THERE IS A HIGH PROBABILITY OF AN IRRATIONAL BUBBLE IN GOLD

Ben Bernanke is confused. And no, it’s not just the monetary system that continues to confound him. This time it’s gold prices. During yesterday’s Congressional testimony Bernanke was asked about the surging price of gold and if that is a sign of no confidence in fiat currencies. He responded:

“Well the signal that gold is sending is in some ways very different from what other asset prices are sending. For example, the spread between nominal and inflation index bonds remains quite low – suggesting just 2% inflation over the next 10 years. Other commodity prices have fallen recently quite severely including oil prices and food prices. So gold is out there doing something different from the rest of the commodity group. I don’t fully understand the movements in the gold price, but I do think there’s a great deal of uncertainty and anxiety in financial markets right now and some people believe that holding gold will be a hedge against the fact that they view many other investments as being risky and hard to predict at this point.”

Mr. Bernanke is no dummy. I know I am a bit hard on him at times, but that is only because he is supposedly the Michael Jordan of the financial system so expectations are high. Unfortunately, he has performed more like Luc Longley (no offense to the superb Aussie readers here). Nonetheless, Mr. Bernanke understands that inflation pressures remain very low (even though he has failed to apply or promote the proper solution to our current balance sheet recession). Aside from gold prices there are no signs of inflation in the economy. But I believe gold prices are moving higher due to the public’s opposition to fiat currency, fiscal stimulus and what is generally viewed as continued “money printing”. This is highly irrational in the long-term in my opinion and creates the potential for gold to turn into a bubble is looking increasingly high.

Gold prices have surged this year as the Euro crisis has created increasing concerns over the viability of fiat money. I have previously discussed the great irony here. Gold is viewed as a hedge against the potential collapse of paper currencies . It is seen as the ultimate safe haven currency. The Euro crisis has created an incredibly misguided belief that the viability of paper money is at stake. It has caused the increasing rally cry for reduced government spending and continued shrieking from deficit hawks who haven’t differentiated between the currency system in the EMU and in most other developed nations. Ironically, the Euro is more a reflection on the gold standard than the paper currency systems in place in nations such as the USA or UK.

Is it irrational for gold prices to move higher in the near-term? Absolutely not. This belief that paper money is flawed is likely to persist. Investors and governments are truly convinced that the USA is the next Greece. Last weekend’s G20 meeting was a clear sign that governments are giving up on fiscal policy. This creates increasingly high chances of global instability. After all, I don’t think there are too many people out there who would deny that the rally in risk assets and the glimpse of recovery was due to government intervention. The CBO’s recent report verified as much.

This move towards fiscal austerity is eerily similar to what we saw in Japan in the 90’s and could very well drive us towards continued recession as we talk ourselves off the edge of the cliff. In the end, however, the Euro crisis will pass. That is unlikely to occur until European leaders recognize that their single currency system is inherently flawed (just as the gold standard was) and that means we could see substantially higher gold prices as investors continue to rush into gold with the belief that gold can serve as a viable reserve currency (something that has already been tested in a global economy and also something that has already failed). All of this increasing worry in Europe is likely to increase the odds of a gold bubble. The great irony here is that while many are worried about a bubble in treasury bonds we are likely to continue seeing increasingly high chances of deflation and/or very low inflation while a bubble grows in gold prices. The inflation trade will continue to fall flat on its face, but gold will continue to do “something different” as Mr. Bernanke so eloquently said.

How do I see such a scenario unfolding? I believe there is a fairly high chance of an eventual defection and default in Europe. After all, there is no good solution in the region and the debt problems will persist until something forces the EMU’s hand. If this in fact occurs gold prices could very well reach stratospheric levels. But ultimately, paper money will survive in its current form no matter what happens to the Euro. Cooler heads will prevail and investors will realize the the Euro crisis is unique to that currency system and not a reflection of the floating exchange system as a whole. As this occurs gold investors will realize that the risk of inflation never materialized and that the Euro was not in fact a flaw in paper currency, but a flaw in single currency systems. Should this occur I believe we will see a spectacular collapse in gold prices not unlike the move in the 70’s.

In the near-term, however, dollars, bonds and gold are likely to remain the safe haven trades of choice as deflation remains a near-term risk and investors continue to misinterpret the Euro crisis as a fiat money crisis. Ultimately, one of the above will end in heartbreak for millions of investors and I for one am not betting against the solvency of the USA.