Does the Rise in Gold Price Reflect Economic Fundamentals?

Last Updated Sep 10, 2009 12:37 PM EDT

What are the lessons of a surging gold price? It has always been perplexing that commodities sometimes soar to new highs even when fundamentals are negative. Last year, it was oil: even though demand was unchanged and supply was bountiful, the price of a barrel of oil rocketed above $140. This year it's gold, which briefly touched $1007 an ounce on Tuesday, the highest price since March 2008. The precious metal is up 12 percent since April.

What's causing the bull run? It certainly doesn't seem to be fundamentals. According to statistics published by the World Gold Council, which has an obvious self-interest in driving gold prices higher, total gold demand in the second quarter was down 9 percent compared with the same period last year. It said demand for gold jewelry was down 22 percent compared to 2008 and industrial use of gold fell 21 percent. The only part of the gold market that flourished was financial speculation, which was up a whopping 46 percent on year earlier levels.

Another reason often cited by gold bugs for the attraction of the metal is that it's a good hedge against inflation. But according to the Labor Department's statistics, the consumer price index in July - the latest month it had figures on - fell 2.1 percent in the 12 months since July 2008. That's disinflation, not inflation. So what are they hedging against?

Perhaps it's a combination of factors. Investec Asset Management, a London-based investment firm, put it this way: "We believe that the combination of unprecedented global fiscal stimulus, quantitative easing, and increased money supply has the potential to result in broad currency devaluation, negative real interest rates and the return of high rates of inflation," it said. "We believe this points to a very supportive backdrop for gold to sustain moves above previous highs." Investec said "it would not be unreasonable" if gold prices went 10-15 percent higher, hitting the $1100 to $1150 range.

David Einhorn, founder of hedge fund Greenlight Capital, began investing in gold earlier this year because he feared paper currencies would suffer. "The size of the Fed's balance sheet is exploding and the currency is being debased," he wrote to investors. "Our instinct is that gold will do well either way: deflation will lead to further steps to debase the currency, while inflation speaks for itself." So gold supposedly benefits if there is either deflation or inflation!

It is true that the dollar has been under pressure and that commodities priced in dollars often move in the opposite direction to dollar moves. The dollar hit a new low against the euro this week. The dollar index, which tracks the dollar against six other major currencies, fell to 77.047, its lowest rate since September of last year.
What caused the selloff? Once again it was a Chinese official saying that his country might sell off some of its $1.5 trillion in dollar holdings to buy other currencies. "Most of our foreign reserves are in U.S. bonds and this is very difficult to change, so we will diversify incremental reserves into euros, yen and other currencies," said the official, Cheng Siwei. The Chinese keeping making this threat, but there is little evidence that it has matched words with action.

Another factor supporting gold is that U.S. interest rates are so low. The London interbank dollar rate, which is what banks charge each other for loans, has fallen to an historic low of 0.314 percent, down from 4.8 percent last October. Because gold does not earn interest like a bond, there is an "opportunity cost" of holding gold, but with dollar rates so low, the opportunity cost of holding gold is negligible.

This all suggests that one factor - financial speculation - is behind the surge in gold prices, not fundamentals. Gold producers are ending their hedge strategies - betting that current gold prices are higher than they will be in the future. That requires them to buy huge amounts of gold. According to the Wall Street Journal, Barrick Gold Corp., the world's largest gold producer, has purchased 2.4 million ounces on the open market and plans to buy another 3 million ounces in the next few weeks.

Finally, that's a clear explanation about why the gold price has shot up. But it also suggests that high price won't last.