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    Article taken from a post on gold-eagle:

    Gold and the Perfect Financial Storm

    We are headed into the mother of all stagflations, a stagflation I predicted as early as 1996, but one that was "deferred" as a consequence of the Clintonites' covert rigging of various markets, most notably the precious metals and currency markets via the precious metals carry trades and currency carry trades.

    It is patently impossible that we are headed for a pure deflationary spiral simply because there are too many infrastructural deficits (e.g., impending national medical care crisis, which will send medical costs soaring; impending insurance industry crisis, a consequence of September 11, plus the insurance industry's financial devastation as a consequence of failing equity investments; impending utilities crisis, a consequence of the Enron failure and the resultant negative multiplier effects, etc.), not to mention the obvious fast developing commodities deficits (e.g., platinum, palladium, silver, natural gas, etc.).

    The most likely causes of a rate hike will be as follows:

    The need to protect the US dollar, as foreigners increasingly repatriate funds into their domestic markets. They are doing so from a crisis of confidence in the safety of US investments, not to mention increasingly favorable yields in those foreign countries in comparison to ultra low yields in US financial instruments.

    The need to suppress sectoral hyperinflations within the United States, even as other sectors deflate rapidly. I alluded to those various sectoral hyperinflations in my second paragraph, and again, I restate that is why we are headed into the mother of all stagflations. For those whose memories are reasonably good, the last time we had such a stagflation occurred in the Carter years and gold exploded through the roof, along with gold stocks too.

    Despite the existence of an unprofitable gold carry trade today, rapidly rising interest rates are NOT favorable to increased gold loans if those interest rates succeed in devastating the value of investments utilized by the gold carry trade (treasuries, bonds, stocks, etc.) Unfortunately, those favored investments of the gold carry trade practitioners will not fare well in a climate of rising interest rates -- and nobody will wish to engage in a gold carry trade if the safety of alternative investments to gold are entirely in doubt.

    You see, the first rate hike will cause an immediate tremendous negative effect in the super-bubble US real estate market, along with a tremendous negative effect in the super-bubble US bond market. With both markets collapsing simultaneously, there will be an immediate negative effect in the stock market too, especially since the implosion in US real estate will trigger a rapid selloff of US equities purchased upon a leveraged basis, those equities purchases having utilized bubble real estate values as the foundation for their origination. Furthermore, the implosion of bond values will create immediate crises for the financial sector, given the huge movement of capital out of stocks into bonds during the bear market to date. The further deterioration of key financial companies (insurance, banking, etc.) will create even greater devastation in their equities, and the financial sector's implosion will lead other equity sectors into a downward spiral.

    In effect, a rate hike, although designed initially to strengthen the US dollar and preclude foreign capital outflows, would have the exact opposite effect and create the "perfect storm" in US financial markets: falling US bond market, falling US real estate market, falling US stock market, falling US dollar.

    In such a scenario, the only true flight to safety sector would be in the realm of precious metals, a pure asset class which represents no other third party's debt obligation. With precious metals soaring, there would be a tremendous inflow of capital into the precious metals mining sector (XAU, HUI), one that would surely overwhelm the outflow of capital resulting from any potential margin calls placed upon the relatively small percentage of over-leveraged PM investors. That is because the precious metals mining sector is coming off of a two decade superbear market and most PM mining companies trade far closer to their all time lows than their all time highs. Moreover, the PM mining companies are in very strong capital positions today, most of them holding no debt, ample working capital, and a tremendous unhedged exposure to the upside of a precious metals' price explosion. There is no comparison between PM companies today and their counterparts of 1929, 1974, or 1987.

    Just as the Internet mania of the late Nineties proved, ultimately, stocks can become functions of liquidity rather than functions of fundamental earnings or asset valuations. In other words, a strong flight to safety capital inflow into the precious metals sector (resulting from redirection of monies from unleveraged owners of bonds, stocks, real estate, foreign capital inflows PLUS the avalanche of unleveraged capital sitting off to the side in the form of money market funds, etc.) will simply overwhelm the sector and result in pure verticality in the prices of PM stocks.

    In concise terms, the PM stocks will become valued entire upon liquidity inflows and will cease to have any relation to fundamental valuations. The P/E's of precious metals stocks will simply explode, just as occurred with Internet stocks.

    In this new world of soaring PM prices and PM stocks, the old timers (those who believe in fundamental valuation vs. liquidity preference valuation) will be the first ones to exit and they will miss the amazing rocket launch. The old timers will simply not believe their eyes, just as the old timers failed to comprehend the verticality of Internet stocks and the role that liquidity preference played in those astronomical valuations.

    Moreover, in this new world, the gold and silver shorts will be decimated in the very same manner that Internet shorts had their heads handed to them in the late Nineties. The daily gap ups taking place in PM stocks will blow past the shorts' various stops and leave them exposed to tremendous losses. Again, by and large, the PM shorts today are disciples of fundamental valuation and simply have no concept of what a shift toward liquidity preference valuation will do to PM stocks. Although the government will be called upon to intervene to suppress soaring gold and silver prices, in the initial stages, the government will be powerless to do anything. That is because their main focus will be in trying to shore up the falling financial sectors -- and precious metals prices will be a secondary concern.

    In conclusion, let me emphasize that I do not believe that the perfect financial storm signals "the end of the world" or other such doom and gloom scenarios. Rather it is a financial storm that will set the first stage in the recreation of the global economic system into a healthier entity, one that will see the US dollar replaced as the global reserve currency, most likely by a basket of regional currencies (e.g. the EURO, the DINAR, a South American currency standard, an Asian Currency Standard, etc.) The financial storm is a necessary component to compel world leaders to sit down at a table and redesign the global monetary system in a manner that precludes the ever recurrent dysfunctionalities in the present US Dollar based system. These dysfunctionalities result in almost monthly economic crises in various parts of the world as it becomes necessary for US hedge funds, etc. to instigate such crises in order to direct foreign flight to safety capital into US financial markets so as to support and maintain the various financial bubbles in this country.

    As I have described it in the past, the anomalies resulting from the world's leading debtor nation (USA) calling the economic shots has led to all variety of aberrations, not the least of which will be a rampant stagflation in the debtor nation itself. There is no condition more anomalous than stagflation since it is a true paradox: rising interest rates in the face of rapidly declining economic growth, along with sectoral hyperinflations. Such an anomaly can only occur in the illogical world that enables the world's leading debtor nation to determine the economic destinies of its various creditor nations, solely on account of its perceived military might.

    In conclusion, let me state that I am not a pure goldbug since I do not feel a return to a gold/silver standard will solve all economic ills of the world. The gold/silver standard failed in the past, it will fail again.

    However, in the perfect financial storm fast approaching, I do believe that gold and silver will prove to be the prime flight to safety sectors simply because, over thousands of years, during the currency crisis of any leading economic nation, the precious metals have become favored targets of liquidity preference.

    The precious metals will serve as a bridge toward the reconstruction of the global economic system. During the perfect storm, PM owners will be protected, and in a relative sense, they will prosper too. The key dilemma facing PM owners in the future will be to recognize the moment at which the perfect storm ends, economic stabilization returns, and the time arises to shift from PM's into the currency and financial instruments of choice.


    15 October 2002

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