Gold: Hold Or Fold?‏

It's starting to feel like we are part of a giant poker game against the US government whose hand is the true condition of the American economy. The government has become so good at bluffing that most people feel compelled to watch how the biggest players in the game react to determine their own investment strategy.

Unfortunately, this past month revealed that even pros like Goldman Sachs have no idea what sort of hand Washington is really hiding.

Goldman Bets Against Gold

A week into the government shutdown, Jeffrey Currie, head of commodities research at Goldman Sachs Group Inc, (GS), declared that gold would be a "slam dunk sell" if Washington resolved the budget debate and raised the debt ceiling. The call was based on an underlying narrative that the US economy is experiencing a slow, but inevitable, recovery.

Taking this recovery as a foregone conclusion, conventional Wall Street analysts saw two clear choices for Washington. On the one hand, Congress could reach an agreement, raise the debt ceiling, and allow the recovery to continue. This would allegedly have been the final nail in the coffin of the safe-haven appeal of gold.

On the other hand, if no agreement were reached, the government would have been forced to default on its debt. This would have erased any signs of recovery and sent the economy spiraling back into a terrible recession - while boosting the gold price.

Goldman reasoned that Washington would never allow the latter to unfold and suggested investors prepare to short or sell gold.

While Washington did kick the debt can down the road as predicted, gold rallied 3% on the news - the complete opposite of expectations. That is, expectations outside of Euro Pacific.

Misreading the Signals

After seeing an investment theory crushed by reality, a rational investor would take a moment to reexamine his premises. In Goldman's case, this would mean second-guessing the conventional belief in an imminent or ongoing US economic recovery.

Yet, the day after Washington reached an agreement, Currie reaffirmed to Goldman's clients that his US economic outlook for 2014 is positive and that he believes gold faces "significant downside risks."

Currie must not have wanted to muddy his message by acknowledging that his original forecast was flat wrong. He did, however, hedge his statements by acknowledging that the Federal Reserve would likely hold off on tapering its stimulus until next year.

Major Wall Street investment houses have come to rely on the investing public's short-term memory to skate by on these bad calls. When the next forecast is issued, clients and subscribers quickly forget that Goldman was blindsided by the Fed's taper fakeout in September. That Currie accepted the government's new taper timeline within a month of being burned by the last shows how little stomach they have for sticking to the fundamentals - and how little accountability they face for getting it wrong.

Instead, major players like Goldman Sachs are betting their books on the government's fearless bluff. In the eyes of Wall Street, the economic indicators support this conclusion - inflation is subdued, GDP is growing!

The Bluff Exposed

I've been an outspoken critic of this official data for years. Over the course of my career, I have witnessed the government dramatically change the way it calculates inflation, GDP, and other statistics. While Washington's latest figures show a year-over-year CPI increase of just 1.2%, the private service ShadowStats, which recalculates the data along the lines that the government used to, finds that real consumer inflation is closer to 9%.

My guess is the true number lies somewhere in between, but that it would be much higher were the US not able to export much of its inflation abroad. The process works as follows: the Fed prints money (inflation) and uses it to buy Treasuries and mortgages. The government and banks, in turn, pass much of that money to consumers, who spend it on imported goods. The money then flows to foreign manufacturers of those products, who then sell it to their own central banks, who print their own currencies (inflation) to buy it. This money goes out to pay wages, rents, etc., which the recipients then spend on goods & services. Finally, the foreign central banks use the dollars they buy to purchase US Treasuries and mortgages, starting the cycle again.

It's a complicated relationship, but the end result is that inflation created in the US ultimately bids up consumer prices abroad and Treasury prices at home. In other words, our trading partners have to pay much more for goods & services while Americans get to borrow limitless money for next to nothing. The products our trading partners "sell" us increase the supply of goods available to American consumers while simultaneously decreasing the supply available to everyone else. That is what I mean by "exporting inflation," and the important thing to remember is that its result is to mask inflation at home and transfer wealth from emerging markets to the US.

The bluff gets worse. These understated CPI numbers distort real GDP, which would be lower if the true inflation rate were applied. The GDP calculations also include items like government expenditures, which are possible only because of money printing and not a result of any real economic production. Again, compare the official figure of 1-2% GDP growth in the second quarter of 2013 to ShadowStat's figure of negative 2%.

If investors can't bring themselves to question official data, there's another way to see through the government's bluff: look to foreign central banks, which are actively preparing for the day when the dollar is no longer the world's reserve currency.

The Bank of Italy recently affirmed that its gold reserves are essential to its economic independence, while the World Gold Council reported that this past year, European central banks held onto more of their gold reserves than ever before. China, the largest holder of US debt and the biggest consumer of gold in the world, has started openly talking about ending the dollar's reserve status. And while we don't know the total gold reserves of the Chinese government, there are signs that they are stockpiling.

Even US Treasury officials admit that the US will never sell its gold reserves to deal with debt obligations. One spokesperson said, "Selling gold would undercut confidence in the US both here and abroad, and would be destabilizing to the world financial system."

Time to Cash Out

So, who should investors believe about gold? Wall Street bankers who directly benefit from asset bubbles created by the Fed's inflationary stimulus?

No, it's time for individual investors to leave the table and redeem their chips. Just remember - the longer you wait to cash out of the US dollar, the less you're going to get for your winnings.