Why Gold Keeps Going Up

Gold
Bullion bulls
Oct 8th 2009
From Economist.com

A weak dollar explains the rising price of gold

AFP

GOLD fascinates investors more than any other metal. The latest surge in bullion—nominal prices topped $1,050 an ounce during Wednesday October 7th, a record—has generated headlines that would not have been seen if a less glossy metal such as nickel had reached a new peak.

That is because gold was once the linchpin of the global monetary system and is still seen by many as a hedge against inflation. But if investors are really frightened of price rises, it is hard to see evidence in the government bond market. There has been a modest increase in inflation expectations (measured by the difference between the yield on inflation-linked bonds from that on conventional bonds). But the Treasury bond market is only pointing to average inflation of 1.9% over the next 20 years.


Other explanations for gold’s rise are even harder to credit. Some reports cited this week’s decision in Australia to raise interest rates, a classic case of the post hoc ergo propter hoc fallacy (just because one event occurred first, that does not mean it caused the second).

Conventional explanations of supply and demand do not work, either. Mining production is slightly up year on year; jewellery demand is down by 13.8%. The main demand has been led by investment. Retail and institutional investors have been buying gold through exchange-traded funds, which allow them to have a pooled stake in bullion. This avoids the extra risk of buying shares in gold mining companies (which might have incompetent managers or shallow reserves) or the complexity of using futures. ETF Securities says its fund now has some 8.4m ounces (worth over $8.7 billion), an 110% increase over the past two years.

But blaming the rise on ETF purchases does not answer the fundamental question; why do investors want exposure to gold at all? The dollar is the prime suspect. Gold’s rise coincided with a fall in the greenback on a report (since denied) that oil-producing countries were talking about replacing the dollar as the pricing currency. When the dollar falls, as it has since March, risk-averse investors tend to buy gold. That decision has little opportunity cost now that interest rates are so low (gold has no yield, of course)


Can the trend go further? Christopher Wood of CLSA, a broker based in Hong Kong, has a long-term target of $3,500 an ounce, the equivalent in purchasing-power parity terms of the metal’s 1980 peak. Mr Wood says investors see gold as a hedge against the depreciation of paper currencies, particularly those in the west. Gold is not just a hedge against inflation, in his view, but a safeguard against financial meltdown; that is why gold and Treasury bonds can do well at the same time. If he is right, we will all be melting down our wedding rings before long.


Back to top ^^