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The Gold Rush

BLOG, MARKETS & ECONOMICS  |  7 Jan 2010

Gold was in the news for much of 2009, and this year looks to be no different. Television commercials urge you to sell your gold coins and jewelry to take advantage of record prices, while the talking heads of financial TV all weigh in on whether the price will continue to rise, and how high it will go. As an investment, gold has performed remarkably well the last few years, and with the price now well over $1,100 an ounce as of the first week of 2010, if you owned your weight in gold, you would definitely be sitting pretty. What is driving the price of gold higher? As an investment, its kind of an oddball in that it has relatively few industrial uses, plus it generates no income. Warren Buffet (not a fan of gold) recently opined that visitors from another planet would be puzzled by the value we place on this commodity. Let’s examine the reasons behind gold’s rapid rise:

5 Year Price chart of gold in U.S. dollars

5 Year Price chart of gold in U.S. dollars

Weakening U.S. Dollar

As much talk as there is about the rising price of gold, there is an equal amount of chatter about the continuing fall in the value of the U.S. Dollar. Gold has traditionally been used by investors as a hedge against the weakness of the Dollar under the belief that gold is an alternative to paper currency, and is not as strongly influenced by a country’s economy. There is little question that the recent trend has been dollar down = gold up.

Purchase by Central Banks

The Chinese and Indian central banks have been purchasing large amounts of gold the last few months. Thus the constant demand keeps the price high. Since central banks typically buy U.S. dollars to store their foreign exchange reserves, gold is a hedge for the vast amount of U.S. Dollars they hold. As the dollar continues to drop, so does the value of those exchange reserves held in dollars. Oil exporting countries are likely following the same hedging strategy.

Distrust of Paper Currencies

Central bankers are growing more weary about paper currency, and its not just the U.S. dollar they are worrying about. Many countries have taken on huge amounts of debt to try to pull their economies out of recession. If they default on that debt, their currency loses value. Gold doesn’t default, it’s a tangible asset, and it doesn’t have counterparty risk.

Fear and Uncertainty

Gold has always been a safe haven in perceived times of fear and uncertainty. Although global economy is starting to see signs of a recovery, there is still a lot of risk and uncertainty. For many, gold will continue to be attractive until the perceived threat has passed. You may often hear people refer to gold as an inflation hedge, but this is not always true, as there have been several times in history that inflation has risen while the price of gold has fallen. It is much more of a “Crisis Hedge” and a longer term fear of governments and wars.

Speculation

Market speculators such as hedge funds have also had a hand in bidding up the price of gold and other commodities over the last couple of years, and this trend continues.

These are the primary reasons the price of gold has continued into the stratosphere, but there are several others. Mining companies are having a harder time finding gold, a situation which increases the costs of extraction. Is this another bubble, like the recent credit and real estate bubbles? That is difficult to say. For every argument that gold should be even more expensive, there is an equally compelling argument holding that it is vastly overvalued. There is also a debate regarding the best way to invest in gold, but we will save that topic for another day.