Wall Street powerhouse Goldman Sachs has recently reiterated its negative view on gold, which it has held for the past year. However, it is now doubling down on this view and advising clients to actually go short the metal. Jeff Currie, head of commodity research at Goldman noted "Our target is really driven by the view that we think that the Fed will ultimately be the dominate force here and put more downward pressure [on prices]."

While I am in agreement with Goldman that the Fed will be the dominant force behind the price of gold, I believe the central bank will soon be back into the QE business, rather than raising interest rates and crushing the dollar price of gold.

Here’s why:

Since Nixon closed the gold window in 1971, gold has made an impressive move upward from its fixed price of $32 an ounce, to where it sits now around $1,250. But few seem to grasp what actually causes gold to move higher. An increase in the gold prices occurs when the market becomes convinced that a currency will lose its purchasing power due to central bank-induced money supply growth and real interest rates that have been forced into negative territory. And nothing convinces a market more of a rising gold price than when debt and deficits explode.

But while the parabolic move higher in gold from 2009 to 2011 did contain a period of low nominal interest rates, real rates did not fall. And, the surging gold price was not accompanied by a growing money supply either. In fact, the growth rate of M3 plummeted during 2009 thru 2010—it wasn’t until 2011 that the money supply rebounded. So what would explain the steady move in gold from $800 to $1,900 per ounce during that time period? The gold price simply got ahead of itself because the market feared that out of control deficits would force the Federal Reserve into an unending cycle of debt monetization, which would engender a protracted period of negative real interest rates, booming money supply growth and inflation.

However, those fears were temporarily ameliorated by the reduction of Federal Budget deficits starting in 2011. This is because the Fed was, ironically, able to temporarily re-engineer asset bubbles, while sending borrowing costs lower, causing revenues to increase and expenditures to decrease. Annual deficits fell from $1.3 trillion in 2011, to $500 billion today. Adding to the gold market’s recent woes is the specious belief held by U.S. dollar bulls that the Fed will be aggressively raising interest rates while the rest of the world is cutting rates. This is the explanation to why gold and gold mining shares have suffered mightily during the past three years.

Today, the equity and bond markets have positioned themselves for the best outcomes of all possible scenarios. These markets are assured that the Fed can painlessly exit QE in October and real interest rates will rise with no ill effects on the economy. The pervasive belief being that US bonds, stocks and dollars will be the sole beacons of economic hope in an otherwise slumping worldwide economy; and, having complete faith that budget deficits will continue to shrink.

I don’t buy any of it, and here are the reasons:

Last week we learned that mortgage applications plunged to a 14 year low. This is because home prices are still so unaffordable that just a slight tick higher in interest rates is enough to stall both potential home buyers and borrowers looking to refinance their loans. This confirms that after six years of unprecedented Fed manipulation of markets, our economy has become hypersensitive to the slightest interest rate blip. It also supports my contention that the rise in rates which occurred during the second half of 2013, was much more influential on the first quarter’s negative 2.1 percent GDP print than what can be attributed to snow. Our economy is not anywhere near strong enough to sustain growth during a rising interest rate environment. And is why the Fed won’t venture very far into this game.

Furthermore, economies in Europe and Japan are in recession, while the once mighty emerging market economies are flailing. As their respective Central Banks frantically print money, the US dollar is soaring due to the belief that the US economy will remain unscathed from a global economic slowdown. But, the belief that the U.S. economy will stand alone on a pristine island, while Europe and Japan sinks into the sea, is just as preposterous and unprofitable as the belief held back in 2008 that economies around the world would remain untouched by the U.S. housing meltdown.

The markets also seemed to shrug off last week’s disappointing jobs report as an anomaly. Perhaps a colder-than-normal August is a good scapegoat. But this week, Janet Yellen gave us an interesting glimpse into the Fed’s view of the jobs picture with her “Labor Market Dash Board”. It showed that only three out of nine metrics regarding the labor market are better than they were prior to the start of the Great Recession. Investors should think again if they believe the Yellen Fed will be aggressively raising rates and boosting the value of the dollar given the labor market’s already-fragile condition.

Most importantly, the tide of shrinking budget deficits is about to turn. For instance, since 2011, we have seen a significant reduction in defense spending (down 5.5% during 2014 alone), due to the drawdown of troops in Iraq and Afghanistan. And although we have yet to learn the full costs associated with Obama’s plan to destroy ISIS--we can safely assume it will be very expensive.

Adding to this, is the drastically underestimated cost of Obamacare. Insurance risk pools failed to get the proper demographic mix, and the Cadillac tax--delayed until 2018--has companies scheming to redesign existing plans in order to avoid these taxes. Add to this the unexpected costs of illegals flooding the border, demographics moving far out of favor, and an increase in interest rates that will drive up debt service costs, and you can see why deficits will rise. But nothing adds to the deficit like a recession. Our asset-bubble addicted economy faces another reduction in GDP growth very shortly. This factor alone will send deficits north of $1 trillion in short order.

Faced with a worldwide economic slump, central banks remain the only game in town. And today’s central banks, determined to smooth out every hiccup in the economy, only have one answer--print money. When all you have is a printing press, every problem looks like a monetary crisis.

The Fed will not be raising rates anytime soon. To the contrary, Ms. Yellen will soon be forced back into the money printing business in an attempt to; force higher money supply growth, push real interest rates further into negative territory, keep the dollar from rising, and to make sure debt service payments remain under control.

Soon we will have a perfect storm in which gold will rise. The next phase in the gold bull market will include the four conditions of; negative real interest rates, rapid money supply growth, a falling dollar and skyrocketing deficits. Investors that have the foresight to realize this opportunity today stand to benefit greatly in the near future.

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Michael Pento - President - Pento Portfolio Strategies

www.pentoport.com

mpento@pentoport.com

twitter@michaelpento1

(O) 732-203-1333

(M) 732- 213-1295

Michael Pento is the President and Founder of Pento Portfolio Strategies and Author of the book “The Coming Bond Market Collapse.”