How Gold Gets to $12,884 per Oz (Updated w/ Further Explanation)

In my last post I pointed out the relationship between gold and both the monetary base and the national debt. Gold prices in US dollars has an extremely high correlation to both. Today, via Zerohedge, I'll point out gold's value using the metric of the "coverage ratio" which is merely the price gold would have to trade at to back the amount of dollars printed 100% by the gold the Fed claims we hold in our national vaults.

As we will see, this historic average has been 40%. That is, we could back 40% of the currency outstanding with the national gold holdings we have. To be on a true gold standard would require 100% backing of our currency with gold. Today, as you will see below, the ratio is at the historic low of 17%. Which means we have printed so much money in recent years, we can only back 17% with gold at the current price. Below, the chart shows the required gold price at several ratios given the an anticipated $700 Billion of added dollars to the Fed's balance sheet through continued QE operations.

Even though we have presented comparable scenarios looking at the coverage of the US money base in gold terms previously, aka "gold coverage" ratio, including once from Dylan Grice, and once from David Rosenberg, now that we have drifted into a new, previously unchartered and very much open-ended liquidity tsunami, it is time to revisit the topic. Luckily, Guggenheim's Scott Minerd has done just that. Not only that, but he presents three distinct gold pricing scenario, attempting to forecast a low, medium and high price range for the yellow metal.

To wit: "The U.S. gold coverage ratio, which measures the amount of gold on deposit at the Federal Reserve against the total money supply, is currently at an all-time low of 17%. This ratio tends to move dramatically and falls during periods of disinflation or relative price stability. The historical average for the gold coverage ratio is roughly 40%, meaning that the current price of gold would have to more than double to reach the average. The gold coverage ratio has risen above 100% twice during the twentieth century. Were this to happen today, the value of an ounce of gold would exceed $12,000.” 

Keep in mind, the $12,000 price is based on the current monetary base. When this number rises by $2 trillion (at least) through the end of 2014, the upside case of gold will be orders of magnitude higher.

And now you know why bickering over a few hundred dollars here and there is largely irrelevant, and in fact one should be delighted if gold can be purchased at as low a price as possible. Why? Because one thing is absolutely certain: in order to keep the ponzi going, with every other sector at peak leverage, including household, corporate and financial, and real assets already massively encumbered by debt, the only real indirect buyer of gold will be the world's central banks, by means of diluting the existing paper supply. And whether or not the New York Fed, or some gold cartel, are actively pushing the price of gold lower, this is very much irrelevant, and in fact continues to be a welcome diversion, one which allows for the artificially low entry prices into gold. Because one day, gold will revert to its fair value, and so often happen, that is when its will go back to 100% "coverage" as faith in fiat evaporates. At that point whether one bought gold at $1000, $1500 or even $2200 will be absolutely irrelevant.

So exactly what does this mean? It means with another $700 Billion of Fed QE, gold will have to be priced at $2,212 to have the same relative value as today. If gold rose to its historic average coverage ration of 40%, then gold would need to be priced at $5,154 per oz. And what of the most extreme case? Well this would be the scenario I have described previously that I have expected where the Dow: Gold ratio closes close to one (Its 7.74 as of 10/17/2012) and gold rises to a point similar to what we saw in the lat 1970's where gold rose high enough to back over 100% of the US dollars the Fed had printed. At 100% that scenario would require gold to rise to $12,884.

With that in mind, I believe you want to buy gold anywhere under the 40% coverage ratio and would want to start selling at some point in the future between 40% to 80%, with most selling towards 80%. At some point in the future their will likely be a true "bubble" that takes gold up to the 100% coverage point. As I said, I think that will also coincide with the Dow:Gold ration between 1 and 2.

Conclusion: 
For long term savers, keep dollar cost averaging your purchases of gold up to $5k per oz.

For wealth preservationists, don't sell early. You will be rewarded for you patience.

Update
I apparently created some confusion when writing this as some have wondered how the conversion ratio could be volatile while the dollar was fixed to gold. Remember, conversion is simply a mathematical ratio between the money supply and gold held at the Federal Reserve. The answer is that the monetary supply has never been static. One of the key characteristics of the Great Depression was a shrinking money supply as banks failed. When runs on the banks occurred, the banks lacked the funds to return deposits as they had been lent out at a ration of 10 to 1. This is the same fractional reserve system I have discussed previously, that is still in practice today.

The Federal Reserve Act required required a coverage ration of at least 40%.

  At that time, the amount of credit the Federal Reserve could issue was limited by the Federal Reserve Act, which required 40% gold backing of Federal Reserve Notes issued. By the late 1920s, the Federal Reserve had almost hit the limit of allowable credit that could be backed by the gold in its possession. This credit was in the form of Federal Reserve demand notes

You'll notice that in the graph above, the line remains above 40% until about 1962. The rise in the coverage ratio during the 1930's is primarily due to a shrinking monetary base, while the gold supply remained constant until after President Roosevelt signed Executive Order 6102 which made it illegal for private ownership of gold certificates, coins or bullion. The confiscation of gold allowed them to increase the monetary supply. Hopefully this helps explain the volatility during the period of the gold standard.

Two side notes:

 1) Much like today, banks focused on building capital reserves and nearly stopped lending. This further dried up the money supply in the economy.

Banks built up their capital reserves and made fewer loans, which intensified deflationary pressures. A vicious cycle developed and the downward spiral accelerated.

2) After WW2 government spending briefly pauses then re-accelerated, driving down the coverage ratio from a high of 120% around 1940 to below 40% around 1962 and further exacerbated by Great Society spending.

 By the early 1970s, as the costs of the Vietnam War and increased domestic spending accelerated inflation,^[1] the U.S. was running a balance-of-payments deficit and a trade deficit, the first in the 20th century. The year 1970 was the crucial turning point, because foreign arbitrage of the U.S. dollar caused governmental gold coverage of the paper dollar to decline from 55% to 22%.

If you're like me you probably wonder, "what happened to the Federal Reserve Act's 40% requirement?" I don't know. If you do, please leave a comment.