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The all-time highs keep coming ...
Gold touched another new all-time high today. In fact, gold has broken the heavily-eyed $1500 an ounce level.
So what's the deal? Why is gold trading above $1500?
Don’t answer that.
Maybe I should ask: why isn’t gold trading at $2500 an ounce?
Gold bugs are notorious for justifying gold’s bull market with anything that conceivably had or might have an impact on prices to any extent. I always like the example of demand derived from those who sprinkle gold flakes on their breakfast cereal. [Ok, maybe that’s just a myth ... and maybe I’m embellishing a bit ...]
What I want to touch upon is the major gold driver commonly seized by analysts and investors – gold as an inflation hedge.
I read recently an article trying to provide evidence that gold is not a legitimate inflation hedge. The basis for the argument was that there is little correlation between gold and the rate of inflation, the rate of inflation expectations, the breakeven rate or the Fed’s balance sheet.
Indeed, there was little correlation between gold and those aforementioned inflation measures. That, however, ignores the general trend in prices. The difference between the two measures can be seen over the last decade in the following two charts:
US CPI, YOY % Change
 Click on image to enlarge!
US CPI, Absolute Values
 Click on image to enlarge!
With the inflation rate gold shows little correlation (-24%, in fact) since 2002-2003. With the absolute value of the CPI basket the correlation is tight (89%). What this seems to reveal is that gold is a good store of value, rather than a short-term hedge against changes in inflation rates. But it seems it is an inflation hedge nonetheless.
Consider these two premises:
- As the price of a basket of essential goods rises, it takes more money to buy the same basket.
- Also, as the value of a currency falls, it takes more money to buy the same basket.
Gold is maintaining its value as the value of the US dollar falls. Gold is appreciating in value as the value of the CPI basket of essential goods rises. So why is gold not at $2500 an ounce?
The value of the US dollar is crucial in the whole store of value/inflation hedge scenario. Investors are very much leaning on gold as an escape from fiat currencies because they have believed that, at least among developed world central bankers, interest rates would remain low. With interest rates low, currencies lose the yield advantage they could have over gold, making gold an appealing store of value in the face of sovereign debts and budget deficits in Europe and the US.
The outlook on interest rates at ECB and, more importantly, the Federal Reserve will dictate gold’s direction. The ECB has made its first move at normalizing interest rates; it is expected they will move again to combat rising inflation in the zone. The Federal Reserve remains the wild card.
They have seen some improvements across the economy but they are looking for improvement in the US labor market. Their second round of quantitative easing comes to an end in June. Analysts will be digging deep to determine if the economy can persevere without QE. Economic recovery is not set in stone yet; QE3 is still an open question.
But should the Fed implement a third round of easy money, it seems there is no question how gold would respond.
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