fact, gold became so valuable that President Roosevelt issued his famous executive order confiscating private gold while he simultaneously removed gold from circulation.

In today’s Wall Street Journal Opinion page Daniel Henninger writes “Trump Among the Canaries.” He warns that the New Hampshire primary is a message from voters that the political status quo is “killing me!” Well, gold is the economic canary. Investors and even sovereigns are saying traditional paper assets are killing them. On the debt side there is too much risk for too little yield. On the equity side there is simply too much risk. If central banks around the world are trying to inflate, the overall message is clear. We should all be looking for wealth preservation.

Gold is what a breakout looks like. After forming a rounded bottom from November into January, gold decisively moved above 110000 on growing volume and open interest. I have been consistently reporting that physical gold is in high demand and short supply. Still, gold prices declined coming into January as the financial media declared gold “dead.” Before stocks began to seriously falter, gold was a “bubble” waiting for a pin prick. Gold’s advance is even more impressive than the DOW’s decline.

Gold advanced just over 19% since its December lows. The DOW dropped 16.24% from the May ’15 high to the August ’15 low and we are about to retrace that correction. In my last SPECIAL REPORT of 2015 I predicted the DOW could touch 14,000 before stabilizing. My calculations reveal that 14,000 aligns more realistically with corporate earnings from 2015 into 2016.

What does a 14,000 DOW imply in the face of a 19% gold advance? What does a 30-year bond yield under 2% suggest for gold that has out-of-the-money options selling above 3%? Right now you can buy gold for April delivery at $1,250/oz. You can sell an April gold 1300 option for $20. The option expires in 46 days. Assuming the strike price is reached, you would take in $70 on $1,250 in 46 days or 5.6%. That represents a 44.43% annualized return. Which would YOU rather have: a) A DOW ETF that may decline to 14,000 or b) the gold?

Of course, today’s volatility has exaggerated gold option premiums. Even so, it does not take a genius to understand that gold can generate an impressive passive return through the sale of options. Unfortunately, most gold options traders are buyers who hope to make a killing as gold moves higher.

My Middle East Friends

The rate of exchange into gold is accelerating in the Middle East. Tenders for Hong Kong, Australia, Indonesia, and South Africa are squeezing the physical market. I mentioned that COMEX approved gold deposits were positioned for more than a 70% decline. I discussed the Iranian cash bonanza and pointed out that Iran would not keep monetary assets in Euros or Dollars. They are not risking newly found capital. I pointed out that even ISIS had developed a sophisticated method for gold exchange. My Middle East friends are moving to a gold marketplace.

When U.S. citizens were forbidden gold in 1933 economists and political scientists were shocked. How could this possibly happen? Yet, our national gold supply was turned over to the Treasury. Although I am sure I am not unique in my thinking, I have not come across fellow market gurus who called attention to the fact that Libya’s paper currency carried a picture of Col. Mummar Gaddafi.

Generally speaking, it is not a good idea to put a dictator on your currency. This tends to be bad for the dictator and the currency.

I have pointed out that there is a gold rush in China where the metal is marketed in fractions of a gram. I have called attention to the religious and cultural attachment Muslims have to gold. Given Middle East conditions, gold falls naturally into place as the asset of first resort rather than simply a hedge against inflation.

Germany has asked the United Stated to return gold from our alleged storage. Other nations have made the same request. The U.S. has sheepishly requested time to gather up the deposits. Like Bernie Madoff, the U.S. government never thought sovereign states like Germany would ever ask for their gold. So, why not spend it? After all, our government has dipped into the Highway Trust Fund, Social Security, and many other earmarked capital resources. Who’s gonna know?

Middle East nations are keenly aware of the U.S. and European propensity to take what does not belong to them. The $150 billion in Iranian funds is only one example. China and Russia see the manipulation of currency by the West and they hear the trumpet of Mr. Trump. Do they want to be exposed to Western monetary sanctions?

I warned that a secondary gold-based Middle East economy is developing. Proof is in gold’s volatility even before this most recent rally. I am certainly happy I had the foresight to buy gold. I do not think gold is anywhere near a bubble as evidenced by its continuing resilience. We were stopped out of long copper, but gold prevailed. We were stopped out of short March T-Bonds, and gold prevailed. Most commodities are deflating, yet gold prevails. All Republican presidential candidates favor gold… Is that a good thing?

February 11, 2016
Philip Gotthelf
Commodity Futures Forecast
P.O. Box 566, Closter, New Jersey

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