08 July 2012

Is Gold Still a One Way Bet?

The disappointing performance in the Gold price so far this year has defied basic economic principles, at least as far as Gold supporters perceive them.

The disappointing performance in the Gold price so far this year has defied basic economic principles, at least as far as Gold supporters perceive them. But the behaviour of the precious metals price so far might reassure investors that their faith that Gold will eventually deliver the gains that they had expected.

Since falling back from its peak of just over $1,900 in September 2011, Gold has been stuck in $100 range for last 3 months, pulled in opposite directions between powerful, but well balanced bullish and bearish market forces, that has left some investors wondering what has gone so wrong for the precious metal.

So the Gold Bubble has burst?

Well it is true that Gold has seen an impressive gains over that last decade, it has risen from $250 to a peak of $1900 per ounce in September last year. But it is also worth bearing in mind that Gold has yet to exceed its inflation adjusted (by virtually any measure) peak of $850 set in January 1980.

Did all that QE Money Fail to Deliver?

All that newly created fiat currency should have benefited Gold. Central banks have created more fiat money than ever before through QE programs, bailouts and stimulus measures in order to try and re-float western economies that are drowning in sovereign, mortgage and consumer debt. As any economics student will tell you, such wholesale currency debasement will stoke inflation and hard assets will benefit.

The motivation for the creation of all this new money, was it would enable banks, enfeebled by the burst of the real estate bubble, to lend to the real economy and stoke economic activity. But much to the dismay of policy makers, the vast majority of that newly created money has remained lodged firmly in the financial system, propping up riddled institutional balance sheets, where it has created virtually no real economic activity. Even if institutions were minded to lend to the real economy, the demand for credit from already heavily indebted consumers is doubtful, having been fed a diet of doom and gloom by media for the last half a decade.

If most of this funny money has yet to make it into the real economy, it would stand to reason that it will take yet more time for QE money to debase the fiat currencies to the full extent. As the possibilities for a third round of QE3 have advanced and receded, so have the prospects for an immediate Gold price boost. QE3 may well still represent the best impetus for an immediate leg higher in Gold prices, though as we saw with the effect of QE2 on Gold, the market prices at least a proportion of this in ahead of the money being created.

The US is drowning in debt. Why has the Dollar stayed strong for so long and damaged Gold?

At time of writing US debt (according to usdebtclock.org) stands at $15.8tn and climbing. The US administration has yet to take any serious steps to address the burgeoning debt mountain, standing at 104% of GDP and climbing. It is unlikely that that amount of debt can ever be repaid, so at some point we will have to see some kind of wholesale default or dollar debasement to ease the burden. But developments in the European debt crisis have so far provided support to the US currency, and probably to some extent taken the spotlight off the US debt problem. Europe’s endless stream of half-baked solutions to its debt crisis has caused a steady depreciation of the Euro. This has benefited the US dollar in a flight to safety trade, to some extent counteracting the debasing effect of US stimulus measures to date.

A stronger dollar (many argue artificially so) has capped the upside for Gold, and further depreciation of the Euro is likely to be to further benefit of the dollar. The fact that Gold has held up so well in the face of such powerful short term negative factors just demonstrates to many the underlying strength of bullion.

The Future

Many analysts and commentators, including us, argue that the world today represents a very Gold friendly environment. None of the environmental factors that were present when gold was rising through $1,900 in September 2011 are missing today. In fact it can be argued many of those factors are more powerful now than in September last year. Nor do any of those problems afflicting the western economies look like being solved without radical action by policy makers. It is also fair to say that the global financial system is not out of the woods yet, and a financial system shock may force policy makers into "radical action".

"Radical action" can be interpreted in 2 ways. The printing of money on a scale that will dwarf that seen so far, or massive default. Given their track record, it is not hard to predict which option political leaders will favour.

Finally investors need to ask themselves “What would I rather own? Gold or a paper promise? While it is true that Gold pays no interest, it also is not anyone else’s liability. As Mark Twain is famously quoted "I am more concerned with the return of my money rather than return on my money". A sentiment that will be all too familiar to holders of Greek Government debt for example.


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