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QE2 Should Be Good For Gold

I am not recommending that anyone buy gold at this point. Aside from some jewelry, and a crown on a molar, I don't own any gold myself -- certainly not for investment purposes. Because investment gold does not earn income, and has no intrinsic value other than the ability to sell it to someone else, it's a speculation rather than a proper investment.

A lot of people invest in gold in spite of these arguments, and if the price is any indication it seems to be getting more popular by the day. During the second round of quantitative easing (QE2) expected to be announced, or at least hinted at, after the Fed Open Market Committee (FOMC) meets this week, odds are it will become even more attractive to its widening base of admirers.

Here's what I mean. With QE2, the Fed is expected to move back into the Treasury bond market, with most of the market thinking it will buy $500 billion of longish bonds, with maturities of seven to 10 years. The short-term outcomes are meant to be, and likely will be, lower interest rates, and in turn a lower value for the dollar against other currencies. Both of those outcomes have led to higher gold prices in the recent past.

A little further out, when the QE2 has had some time to work on the economy, we'll see whether it has pushed things in the direction the Fed has planned, and the pace of recovery, jobs, et cetera pick up. That would lead to an increase in inflation, and in turn a higher price for gold. (If the higher inflation turns into absolutely high inflation, so much the better, the gold investor would say.)

If the QE2 doesn't work, it means the U.S. economy is weaker than we thought. That could lead to deflation, the arrival of which should not be a good thing for gold, but it's one of the gold fans' arguments anyway. A failing QE2 does suggest, though, that the central bank doesn't have the control over the economy that it thinks it does. That uncertainty likely would bolster the gold bulls' argument too.

So gold will probably rise no matter what happens in the next few months, because the uncertainties that have taken it all the way to $1300 an ounce are still present, and in size.

And QE2 should be good for stocks as well -- 10 percent on the S&P 500! -- says an investment strategist at JPMorgan:

The Standard & Poor's 500 Index may rise 10 percent by the end of the year if the Federal Reserve announces plans to buy more bonds to inject money into the economy, a tactic known as quantitative easing, said Thomas J. Lee, chief U.S. equity strategist at JPMorgan Chase & Co.
"We've already seen some of it in pushing up asset prices or risky assets," [said] Lee... "QE2 is going to ultimately be very effective. For now, it's very good for equity markets."
But enthusiasts should recognize that gold is what the professionals call a "crowded trade." That means there is a lot of interest on one side, in this case in favor of buying. Gold is not that big a market, really, and since there is not a fundamental case to be made for buying gold -- that is, one based on yields, discount rates, and the like -- the crowd could very easily get emotional and head the other way once the economy starts to behave reasonably. And you can be sure that the big fish won't be advertising that they are selling, as they did when they started buying. Be careful out there.