Gold (PM) Breakout Coming

The argument about inflation vs deflation is predicated on a Keynesian thought paradigm. When too much money chases too few goods, the value of money falls and prices of everything else rise. When 'money' is valued above all else (because it's hard to come by, and debts are being recalled) the price of money rises relative to everything else. i.e. The prices of everything else falls.

Where you have Central Banks capable of creating money out of thin air and backed by nothing, without a collapse of confidence in the Central Banking system, "deflation" is off the table as a possible outcome.

That's not to say that the Central Banking system won't collapse but, if it did, deflation would be the least of our worries. Prices of some essential products would probably rise because we would experience shortages - of everything, including money.

So let's focus on the other side of the coin. Will the predisposition of the Central Banks to create money floods cause price inflation?

Again, the cause of price inflation needs to be examined.

"Too much money chasing too few goods". Are there too few goods?

Too trite a question at this stage. There's one more step in logic.

If the Central Banks create 'too much money' in whose hands will this money land up?

• Africans? Probably not
• South Americans? Probably not
• Indians? Maybe the middle class minority. Certainly not the impoverished
• Asians? Same story as the Indians.
• Industrial Country Consumers? Possibly, but they're bending under their debt burdens.

The "too much money" will probably land up in the hands of the already wealthy, who will probably not increase their consumption of anything. They will look to park this (surplus) money somewhere. So there won't be "too few goods".

But there might be too few assets.

Oh? So that's why the stock markets have been rising!? We have had asset price inflation.

We will probably also land up with "cost push" inflation in some areas, where the price of commodities in relatively short supply might rise.

This brings into focus two possible scenarios:

• The Central Banks continue printing money and we enter the 'exponential blow-off' phase of the equity and commodity markets, the possibility of which started to raise its head a couple of months ago
• The Central Banks, recognising that an exponential blow-off in asset prices is not an aspirational outcome, shift their focus of attention to managing the 'price' of money - i.e. interest rates.

So, if the emphasis is going to shift from more money to cheaper money, what will happen?

This is a two edged sword. The older generation who are approaching retirement will become desperate for income. The younger generation, who are already up to their ears in debt, will find it a bit easier to continue muddling through.

But cheaper money has a third dimension. It becomes less desirable to own. If I can only get (say) 4% on my money from the government, maybe I should be looking to attend distress property sales and buy myself a bargain price rent producing property. Cheaper money will likely put a floor under property prices. Rents will likely rise as part of this process as owners become renters and the demand for rental property rises.

Cheaper money will also generate capital gains in the Treasury markets - for a short while.

Cheaper money will also (theoretically) put a downward pressure on the US Dollar. Except, when you stop to think things through, those who own dollars don't really want to see the dollar falling. It's the international currency of last resort.

What else are they going to put their dollars into? Euros? Yen? Renminbi? That's for traders. Big institutional and sovereign money can't flow like water from one place to another. Just think of what happened when you were a kid in the bathtub making those waves. The water lands up on the floor. Central Banks are bright enough to know not to make waves. Come to think of it, Central Bankers tend to be smarter than the average bear. A dollar collapse is the last thing they want in a world of fiat money, and with the US Dollar at the epicentre of all of that.

So, in a world where income is getting harder to come by and baby boomers are ageing, and the young and the poor don't have surplus cash and gold doesn't pay interest, who will be buying gold?

The short answer is: "Those forward thinking people who begin to understand that the days of the current structure of the world of International Finance are limited."

Gold, in the end analysis, is an insurance policy. The super wealthy are soon (if they have not already done so) going to start putting (say) 5% of their capital into precious metals as an insurance policy against a change in the Central Banking status quo.

Ahh! But this is a two edged sword. The more some people put their money into gold, and the higher its price, the more other people are going to start asking "Gee. I wonder why the gold price is rising? Could it be that the Central Banking system is at risk?"

The paradox is that an investment in gold will become a self-fulfilling prophecy. The very act of taking out the insurance policy will cause you to increasingly need it.

So a rising gold price is a frightening prospect for those who are predisposed to think things through.

Question: What's the probability that we are going to experience a rising gold price at this time?

Answer: How long will the Central Bankers be able to continue suppressing the gold price?

The reality is that Central Bankers do not have physical gold to dump into the markets anymore; so they have to rely on the derivatives markets.

There is certainly evidence that their predisposition to manage the prices of PMs has been rising of late, and there is also evidence that people are generally becoming more nervous about their future.

But here's the real opportunity!

Remember all those gold "juniors" that started to list about five years ago?

You want income?

Guess what? Some of those gold juniors are starting to approach the production phase. This may put a downward pressure on PM prices, but it will create cash flow for the juniors - and cash flow is what it's going to be all about. My bet is that money will soon start to flow into those juniors which are close to production.

Now comes the "crunch" question. If the juniors are going to add to supply of the metal, will insurance demand from the baby boomers offset this increased supply?

Answer: Life is such a paradox. If the $XAU and the $HUI start to break up because more money is flowing into those mining companies that are expected to become cash flow positive (and possibly dividend producing) then "the market" is likely to argue "Gee. The $HUI and the $XAU just broke up. Don't the share prices precede the metal prices? Isn't that 'evidence' that the price of PM's is going to rise? Maybe we should buy some Precious Metals now.

The paradox is that, in their need for cash flow, the behaviour of the baby boomers may just cause the non interest paying gold price to rise as an 'unintended consequence'.

So the $64,000 question is therefore whether the shares are going to start rising relative to the metals. That's what we have to look for.

Okay. So let's do that. The following charts of the $HUI:$Gold and $XAU:$Gold are courtesy stockcharts.com

Daily $HUI is showing a tentative break-up relative to gold (as at April 2nd 2007)

The weekly chart is showing consolidation, but the oscillator is strengthening

The $XAU (the already cash flow producing mines) have been weaker relative to gold

The Daily Chart of the $XAU is also showing a tentative breakout relative to gold.

Weekly chart "may" be bottoming in a falling wedge

Finally, lets have a look at what the P&F Relative Strength chart (3% X 3 box reversal) is telling us (also courtesy stockcharts.com)

This chart is showing long term relative strength and short term weakness during a consolidation phase. It is showing strong support at the current level of 48-52. This is a "healthy" chart.

On the 3 box X single point chart below, a breakout above 52 will probably take it to 56

And, a break-up above 56 will probably take the RS chart to new highs.

Conclusion

It's too early to call it, but the very first chart above makes sense to me in the context of the preceding reasoning process. Let's put it this way: I will not be surprised to see the gold markets starting to show increasing strength over the coming weeks/months and, eventually, leading to a strong breakout.

But be sure that the Central Banks do not want this to happen. If you decide to "invest" it should be with patient money. There is a lot at stake here.