The thing with gold is; it’s not really about itself. It’s all about what’s happening with it’s biggest competitor: fiat.

With fiat you basically have four scenarios: 1.) deflation, 2.) weak inflation, 3.) high inflation without loss of confidence, and then you have 4.) loss of confidence (hyperinflation).

I think most people can agree that gold is a hedge against the two last scenarios, let’s start with #3 above, these graphs pretty much sum it up (chart basket #1). Open it in a new tab or something because I’ll get back to it later.

Note how gold shot up like a rocket from 78 to 80 when inflation almost went hyper. This is exactly the same scenario gold investors are hoping to bank on this time too. The inevitable devaluation of fiat money, trust me, this is where we’re going, there won’t be a Japan style deflationary scenario for the US, or Europe, or China, or… The Bernank will see to that.

Obviously gold seems like a good bet, as evidenced by the charts above. But that was 30 years ago, at the moment there are so many more instruments you can use as a small investor. Take for instance TBT and how it correlates with GS20 (chart basket #2).

An increase in the interest rate from 3.5% to 4.2% makes the TBT go from 30 to 40. By extension, if the interest rate goes to 15 (chart basket #3) the TBT will go to almost 200. If we follow the same logic, gold will go from 23.5M/t to roughly 40M/t, a “mere” 100% to compare with the 400% we can expect the TBT to go. Sure, if you bought gold in 2002 the numbers are comparable but if you’re thinking about jumping on the gold train at this point in time (Apr, 2011) then you should think twice.

Let’s finish off the TBT discussion with these graphs (chart basket #4, open them in a new tab because they will be referred to later). As you can see, gold and GS20 rates were both correlated to inflation “in the good old days”, but as you can see at the end there the correlation has broken apart, we’ve entered more “modern times”, courtesy of the QEs and the POMO actions. Can this dislocation continue? The answer to that question and how it will affect the stockmarkets is important in our search for more gold alternatives than the TBT.

We’ve just had good job numbers and it looks like the commodity inflation will finally start to spill over into the CPI, add to that the Nov 2010 GOPs in the congress and the picture for further open market operations look bleak. Even the ZIRP might be in jeopardy. Oh dear…

When the FED completely stops its purchases of treasuries the following will happen:

1.) Treasury rates will go up, a no-brainer of course.

2.) Higher rates will force congress to start to get more serious about fiscal responsibility and they will start to make the appropriate noises (just like EU politicians are making appropriate noises at the moment, that on top of #3 seems to be what keeps the EUR buoyant). And by noises I mean more than bar tabs on the Titanic, much more. This one will fight #1 of course but will probably not be enough, it will however affect the mood, in a big way, in other asset classes (think gold for instance).

3.) The USD will go up absolutely against all other currencies and commodities (including gold) as a consequence of money inflows due to #1 and increased market morale due to #2. Remember what has happened with the EUR since Trichet made noises about abandoning ECB ZIRP some weeks ago.

4.) The carry trade might start to stutter as a consequence of an appreciating dollar, emerging markets might take a hit.

5.) As a consequence of #1 and #2 all other debt instruments will start to look less appealing, corporate junk for instance. Beware of companies with high debt burdens, you should always be but especially in the near future.

6.) The stock market will go down as a result of the increased opportunity cost of not owning treasuries and more expensive corporate debt, apart from #2 of course which will act like a drag. I don’t expect it to be affected in a big way though.

7.) Whatever other consequences of the above that I forgot which flips the binary on and off button.

All of the above is of course bad for gold and good for other instruments that might also be good in case the QE madness goes on uninterrupted. As you can see, high inflation is only correlated with an appreciating stock market up to a point (chart basket #5)…

So if the US starts to approach double digit inflation without the Bernank being able to stop it we might get a tanking stock market and then a plethora of various volatility and bearish papers will probably be better investments than gold. Granted, gold will go another 100% practically maintenance free in this scenario whereas these other instruments will need a lot of baby sitting. On the other hand the same instruments will probably be good investments if QE ends whereas gold — in that case — will suck.

OK so QE and POMO ends and now everyone warily await the results…

1.) The consequences don’t take long to materialize, CPI starts to edge towards 0 and unemployment edges upwards as a consequence of #2 above in the form of public sector layoffs. These poor bastards are considered unemployable by the private sector so it will increase the structurally high unemployment which itself is a result of the globalization. The Bernank turns on the money spigot again…

2.) Not much happens, most of the budget cuts happened in social security and health care, unemployed people starve and die, just like in Africa, but employment stays up and so does CPI, the Bernank abandons ZIRP…

What will happen in the first scenario is quite hard to predict (at least for me). The market has already started to signal that never ending QEs are not OK in the form of treasury rates increasing despite all the FED purchases. We might have some kind of adverse reaction in anticipation of a repeat of the seventies (see chart basket #5). Only an idiot thinks the Bernank is Volcker 2.0. It’s either that or back to “normal”, ie. what we have now, gold up, stocks up, everything up up up, well except for the USD of course (which is the whole point). It won’t stop until a typical manufacturing wage in the US approaches that of China.

In the second scenario we will get more of the same stuff we got when QE was abandoned, only much more pronounced due to the fact that all that leverage will get more expensive. Look forward to a collapse of the carry and hence emerging markets. Commodities will tank like nothing else when producers realize that prices won’t go up forever and start to dump bloated inventories. The only thing that will stay up is the dollar. But there will be a killing to be made in the bearish ETFs on virtually everything.

To sum it up, gold seems like a bad investment at current levels from an opportunity cost perspective. And it stays a bad investment for the same reason, no matter which scenario that will play out. Back in the late seventies and early eighties there weren’t as much choice as there is now (at least when it comes to retail) to play the high inflation scenario, gold was one of few things available. It is truly a relic in every sense of the word.

I think I’ll stop there, I’ll reflect on the hyperinflationary scenario in a future post (hint, I still think gold is a bad investment).