Free Gold Part 2: When Governments Attack (GS)

As I wrote yesterday, my wife and I just had our first son.

While I'm out of the office for a short period of time, I've asked my friend, colleague and fellow gold investor Tom Cullis to explain a somewhat complicated concept known as "Free-Gold."

Here's Tom:

Thanks Kevin.

Yesterday I discussed a brief history of Keynesian monetary policy, and how it is becoming increasingly difficult for our Government to maintain their policies further.

The problem is too much debt. And while there's no way for anyone to wipe this debt clean or pay it down with higher taxes, lower spending, etc.  - it will be taken care of. And as I said yesterday, it will be passed onto EVERYONE who owns dollars and dollar denominated assets. 

Obviously Central Banks and Governments have been trying to socialize losses for two years now by crushing their currencies and taking on the bad debt through bailouts, Quantitative Easing, Austerity and a variety of other programs designed to push these losses onto the general public.

This is the best example of the boiling frog metaphor I have ever seen with the Federal Reserve slowly turning up the heat while hoping we sit in the water not noticing that we are stewing in our own juices.

Free-Gold is most simply put as the push back against this attempt to socialize the losses, but the process is not simple nor is it guaranteed. Physical gold and silver are clearly the best bets for diversifying your assets away from those that are going to be devalued by government action and to retain your purchasing power and, if you get in early enough, possibly increase it dramatically.

*****As the fortunate, intelligent, investor who got into precious metals over the past few years while many of your friends, family and colleagues watched their houses 401ks or even jobs plummet in value it will be those few of us who own precious metals who will be more strongly influencing the future.

Every family member who took your advice and bought a few ounces of gold will be grateful and eager to hear your future opinions while those who have scoffed and derided your decisions will be forced toward the realization that you were, at the very least temporarily, right. This is the beginning of the cascade and the early stages of Free-Gold.

The evidence for this stage is all around us with the massive success of precious metal based ETFs and demand for coins skyrocketing and prices hitting record highs.

Obviously the most recent of these changes aren't being driven by the hardcore gold bugs as they have traded in the majority of their assets for gold years ago, and unless they are also all getting multimillion dollar bonuses from Goldman Sachs (NYSE: GS) this small segment of the population simply can't be driving the newest demand. The simplest conclusion to draw is that new investors are converting their assets to gold at rates high enough to create near perpetual new highs. Stage 1 of Free-Gold is well underway.

Stage 2 is a continuation of Stage 1 as more entrants for the gold market are found. The place to find them will be in the areas that have not yet suffered major losses and that place is clearly the bond market. Basically all bonds issued prior to 2006 and haven't defaulted have done very well in this climate with record low interest rates driving up demand for the securities available that hold some kind of decent yield. These prices will face pressure in the near future in all likelihood.

An increase in inflation will eat into the return of all bonds and cause flight and frustration. Some will run into the equities markets but most bondholders are often in that market specifically because they are risk averse, they don't mind passing on some yield if they think it provides them with greater security and the past few years aren't exactly going to instill them with confidence that the equities market is a calm, safe place to put their money.

This is one reason why the coming phenomenon is called Free-Gold and not Free-Precious-Metals or Free-Silver. Gold has both a long term reputation that is better known than silver and the additional short term reputation created over the past decade.

If the Fed tries to anticipate and nip inflation in the bud all the bonds, including the trillions in debt governments have racked up the past few years, which have been sold recently will decline in value. And if history is any guide a simple ½ to 1 point increase will not be enough to fight inflation and the losses will be dramatic while also erasing some of the gains that older bonds had made.

The scenery for Stage 2 is set with the end of QE2 in sight. Either QE3+ will be implemented and inflation will eat away at the bond market or QE3 will be postponed and rising interest rates will eat away at the bond market, either way its dinner time for gold holders.

Portions of stage 2 have already occurred with the Fed driving out many traditional bond holds (think PIMCO), and this stage could last for several years or it could see a catalyst of epic proportions (think China dumping $1.7 trillion in bonds as they have recently threatened to do) and spiral in a few weeks or even faster.

Stage 3 is what separates Free-Gold from those who believe a return to the gold standard is in the cards or those who believe a crash in the dollar will lead to a true free market in money.

Keep in mind that though Free-Gold implies a crash and run from the Greenback it does not imply its total destruction.

Stage 3 is when central banks start looking to the gold price for their marching orders. Students of hyper-inflation know that prices eventually start to spiral faster than the printing of money would imply. They also know that gold's price rises even faster than general prices. In fact during hyperinflation in Weimar there were two types of currency available- the paper mark and the gold mark and there was actually deflation in terms of the gold mark! Cash, in terms of gold as cash, truly was king even during hyper-inflation.

Tomorrow I'll discuss the end-game for Free-Gold and dollar, and I'll give you some ideas about what to do next.

Good investing,

Tom Cullis

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