PIMCO Calls Gold 'Compelling Inflation Hedge'

http://www.minyanville.com/sectors/precious-metals/articles/pimco-gold-currencies-gold-price-price/10/1/2012/id/44563#ixzz285KihOuL

China approves gold fund of funds

http://www.marketwatch.com/story/china-approves-gold-fund-of-funds-2010-11-30

China’s securities regulators have given the go ahead for a mutual fund to invest in foreign exchange-traded gold funds, potentially tapping interest among mainland China investors who face negative real interest rates on their bank deposits and want to hedge against inflation.

The state-run China Daily said Tuesday that the new gold fund was the first of it its kind to be available to mainland investors. 

More funds could be on the way soon, as several other fund providers have pending applications for similar products, seeking to tap rising interest among mainland Chinese investors for precious metals, the report said.

The potential perils of paper gold and silver ETF's

I've blogged on this topic several times, and it's worth revisiting.

http://dailyreckoning.com/golden-shell-games/

The gist of the article states that the GLD and SLV ETF's are good proxies for the spot price of their respective precious metals, but in the event of "failures to deliver" physical gold and silver, the prices between the ETF's (paper contracts) and the physical prices would decouple, as the physical shortage would cause the prices of the actual metals to soar, while the ETF prices would languish. The reason is the precious metals COMEX futures contracts and ETF's are not backed by allocated bullion. They are derivatives, much like mortgage-backed securities were derivatives of the actual mortgages themselves. Buyers of said derivatives lost everything when subprime home borrowers defaulted on their mortgages. Holders of COMEX precious metals futures contracts, and the GLD and SLV ETF's would be similarly exposed to counterparty risks.

So if you believe you can trade the fluctuations of gold and silver prices, then the GLD and SLV ETF's may be a cost-effective trading vehicle. But if you are looking to hedge against inflation, currency debasement, and/or financial crisis, owning physical gold and silver may be a safer play, despite hefty premiums.

See disclaimers in the side bar.

Disclosure: no position in GLD or SLV.

Hedges against inflation--and central banks

Note this article was written by Peter Warburton in 2001, after the internet bust. Former Fed Chairman Alan Greenspan subsequently turned on the spigot by implementing easy monetary and fiscal policies. It's a strategy similar to Ben Bernanke's zero interest rate policy and quantitative easing, injecting liquidity into the financial system in order to avert a credit crisis.

Warburton also accurately predicted a credit bubble and financial crisis.

http://www.gata.org/node/8303

Monarchs of old, when hard-pressed for finance, would debase their precious metal currency by reducing its weight or by mixing in base metals to create an alloy. Hey, presto! They were able to increase the money supply and buy more munitions and enlist more soldiers. By this deceit, they separated the face value of the currency from its inherent value, derived from the scarcity value of the gold or silver. These debased coins were, of course, the forerunners of our modern monies whose face value is established by government fiat or decree. The face or nominal values of the notes and coins in circulation with the public greatly exceed their inherent or commodity values, and do not purport to have stable ratios with them.

In the post-war period, economists have compensated for the lack of a commodity base (e.g. gold standard) for a currency by constructing weighted indices of commonly purchased items. The rationale for the purchasing power approach is that the supply of consumables is constrained by the availability of scarce resources such as land, capital equipment and labour services. Because the supply of these resources is finite, then an excessive growth in the stock of domestic monetary assets would give rise to an inflation of the market prices of the consumables. Hence, if consumer prices are constant, then this is a positive indication that the money supply is not growing too rapidly and that the internal value of the currency is being maintained. Countries with stable price levels, or equivalently low inflation rates, would also be expected to have currencies that held their external value with each other, and steadily gained in value versus countries with higher inflation rates.

The fatal flaw in the 'inflation target' mentality

Unfortunately, there is a giant flaw in this logical structure. Restraining the growth of the money supply does not prohibit the excessive expansion of the credit system, unless banks have a credit monopoly and operate only as lenders rather than investors. An excessive expansion of credit can create an environment where the factors of production -- land, capital and labour services – appear to be in infinite supply. If sufficient (borrowed) financial resources are made available, then sterile, parched and polluted land can be fertilized, irrigated, cleaned up and turned to productive use. Similarly, more factories, kilns, assembly lines, steel mills, semiconductor plants and so on can be built using state-of-the-art technology. Idle and untrained workforces can be mobilized and organized into productive units. A rich country, with plenty of collateral assets against which to borrow, can indeed face a supply curve that is seemingly infinitely elastic. I can assure you that consumer price inflation will not be a problem for such an economy.

Where is the flaw? It lies in the fantasy that the stock of borrowings (of all types) can somehow be divorced from the money stock. The physical representation of the abundant supply of credit to producers and consumers lies in the over-production of goods and services. When this has occurred on a global basis, then a point is reached when it becomes impossible to find new export markets and the degree of spare capacity begins to rise. Profit-seeking companies will be compelled to shut down capacity and lay off staff in order to restore ailing profitability. The financial counterpart is the erosion in the ability of borrowers to service their debts. In the limit, the construction of excess capacity gives rise to debt default, as the idle portion of capacity does not earn an income and cannot service the debt that financed its construction.

