Gold Sounds General Quarters: “All Hands to Battle Stations!”

I’ve never been on a warship, but I’m sure the movies present a perfectly accurate depiction of life aboard ship; then again … maybe not. But, I’m sure they do have a station of combat readiness where all members of the crew assume their stations and prepare for combat. I grew up watching certain Cold War portrayals of US versus Soviet naval vessels in tense situations such as The Bedford Incident (an excellent film, by the way) where two warships were in an emerging conflict with a heightened state of readiness on the parts of both crews. In these types of stories, the sounding of “General Quarters” is made as the ships approach a hostile situation. The fighting hasn’t started yet, but it looks like it might, and it’s time to prepare the ship and the crew for that possibility.

In the financial markets, I feel that gold just sounded “General Quarters” on Friday; The Comex price of an ounce of it rose $37 to close at $895.80. Even more telling, were that yields on the US Government’s 30-year bond rose from 2.87% to 3.31%. As I’ve said in prior blog posts, the Federal Reserve is trying to use its printing press to contain interest rates by creating money and using it to buy bonds across the board. It can’t get too carried away with this practice, though, because it’s very inflationary. The Fed is getting a free pass on inflation right now as the banking system collapses, since the majority of this newly-created money is being put into it. But the banking system is so worried about not being able to meet its cash withdrawal obligations, that they’re not loaning this money back into the economy. Consequentially, Ben has a license to print money — and not have it cause consumer inflation in the short term. Of course, these deflationary pressures will just build up and come roaring back with a vengeance once the money does start circulating. But the fiat money game has always been a short-sighted system. After all, if the currency does go through hyperinflation, they figure they can just start over with a new currency.

Meanwhile, there are some signs we can look for that the deflationary slack is starting to disappear from the system, and inflation is once again about to come roaring back:

  • The price of gold
  • Yields on long-term bonds

In inflationary times, people flee government bonds and go into gold. This causes the price of gold to go up, as well as the yields on bonds, as people demand higher and higher interest rates to compensate them for the inflationary risk being undertaken.

That’s exactly what we witnessed Friday.

Bernanke wants to keep the long-term bond yields as low as possible in an attempt to re-inflate the system. Low long-term bond yield will mean lower mortgage rates — which he hopes will get people buying houses again, as well as borrowing money on the equity they have in their home. However, in order for this to work, investors, particularly foreign, need to be fooled into thinking that inflation is gone from the system and that loaning the government money for 30 years at 3% return or so is a good deal. If they demand a higher yield, then Ben won’t get the lower mortgage rates and, consequently, won’t be able to re-inflate the system.

In other words, if you start to see the price of gold and long-term bond yields moving up, you know that Ben’s attempt is failing.

That’s what happened Friday. The reason I liken it to a “General Quarters” alarm is because the financial shooting war hasn’t started yet. As far as the average investor knows, deflation is still the order of the day, but the situation is starting to get tense. Gold is telling us that enemy warships have been spotted in the area and it’s possible that we may come under attack. Report to combat stations! Clear the gear off the deck, and baton down the hatches!

This situation could get explosive.

I’m expecting to see a sharp rise in gold and long-term bond yields over the next few weeks. No doubt, this will prompt Ben and Obama to ease off of the inflationary rhetoric. We won’t hear any more quotes about trillion dollar deficits for years to come and Ben may have to start talking about raising interest rates. This will spook the stock market and prompt another sharp drop in equity prices. From there going forward, this situation is going to get increasingly desperate and the solutions proposed increasingly weird — although, how anyone can come up with a weirder solution than Bernanke’s idea to create a “bad bank” which would warehouse all of the bad loans made — is beyond me.

Obama’s mettle is going to be tested very early in his administration and we will quickly get to see his true colors. Whether he decides to adopt to reach for the statist tools of more government control, or let the free market try to hash things out on its own, is going to become an increasingly stark decision with both solutions seemingly apocalyptic. I’m sure he’s going to put this decision off for as long as he can — but he will be forced to deal with it soon.

It’s strange how history works. Obama is going to be thrust into the middle of a situation that was not his doing, but rather the culmination of a number of generations before him: to allow banks to control the issuance of currency, to endorse fiat money, to attempt to control the financial markets. As Ludwig von Mises wrote in a Critique of Interventionism, the state intervening in the free market causes even larger crises later, which forces even more interventionism. The end result, Mises wrote, was that eventually the government must control everything. That’s the decision Obama’s going to be forced to make, and once he does, it’ll set him on an irrevocable path which will define his administrtion.

It’ll be interesting to see how things shake out.

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