Donald Luskin: Gold and the Upside-Down Bell Curve

From Donald Luskin, Trend Macrolytics:

The U.S. dollar is the world's reserve currency. No other central bank has that status. So when anyone else in the world wants to save, as opposed to invest, you buy Treasury bills. It's just what you and I would do if we wanted riskless balances: we'd buy Treasury bills.

But what does the Treasury buy? How does the Treasury save? That subtle logic paradox: Who cuts the barber's hair? The Treasury has no capacity to save. It lacks the physical mechanism. It could invest, it could go out and buy an S&P 500 index fund, but that's investing, and it's not eager to invest, because at the moment, at least the culture is that the federal government doesn't want to be an equity owner in private enterprise.

So with all this money being thrown at the Treasury from around the world, there's really no choice but to spend it, so an $800 billion stimulus bill like we just rammed through in a rush to judgment a couple months ago is entirely feasible. In fact it was kind of a rational response to the world just throwing money at us, and so that's the setup.

But here's the thing. If this were a rational thing for the Treasury to do, then you could say it was rational for unqualified homeowners to accept subprime mortgages three years ago to buy inflated tract homes in Stockton, California, on the theory that three years from now when the mortgage reset, they could just walk away. So what the U.S. is doing with its Treasury debt is in essence the world's largest teaser mortgage.

We're funding most of this with debt that's with an average maturity of around three years. So three years from now, if the world credit crisis is healed and you don't have the world throwing money at you anymore, then this is going to reset and we're going to have to roll this debt. We're going to have to refinance. These three-year notes are going to mature, and what will interest rates be then, when people aren't desperate to own Treasury bills because they're afraid of owning anything else?

So this long detour to tell this story has really been about inflation. There's going to be a run-up to this; it won't wait until three years, it will be anticipated. So at the year-and-a-half point, when people start talking about it and it starts to be part of the dominant narrative, rates will start to go up, and the Fed's going to say, "Oh hell, just when recovery started to set in!" And the fact that recovery is setting in is what's causing these rates to go up.

So just when things are starting to look good, these rates will start looking a little scary, and the dollar will be falling in value, things will get kind of crazy again. But the Fed will say, "We can't let this nascent recovery be killed by a 5% 10-year rate! That was the kind of rate we had just when the wheels came off starting in 2007. We can't let that happen again!" So it's going to be time for the Fed to buy another $300 billion worth of Treasuries and another $600 billion and another $900 billion.