When hedge fund managers speak of “deleveraging,” buy gold (GLD)

Robert Prince, head of Bridgewater Associates, the largest hedge fund in the world, says his fund is long gold (GLD, quote) because the global economy is in a “deleveraging” process that would take decades. But what does this really mean for traders?

Bridgewater’s position was earlier reported in an article on www.emergingmoney.com. “Deleveraging” refers to the way financial companies and the global economy in general is eliminating debt.

Before the Great Recession, financial houses had leveraged positions of over 30-to-1. When the bubble inevitably burst, central bankers, led by Federal Reserve Chairman Ben Bernanke, had the option of letting the market work through the crisis or intervening to recapitalize private sector financial institutions. 

Through various measures of “quantitative easing,” the Federal Reserve and other central banks around the world took the intervention option and purchased toxic assets. This continues to this day. In addition, the toxic assets were bought at book, not market, value.

At present, the Federal Reserve has about $3 trillion on its balance sheet, up more than $2 trillion from mid-2007.  This is likely to increase even more in the spring, when many expect a third round of quantitative easing to commence. 

According to Bill Gross of Pimco, Quantitiative Easing 3 will entail the Federal Reserve expanding its balance sheet to buy mortgage-backed securities that no one else wants. If there was any alternative demand, there would obviously be no need for the Federal Reserve to intervene to keep money flowing into the housing market.

These Federal Reserve actions ultimately facilitate deleveraging on the part of banks and even consumers, who move that debt off their own balance sheets and onto the government’s books. But they require the production of massive amounts of U.S. dollars.

Quantitative Easing 2 consisted in the Federal Reserve buying about $700 billion in Treasuries.  Naturally, when this many new U.S. dollars are created, it increases the risk that the value of existing greenbacks will diminish — supply increases, demand remains relatively constant. 

As the U.S. dollar falls in value, gold (GLD) will increase as a hard asset alternative to fiat currency.

At present, the exchange-traded fund for gold (GLD) is trading around $160.  Before the Federal Reserve intervened in financial markets in an unprecedented scale in late 2008, it was around $70 a share.