Deficit Denial Presents Unique Entry Point for Gold, Silver


In recent economic speeches­­­­­­ President Obama reported that the deficit is decreasing at the fastest rate since World War II. While true, the point is misleading. First, one should not confuse the deficit with the debt; the amount owed is not decreasing but rather the rate at which the debt is growing is decreasing. Second, the deficit has risen in recent years to such an extent that decreases are relatively large when compared to the past. The decrease the President touts is akin to a driver applying the brakes before a high-speed collision. The car's speed may be decreasing rapidly yet still traveling at an elevated rate.

Federal Surplus or Deficit Chart
Federal Surplus or Deficit Chart

Federal Surplus or Deficit data by YCharts

The increasing government debt is crucial to long-term money supply and commodity prices. Despite all of the recent hype surrounding the tapering of the Federal Reserve's quantitative easing, the growing debt remains the key to ­­­­­future inflation. Yes, the end of quantitative easing terminates the most direct form of money creation. However, future issuances of Treasury securities put upward pressure on the money supply and inflation. The mechanics of this process are often debated. But put simply, intractable deficits lead inevitably to further monetization.

US Public Debt Chart
US Public Debt Chart

US Public Debt data by YCharts

One logical mechanism by which future public spending may be monetized is through the use of bank reserves. Since the recent recession, depository institutions are carrying an unprecedented level of excess reserves. Depository institutions are free to grow their government security holdings by "providing" the federal government with cash that can be used to buy goods or services.

US Excess Reserves of Depository Institutions Chart
US Excess Reserves of Depository Institutions Chart

US Excess Reserves of Depository Institutions data by YCharts

Physical precious metal ETFs
Precious metals provide a direct hedge against future inflation or purchasing power degradation. Interestingly, the metals are priced at multiyear lows while equities are topping. Those looking to take advantage of this entry point should consider the large, liquid ETFs such as SPDR Gold Trust and iShares Gold . Both provide direct exposure to gold prices and are backed by physical metal stocks held at their custodians.

While these physically backed ETF investments do not remove counter-party risks in the financial markets, they do avoid in-country political and technical risks the miners face. Consider the Market Vectors Gold Miners ETF ; the earnings in the fund's basket are highly leveraged to metal price movements and will disproportionately benefit from rising prices. However, political instability and tax regime uncertainty in West African and Southeast Asian countries coupled with infrastructure challenges continue to suppress their stock prices.

Prudence and diversification demand a percentage of any precious metal investment should be personally held. However, the physically backed ETFs remove liquidity and security costs that purchasing physical coins or bars present. Coins and bars are illiquid because of shipping costs and time to clear funds when sold for maximum return to a bullion dealer or collector. And, though small, insurance and storage costs also generally exceed the fees associated with ETFs.

Considering silver, the iShares Silver Trust is also an option. Silver prices are more volatile in the short run than gold. However, since silver prices have fallen more sharply than gold, the gold-to-silver ratio is well above historic averages. A normalization of this average would be positive for silver. Additionally, 75% of silver produced each year is used in industry, thereby providing a demand floor.

Bottom line
Quantitative easing is just a symptom of the large deficits and growing debt. The underlying issue remains the inability to control spending. Heightened government deficit spending is inherently inflationary. Alternatives exist to hedge against future inflation and protect purchasing power. Chief among these alternative investments is precious metals. Because of recent price pullbacks, these metals also offer an interesting entry point for those looking to diversify and protect savings.

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Originally published