Where is the gold price heading

Gold, as an investment vehicle, has been in a bull market for over a decade. Since January 1999, when an ounce of gold was selling for $252, gold prices have risen more than fourfold. This surge has been a result of several factors, including, primarily, the falling value of the U.S. dollar amidst the burgeoning U.S. fiscal debt coupled with the rising supply of the U.S. currency and the expanding U.S. trade gap with the rest of the world. The collapsing asset prices and weak economic growth in the aftermath of the dot-com bubble, the rising political uncertainty following the 9-11 terrorist attacks, and the recent economic and financial malaise that has ravished the global markets have all added significantly to the allure of gold as the preferred investment hedge against economic and political uncertainty. This appeal of gold in relation to most other assets should continue in the future.

 

Despite concerns that gold is overvalued at current prices, a thorough analysis that incorporates the historical perspective on gold suggests that the upward momentum in gold prices should remain intact. In 1944, when the Bretton Woods, New Hampshire (USA) conference set the “gold standard,” under which the price of gold was fixed at $35 per ounce, gold’s primary purpose was to serve as a reserve of value for the world currencies. Under that system, the U.S., which controlled some 60% of the world’s gold reserves at the time, was required to convert, at the fixed price, the U.S. dollars into gold, on demand of the monetary authorities. Hence, the dollar was “good as gold.”

The system was also designed so as to allow the U.S., which had a trade surplus with the rest of the world, to fund, vis-à-vis trade deficits, the expansion of the world’s economy, in particular the economy of the war-ravaged Europe. Yet, while the price of gold was fixed for the U.S. in its monetary dealings with the world’s monetary authorities, gold was still traded in the open market in London. However, at the time—in fact, since the Great Depression—U.S. citizens were prohibited from owning and trading in gold.

 

Over time, the rising fiscal and trade deficits—so called “twin deficits”—undermined the U.S. dollar as the world’s reserve currency. Confidence in the greenback under the Bretton Woods system was especially eroded by the run-down in the U.S. gold reserves to 22% of the world’s stock by 1971. Forced by the rising economic and financial imbalances in the global economy—and the overvaluation of the U.S. dollar relative to gold—the largest industrialized nations, in an attempt to restore international economic stability, agreed to devalue the dollar (and thereby their currencies) relative to gold in 1971. The price of gold was then fixed at $38 per ounce.

This unsuccessful attempt to mitigate the economic problems worldwide was followed by another devaluation, in 1973, that raised the value of gold to $42.22 an ounce. Consequently, the system of currency pegs, established in Bretton Woods, collapsed and the currencies were allowed to float freely. At the same time, the U.S. lifted the prohibition on ownership and trade in gold by its citizens, which set the stage for the evolution of gold prices according to market forces and the surge in prices to new highs.

Trading in gold in the open market—especially following the opening of gold futures trading at COMEX—set the stage for the surge in gold prices, which, in the nine years following the collapse of the Bretton Woods agreement, surged by a breath-taking 2,200%. At their peak reached on 21 January, 1980, gold was selling for more than $850, in nominal terms. However, the “nominal terms” is the key word here. This term, which denotes the non-inflation adjusted prices, is especially important when evaluating the recent jump in gold prices. Thus, the appropriate way to look at the current gold rally is to assess it in inflation-adjusted terms.
 
While many investors say that prices of gold at the current record levels are some 33% higher than those set during the “gold bubble” of the early 1980, they ignore to account for inflation when comparing the level of prices in the previous bubble and today. When adjusted for inflation, current gold prices are still more than 50% below the inflation-adjusted peak reached on 21 January 1980 (see the chart below). In fact, the surge in gold prices since the late 1999 has not been nearly as steep as the skyrocketing of prices in the late 1970’s and early 1980’s.

With all the aforementioned in mind, the expanding U.S. fiscal and trade deficits, unsustainable corporate balance sheets, overindebted households, financial instability, the global economic fragility, and the rising concerns about the U.S. dollar as the world reserve currency indicate that demand for safe-haven investment will rise. In this context, gold is likely to continue to benefit and to rise higher in price in the years ahead.    

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GoldBuzzer,
Newsletter of the 31st December 2009