Trickster Gold: The 4 Forces Affecting the Price of Gold

The 4 Forces Affecting the Price of Gold
Acting in opposition at times and in concert at other junctures, the following 4 forces make a mockery of any simple explanation of gold’s wild price action:

1. gold as a safe haven–”flight to safety” in volatile, risk-averse times
2. gold as a store of value and hedge against inflation
3. gold as an asset to be sold to raise cash to pay down debt that is due
4. gold as an asset which becomes less attractive in deflationary eras

The Pros and Cons of Gold As a Safe Haven
In early 2007, strong global growth drove up fears of inflation [Force #2], giving gold a boost as a hedge against rising inflation. As the global financial system started looking vulnerable, gold slipped along with inflation fears. Then, when the global credit crisis began building in early 2008, gold rocketed as investors fled risky assets for the “safe haven” [Force #1] of gold. Then, as fears of a contagion receded, so did gold’s price from above $1,000 per ounce down to $750/ounce in early September 2008. We might also have attributed to some of this decline was a recognition that deflation [Force #4] might be the danger rather than inflation. A few weeks later, Lehman Brothers collapsed, and the “flight to safety” [Force #1] drove gold almost $200/ounce higher in a matter of days but by October, gold had crashed [Force #3] to the $680/ounce level, a 35% decline from its peak in March as investors, desperate to raise cash to meet margin account and other debt requirements, sold gold precisely because it had retained its value in the global meltdown of financial and real estate assets. [So much for gold always being a safe haven!]

The Pros and Cons of Gold as a Store of Value and Hedge Against Inflation
That gold tends to hold its value ironically makes it an attractive asset to be sold in times of need [Force #2; Force #3]. Consider India, where gold and silver are traditionally favored as hedges against inflation. With food inflation running at 16% now in India, families hard-hit by sharply rising food costs may not be able to afford to hold a gold hedge permanently.

The Pros and Cons of Gold When Markets Plummet
The same phenomenon may also be present in financial crises. When stocks plummet and margin calls must be met, then asset managers might be tempted to sell the assets [Force #3] which have held up the best–in some cases, that would be gold–to quickly raise cash to either make interest payments or reduce debt.

At this point it’s worth recalling the relatively small size of gold in the universe of assets. In a world of unlimited leverage and debt, $1 trillion in debt is small percentage of total debt outstanding but $1 trillion in gold is fully 20% of the entire tradable value of all gold. As such, any dumping of gold to raise cash to pay off pressing debt that is pressingly due and payable would exert an outsized influence on the price of gold.

The Cons of Gold During Deflationary Times
Anticipation of deflation was potentially another factor. Gold’s value as a hedge declines [Force #4] somewhat in deflationary periods when U.S. Treasuries or high-quality corporate bonds paying some yield become more attractive, at least to those funds and players who need some yield.

Despite gold’s long-term uptrend it has suffered sharp swings in price in the past two years that defy simple explanations. To wit: gold suffered its sharpest recent decline right when the global financial meltdown peaked in late 2008 [Force #3], falling about 35% from its peak.

As global growth resumed in Spring 2009, then the “flight to safety” trade in gold gave way to the “hedge against inflation” trade [Force #2], as traders anticipated resumed global growth and heavy government stimulus might stoke the fires of inflation. As confidence on global growth strengthened, gold gained about 20% from its previous high in March 2008.

When global stock markets dipped in November 2009, then gold responded in see-saw fashion by spiking up [Force #1]. Amidst the recent stock market turmoil, gold responded by hitting a new high–perhaps as a result of the re-emergence of the “flight to safety” trade.

Conclusions
All this suggests that gold’s short-term price swings depend on the global financial situation and, as such:

a) If deflation is once again foreseen as a risk, and cash must be raised quickly to pay down debt or make interest payments, then recent history suggests gold could swoon as it did in late 2008.

b) If global economic growth resumes, then gold’s long history as a hedge against inflation suggests the current uptrend could continue unbroken until the next global financial panic occurs.

c) To assume new highs will be reached on a “flight to safety” ignores the lesson of 2008: gold is subject to losing a third of its value in short order if a liquidity crisis forces players to sell anything in their portfolio that still has value to raise desperately needed cash.

*http://charleshughsmith.blogspot.com/2010/06/trickster-gold.html

Editor’s Note:
– The above article consists of reformatted edited excerpts from the original for the sake of brevity, clarity and to ensure a fast and easy read. The author’s views and conclusions are unaltered.
– Permission to reprint in whole or in part is gladly granted, provided full credit is given.
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