Gold's spectacular rise over the past decade has seen its price climb from $256 per ounce in2001 to more than $1,900 at its recent peak before sliding a little. In the early stages the maindriver was the boom in emerging economies. Rapidly rising incomes increased the demand forgold as a status symbol and store of wealth at a time when the supply of newly mined gold wasstruggling to keep up.
But since the global economic crisis began in 2008, gold has also become a mainstreamfinancial asset, increasing in demand as insurance against the risk of a surge in inflation andas a safe haven from other shocks.
Confidence in "paper" currencies, notably the US dollar, has been declining, and very lowinterest rates in the major economies have reduced the opportunity cost of holding an assetsuch as gold that does not pay any income. Finally, the surge in gold prices has encouragedthe development of new products that have allowed more people to participate in the market.Even the central banks of many countries have switched from being net sellers of gold to netbuyers.
After such a long bull market, people are inevitably starting to ask whether gold prices are nowforming a bubble. This is a difficult question to answer, because it is hard to determine a fairprice for an asset that has no income stream. But there are two approaches that we can take.
The first is to compare the current price of gold to that of other assets and to its own history.Gold has been much more expensive in the past relative to equities and other commoditiessuch as oil. What's more, after adjusting for inflation, the current price of gold is still well belowthe record of around $2,500 in real terms that was reached in 1980. On this basis, gold pricesare not forming a bubble.
The second approach is to look at the factors that have recently driven gold higher and askwhether these are likely to continue or instead go into reverse. One downside risk to goldprices is that global inflation fears are likely to fade as economies slow down and othercommodity prices, notably oil and key agricultural products, drop back. Headline inflationalready appears to be close to a peak in most major economies, including China. This willreduce demand for gold as an inflation hedge.
Another downside risk is that the cycle of monetary easing by the major central banks, led bythe US Federal Reserve, is now largely complete. The worst scenario for gold prices wouldinclude a strong economic recovery that reduces safe haven demand as well as allows the Fedto return interest rates to more normal levels. This scenario is unlikely in the foreseeablefuture.
But the Fed seems to be losing its appetite for further quantitative easing (QE), in part becauseof the risk that it would drive commodity prices higher again. Any further action from the Fedthis year is therefore likely to be limited to lengthening the maturity of its existing holdings of USTreasury securities ("Operation Twist") rather than a third round of outright purchases (or QE3)that would have done more to boost gold.
A final downside risk is that the dollar is coming back into favor as a safe haven. The currencyand bond markets have shrugged off the downgrade of the US sovereign credit rating byStandard & Poor's and the dollar has begun to recover against the euro. This would reducedemand for gold as an alternative to the dollar, which at least for now remains the world'sdominant currency.
All of these potential negatives, however, could be more than offset by continued strongdemand for gold as a refuge from other shocks. Gold is the ultimate safe haven because itsvalue is not dependent on the creditworthiness of any government or financial institution, norcan its stock be increased in the same way that monetary authorities can create money.
In my view, the financial crisis in the West that began with the banks was only temporarily easedby transferring the problems to governments in the form of massive budget deficits. Theworsening debt crisis in the eurozone is the most extreme demonstration of this and is likely toprovide continued strong support for gold. If, or when, fears that the eurozone is about to breakup become widespread, gold price would probably rise significantly further.
Uncertainty about the economic and financial implications could trigger a run on Europeanbanks and a collapse in confidence in the creditworthiness even of the German government. Atthe very least gold price could then be expected to return to the previous record in real termsor even rise further.
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