However, since all debt is borrowed money, in order to write off a debt, it is necessary to destroy part of the money supply. It may be that the debt was structured as a bond issue rather than a bank loan; it doesn’t matter. The bondholders exchanged money balances for those bonds when they acquired them. If the bond is cancelled, this money is lost. Actual and impending losses give rise to a desire for additional liquidity in the financial system. Here, only money will do.

Central banks are engaged in a desperate battle on two fronts

What we see at present is a battle between the central banks and the collapse of the financial system fought on two fronts. On one front, the central banks preside over the creation of additional liquidity for the financial system in order to hold back the tide of debt defaults that would otherwise occur. On the other, they incite investment banks and other willing parties to bet against a rise in the prices of gold, oil, base metals, soft commodities or anything else that might be deemed an indicator of inherent value. Their objective is to deprive the independent observer of any reliable benchmark against which to measure the eroding value, not only of the US dollar, but of all fiat currencies. Equally, their actions seek to deny the investor the opportunity to hedge against the fragility of the financial system by switching into a freely traded market for non-financial assets.

It is important to recognize that the central banks have found the battle on the second front much easier to fight than the first. Last November, I estimated the size of the gross stock of global debt instruments at $90 trillion for mid-2000. How much capital would it take to control the combined gold, oil and commodity markets? Probably, no more than $200bn, using derivatives. Moreover, it is not necessary for the central banks to fight the battle themselves, although central bank gold sales and gold leasing have certainly contributed to the cause. Most of the world’s large investment banks have over-traded their capital so flagrantly that if the central banks were to lose the fight on the first front, then their stock would be worthless. Because their fate is intertwined with that of the central banks, investment banks are willing participants in the battle against rising gold, oil, and commodity prices.

Central banks, and particularly the US Federal Reserve, are deploying their heavy artillery in the battle against a systemic collapse. This has been their primary concern for at least seven years. Their immediate objectives are to prevent the private sector bond market from closing its doors to new or refinancing borrowers and to forestall a technical break in the Dow Jones Industrials. Keeping the bond markets open is absolutely vital at a time when corporate profitability is on the ropes. Keeping the equity index on an even keel is essential to protect the wealth of the household sector and to maintain the expectation of future gains. For as long as these objectives can be achieved, the value of the US dollar can also be stabilized in relation to other currencies, despite the extraordinary imbalances in external trade.

Warburton then outlines potential hedges against inflation.

The search is on for the perfect hedge

What would be the ideal characteristics of such a numéraire? First, it would be in fixed physical supply. Second, it would be resistant to weather-related influences. Third, its ownership would be diffuse, rendering futile any attempt to restrict supply through a non-competitive structure. Fourth, it must be freely tradable. Fifth, there would be no futures or options markets attached to it.

Finally, I list some of the candidates, in no particular order. Each seems promising, yet none of them seems to me to satisfy fully all five of the requirements above.

Arable land with a dependable climate

Oil-refining capacity

Electricity generating capacity

Water-treatment capacity

Drinking water, bottled or piped

Coastal access, harbours and ports

Palladium/platinum/diamonds

Real estate in long-standing, distinctive locations

Antiques, fine art, stamps and coins

Commodities without futures and options markets

Could these be the winning investments of the early years of the 21st century?

Cal STRS looking at commodities play

http://www.bloomberg.com/apps/news?pid=20601087&sid=adUC4S1obfh4&pos=7

The California State Teachers’ Retirement System, the second-biggest U.S. public pension, is considering investments in commodities to boost returns and provide a hedge against inflation and slumping equities.

The governing board of the fund, with $134 billion under management, is scheduled to hear today a staff report in Sacramento that recommends its first-ever commodity investment. The board will decide whether to seek additional research on strategies and portfolio weightings.

Given their poor timing and wrong-way investments, is it time to exit the commodities reflation play? They're only a year late.

GLD vs. physical gold

The Exchange-Traded Fund (ETF) GLD has been a popular vehicle for investors interested in participating in gold price appreciation--and as a hedge against inflation and financial crisis. But there is a potential downside, as previous mentioned. According to James Turk:

“For now, gold is marching to a different drummer,” says Mr Turk. “We are seeing a scramble for physical metal, and that demand is driving gold higher. Buyers are opting for physical gold, not paper gold.”

He points out that when gold was trading at $870 an ounce back in early April, the SPDR Gold Trust – the world’s largest gold exchange-traded fund – recorded ownership of 1,127 tonnes of the metal. Since then, SPDR’s holding has shrunk by 20 tonnes, but gold has climbed by more than $200. “It is a clear example that buyers want physical gold and not paper gold. They are opting for the real thing, not a substitute.

“Why? Because risk aversion has returned to centre stage as worries about bank solvency have resurfaced. It is possible we have been in the eye of the hurricane. Physical gold does not have counterparty risk, which makes it the safest haven of all.”

With a shortage of physical gold, many doubt the gold paper certificates are actually backed by physical inventory, with matching serial numbers.

Of course, there are disadvantages of owning physical gold--especially with bullion, including safe storage and security. But in times of extreme financial crisis, claiming that physical gold may be difficult--if it doesn't exist.