The above comments are edited excerpts from an article* by Ryan Puplava (FinancialSense.com) entitled Gold Benefiting From Behind-The-Curve Fed.
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Puplava goes on to say in further edited excerpts:[How these 3 factors unfold are extremely important for a sustained rally in the price of gold:]
The CPI has been rising as of late. Of course, the Fed will be labeled as “behind-the-curve”, as it pertains to inflation, because right now they want to see healthier (in their eyes) levels of inflation. It is only when the Fed sees persistently high levels of inflation and inflationary expectations that they will begin to react.
I believe the gold market is finally waking up to this phenomenon. I also think that gold investors and traders are finally waking up to the idea that, technically speaking, gold has been, and is currently, going through a bottoming process. Even the miners are showing signs of confirmed bottoms like Agnico Eagle Mines (AEM) and New Gold (NGD) with many more high quality names lunging to reach the March highs like Pan American Silver (PAAS), Gold Corp (GG), and Silver Wheaton (SLW).
Before going much further into precious metals, I want to reiterate the factors that influence the price of gold:
- Demand and supply (as in any commodity) — As prices rose in the 2000s, miners became believers and built up production. More supply puts downward pressure on prices as more demand (from investing and consuming) puts upward pressure on prices.
- Speculation — Traders and Investors are drawn to returns, both negative and positive. News and sentiment guide activity.
- Interest Rates — The opportunity cost of holding gold is the interest one could earn in another income-generating investment. A business, a stock with dividends, a bond — these are examples of investments that generate income and thus a return. Gold’s return is based on the price rising. Recently, many miners have sweetened their stock ownership with a dividend to attract investors seeking yield and to differentiate more between owning the commodity and owning the producers of the commodity. If interest rates are high, the opportunity cost to hold gold is high relative to the market and thus interest rates are typically negatively correlated to gold.
- Store of value — In days of old, the U.S. dollar was backed by gold and became the world’s reserve currency. You could exchange dollars for gold but that was closed in the ’70s by Nixon. Well, we’re still the reserve currency due to our economic strength but, unfortunately, the paper money can be printed and expanded very easily. Gold still is a store of value, but as the U.S. dollar has become a substitute for gold as a store of value worldwide, these two are negatively correlated to each other — when the dollar goes up, gold typically goes down.
- Debt — As the debt of our country gets “too big” or unmanageable, then confidence in the fiat “faith” currency is eroded. This has been a major issue over the past ten years as debt has expanded at an accelerated pace due to the recession.
- Financial or Political Crisis (“the safety trade”) — As a store of value, investors and traders turn to gold in times of financial or political crisis. Gold has been known to transcend any cultural difference and in an age of money printing, it is the place to turn to in times of crisis. Under a short period of time, typically we can see both the U.S. dollar as well as gold trade in the same direction….
2. The U.S. Dollar
The U.S. dollar has also been rising on:
- a recent rise in interest rates,
- the improvements of our economy (J.P Morgan is calling the recent rise in the Philly Fed Survey “the most favorable forward-looking gaps between orders and inventories in recent years”),
- the improvement in our stock market, and
- the expectation that the Fed will have to tighten its language as I’ve already discussed.
The only thing that has changed recently is that the Fed plans to tighten sooner than mid-2015….[and that has caused] traders to reverse expectations and bid up metals given the continued dovish posture of the Fed.
3. Interest Rates
Interest rates are expected to continue to rise. As I’ve mentioned in the factors that affect gold, interest rates represent an opportunity cost for gold. Typically gold trades at a negative correlation to interest rates: as rates go up, gold falls and vice versa. We are at historically low interest rate levels so the opportunity cost of owning a 10-year Treasury paying 2.6 percent versus gold is low. It’s hard to say actually how much gold will trade versus the 10-year Treasury.
Most traders are more interested in the interest rate differential between our central bank and the central bank of other regions (currencies). As the Federal Reserve bank is still purchasing $35 billion in long-term bonds, it is still being accommodative, but the writing is on the wall with already a drop of $50 billion in purchases over the last half year. Attention has turned towards Fed policy on rates.
If we begin raising rates while other central banks continue to lower or keep theirs artificially low, it puts upward pressure on our currency as foreign investors invest in a higher rate environment here.
To summarize recent events:
- Long-term, it is expected that the dollar will strengthen as our economy continues to outperform foreign economies and our central bank begins to remove accommodation. This puts downward pressure on gold.
- However, the Fed that may allow inflation to run above target if employment remains sub-par. In that type of environment, if the dollar doesn’t melt up on positive economics, gold can rally.
- If the U.S. economy weakens in the second half as a result of higher energy prices, that could cause interest rates and the dollar to fall — fueling a rally in metals.
Editor’s Note: The author’s views and conclusions in the above article are unaltered and no personal comments have been included to maintain the integrity of the original post. Furthermore, the views, conclusions and any recommendations offered in this article are not to be construed as an endorsement of such by the editor.
*http://www.financialsense.com/contributors/ryan-puplava/gold-benefiting-from-behind-curve-fed (© 1997–2014 Financial Sense® All Rights Reserved.)
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