How the Debt-Ceiling Debacle Will Spark a Short-Term Drop in Gold Prices

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"Don't be surprised to see investors sell gold and use the proceeds to pile into U.S. Treasuries."

I'm an avowed gold bull, and I truly believe that gold investors will end up benefiting from the biggest bull market of our time.

But we have to be honest: Investor psychology plays a crucial role in shorter-term investment results. And recent trading patterns clearly demonstrate that most of the recent increase in the price of gold is due to the debt-ceiling debate in Washington, as well as the European sovereign-debt crisis that continues to lurk in the background.

The bottom line: The debt-ceiling debacle could cause a short-term drop in gold prices.

Congressional leaders as of early Sunday afternoon had yet to reach a debt-ceiling deal, but said they were close to an agreement that they hoped would prevent default.

As of late Thursday, gold was trading within 1% of the all-time high of $1,628.05 reached on Wednesday, and was poised to record its first monthly increase in three—all because of the debt-ceiling deadlock and the fear that a U.S. government default would level the global financial markets. Spot gold has surged 7.6% in July.

If you think about it, a number of things just don't add up. For instance:
  • The 30-year U.S. Treasury bond is yielding just 4.31%—meaning the rate is virtually unchanged since the start of the year. But with Standard & Poor's saying there's a 50% chance it will downgrade the United States' top-tier AAA credit rating—something once considered bulletproof—you'd expect that yield to be surging as "rational" investors dump U.S. debt. Right?
  • In fact, a quick glance at yields on the one-month, one-year, two-year, five-year, 10-year, 20-year—and every maturity in between—shows that yields are down from the start of the year, meaning investors are still buying U.S. Treasuries, despite record deficits and the fast-approaching debt-ceiling deadline. If there's a risk of a downgrade and a default, shouldn't those same "rational" investors be avoiding all new purchases, even as they dump current holdings?

So what will we see if tomorrow's (Tuesday's) deadline comes and goes, and no deal is reached down on Capitol Hill?

For instance:

  • Does the government stop making payments to vendors, retirees, and others in order to conserve cash flow?
  • Does it default on payments to bondholders?
  • Does government activity seize up altogether?
  • Does gold shoot up to an all-time high of $1,800 an ounce?
  • Is it "TEOTWAWKI" (the end of the world as we know it)?

Ignore the Fear Mongers

Well, the usual suspects—U.S. President Barack Obama, Treasury Secretary Timothy F. Geithner and Federal Reserve Chairman Ben S. Bernanke—would sure like you to think so.

During his primetime television address last week, President Obama actually told us that interest rates on credit cards and car loans would spike, and that the U.S. economy would suffer a serious disruption.

Sorry, but I don't buy it.

And neither does Jan Ericsson, assistant professor of finance at Montreal's McGill University.

According to Ericsson, whose latest research has focused on bond-market default risk, U.S. interest rates may increase by 50 whole basis points, or half a percentage point—hardly the financial-market Armageddon that the fear-mongering gloom-and-doom crowd claims is fait accompli.

In actuality, the U.S. Treasury holds more than $1 trillion in marketable securities—more than $100 billion of which is in cash. If no deal is reached by the deadline, instead of just defaulting on payments, there's no reason the government can't just use this cash, or liquidate assets, and buy some time until an agreement is actually reached and the debt ceiling raised.

In fact, the government can probably hold out for a couple of weeks, says a recent Bloomberg News story. Playing the fear card just raises the odds the current administration will get what it wants sooner—a much higher debt limit to facilitate even more spending.

I can even envision the U.S. Treasury selling off some of its gold, helping to push gold prices down and suppressing any concerns that inflation-fueling money printing is out of control.

I submit that, even if U.S. Treasuries lose their coveted AAA rating, government-bond yields may still go down.

Justified or not, this "shock" could temporarily hurt stock markets and any other "risk-on" assets. And that could lead investors to buy yet more bonds from the largest and most liquid debt market on the planet, helping to keep yields near their historical lows.

In fact, weakness in "risk assets" coupled with a surge in demand for safe-haven Treasuries could strengthen the U.S. dollar in the short term, making Washington's puppet masters look like geniuses in the process.

But the real question is this: What will all this maneuvering mean for gold prices?

The answer is pretty clear.

A Short-Term Drop in Gold Prices

Much of the recent run-up in gold prices is due to the debt-ceiling debate. In other words, gold has already priced in worries about a non-resolution to the debate potentially leading to a delay in raising the debt ceiling.

That's why I conclude that—whether or not the debt ceiling is raised by Tuesday—there's a pretty fair chance we'll see a short-term drop in gold prices. If that happens, it'll be due to a sense of relief that the economy most investors still embrace as the world's most stable isn't facing an imminent collapse. In fact, don't be surprised to see those investors sell gold—and use the proceeds to pile into U.S. Treasuries.

The bottom line is this: Whether it's this week or next month, Washington is going to raise the federal debt ceiling, leading to still more borrowing and spending, and an ever-expanding money supply. Over the long haul—as we've told you again and again here in Money Morning—this ever-growing debt load will be highly bullish for gold prices.

So how should you play this? My advice is to just keep your eye squarely on gold.

Any short-term drop in gold prices caused by the debt-ceiling debacle should be temporary -- and a buying opportunity for the savvy investor.

It's up to you to seize it.

Peter Krauth, Contributing Editor, Money Morning

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