Before answering the question, I want to review the main factors that dictate the price of gold at any given time.
Firstly, if you look throughout history, gold price tends to move counter to the values of other assets. Equities, bonds, and property prices increase when there is a feel good factor in the broader economy. When jobs are increasing, wages rising, unemployment falling, when the political map is solid and stable, confidence grows from the base of individuals and spreads. Spending increases, confidence booms, and investment in traditional assets rises.
Gold, on the other hand, rises when the political map is changing, or about to. It increases in value when confidence falls, interest rates are low, and inflation wipes out any gains on cash in the bank. Gold is seen as a store of value and a hedge against inflation.
Inflation and interest rates
The value of the dollar in your pocket falls when inflation rises. And when inflation rises above interest rates, thereby turning real interest rates negative, savings are hit hard, too. You don’t receive interest or dividends by holding gold, but with it being a finite resource, capital appreciation is an attractive possibility.
Governments and Central Banks relax monetary policy
Essentially this is a question of cutting interest rates or pumping money into the economy. Governments do this in order to try to boost an economy, flooding it with cash, making borrowing and lending easier and printing money in attempts to promote growth. This new money creates demand, which in turn increases inflation or stores inflation up to be released when the economy turns better.
Central Banks turn from sellers into buyers of gold
At times, central banks will sell some of their large reserves of gold in order to raise money to pump into the economy. Such selling pressure depresses the price of gold. When this selling stops, it’s likely to come ahead of a rise in the gold price, as central banks become buyers and look to replenish gold stocks.
At some point debt will need to be repaid. There are only a limited number of ways to do this. Raise taxes, which is derogatory to economic growth; cut spending, which is bad for economic growth; or print money, which is inflationary and devalues a currency.
When markets such as China and India increase their buying of gold, then the extra demand will cause the gold price to rise.
The fear of political change, perhaps leading to a complete reversal of established economic policies, or unrest in governments in sensitive parts of the world, creates uncertainty. In times like these, gold becomes a haven of safety for investors.
So how does all this relate to now?
Since the turn of the century, equities have staggered as the world has lurched from one crisis to another. These crises have increased in seriousness as each on has hit. In 2000, when Britain was selling its vast reserve of gold, the gold price stood around $300. Last year, gold hit an all-time high of $1920, though it has since settled back to around $1600 today.
Equity markets have been up and down through this time, but the Dow Jones, for example, now stands at around 13000 points, as against 11500 points when gold was at $300 in 2000. Gold investors have had it good over the last 12 years, while equities have seen little growth.
But what about now: does the fall from last year’s high signal a real turning point for gold, or simply a breathing space in its decade long bull run?
Revisiting the fundamentals
The global economy is slowing, as Europe’s debt problems hit hard and cause weakening demand for cheap goods from abroad. As government spending in the Eurozone falls and taxes rise in response to the need to cut debt, economic activity is diving. Unemployment is rising, wages are falling.
The new powerhouse of the world economy, China and India, are suffering with rapidly slowing growth. No longer do Europe’s leaders believe that these countries, along with Korea, Taiwan, and the Philippines, will import its products, and aid the European recovery. Indeed seven of the Eurozone’s countries are in a double dip recession, never having fully recovered from the last. Others may soon follow suit, and the UK is in a deep dip.
In reply to its woes, Europe has seen its political color change over the last 12 months, with administration change in many of its countries voted in by disillusioned populations. The Arab Spring still rages, with the political climate across the Middle East still fluid and changing.
In order to combat a slowing economy, the world’s major nations have continued to pump billions, even trillions, into circulation by way of quantitative easing measures and cutting interest rates. The United States, the UK, and the Eurozone all have historically low interest rates (the US has declared that its ‘zero’ interest rate policy will remain in place for at least another 12 months). China has completed one round of quantitative easing, and cut its key lending rates: it is expected to announce more soon.
Interest rates are likely to stay low for some time to come. Raising rates will mean dearer money, and mean servicing of debt becomes more expensive. It is estimated that a rise of 1% in the United States’ interest rate will cost it $180 billion in debt servicing charges each year.
Finally, central banks have been adding to their reserves. Russia, China, Mexico, Argentina, Belarus, and even Kazakhstan have increased their gold reserves by 600 tonnes over the last 24 months. Could it be that these countries are beginning to fear a massive dollar devaluation, as it attempts to pay debt and rebuild its finances after its November elections?
So is it time to buy gold now?
Looking at the fundamentals, and the global political and economic situation, the building blocks for another round of gold price hikes seem to be falling into place.
Gold is a finite resource, and buying pressure is beginning to increase. An imbalance of supply and demand was a root cause of gold price inflation last year – its record high coincided with record buying by Mexico. This imbalance could soon return, with central banks and investors in India and China increasing their purchases.
Technically, gold has retreated and found a good base of support at current levels. The retrenchment of price is in the order of about 16%. Over the last ten years such a price pull back has happened twice: once in 2004/ 5 and then again in 2008. On both occasions, gold consolidated for around 12 months before then exploding and rising by more than 60% over the ensuing couple of years.
Europe is struggling on a daily basis with a failing economy and growing debt. US debt is also out of control. Inflation is set to rise (the drought in the US is expected to pressure food prices up, and the fall of oil has stubbornly stopped and shown signs of rising again). Interest rates are low and/ or falling around the world.
The US elections in November could be the key that unlocks the door for a flood of money into the yellow metal.
Michael Barton has a career of 25 years covering global financial markets. Having worked for companies large and small, trading and advising on assets from equities to derivative products, Michael now writes about the opportunities and markets that matter to investors. He contributes content to several keenly followed investment blogs and websites.