KEY GOLD PRICE DRIVERS / SEEKING ALPHA

Key Gold Price Drivers

by: Jeffrey Nichols

August 25, 2009

We remain “extremely optimistic” on the gold-price outlook — but, unlike many other bullish analysts, we believe the metal’s ascent will take several years to reach its next long-term cyclical peak.

In the meantime, expect high volatility and a difficult climb, fraught with sharp reversals along the way that will, at times, cause some observers to wonder if the market has already topped out.

Ultimately, gold will most likely climb into the US$2000 to $3000 range – but it could go even higher given the right confluence of economic and political developments . . . or if a late cycle mania produces a final bubble before the market shifts into reverse.

Here’s a quick review of the key drivers producing this bullish scenario:

The macroeconomic outlook for the industrialized and newly industrialized nations – with recovery (measured by unemployment, household incomes, and other qualitative indicators of wellbeing) agonizingly slow.

The eventually inflationary consequences of central bank monetary creation in the United States and, indeed, around the world.

Here in the United States, we expect continued growth in federal spending – in order to shore up the economy, bail out more bad loans (in the commercial real estate market, for example), finance state and local budget deficits, and promote the new social agenda.

With voters too strapped to accept higher taxes and the Federal Reserve necessarily pursuing a low interest rate policy, the only financing alternative is the printing press and the invisible tax of inflation.

A continuing erosion of the U.S. dollar as a stable, reliable, store of value – at least “attitudinally” if not vis-à-vis other major currencies.

An on-going official sector “rehabilitation” of gold – with annual aggregate central bank sales (including the expected sale of 403 tons by the IMF) ending in the next year, if they have not done so already, and the emergence of the official sector as a net buyer of gold by the turn of the decade.

The central banks of China and Russia have already embarked on gold-buying programs – and some other central banks with low exposure to gold as a percentage of total official reserves are likely to join them. Meanwhile, the major European central banks with high gold holdings as a percentage of total reserves are likely to abandon altogether their gold sales programs of the past decade.

A gradual recovery in gold jewelry offtake reflecting the hesitant economic landscape in the main gold-jewelry consuming nations and the continued growth of China, now the world’s biggest gold jewelry market.

Bipolar behavior of the historically crucial Indian market with good underlying demand (at least in years of satisfactory rainfall and agricultural incomes) offset by waves of price-sensitive dishoarding and large-scale recycling of old gold jewelry with each major gold price rally.

The price sensitivity and magnitude of secondary supply and the emergence of a jewelry-scrap market infrastructure, particularly in the U.S. and Europe.

Now, with each gold-price advance of any magnitude comes another wave selling by housewives, retired folks, the newly unemployed and other cash-strapped holders of old gold items.

In a sense, we are seeing the United States and Europe becoming more like India – where people not only buy gold jewelry and other items but at times re-sell it . . . so that old gold held in this form becomes a growing reservoir of metal that can, under certain conditions, return to the market in large quantities sufficient to have a dramatic negative effect on the metal’s price.

The introduction and attractiveness of exchange-traded gold funds (gold ETFs) – which trade and are regulated as equities on world stock markets – have made gold more accessible and acceptable to more investors – both retail and institutional – around the world.

Rising gold investment interest is also a reflection of the metal’s strong performance in the past few years relative to equities, real estate, and other financial instruments. And, on the part of institutions, new investment is coming not just from the risk-taking hedge funds run by sometimes flamboyant managers – but also from traditionally conservative pensions and insurance companies.

Importantly, there are also growing numbers of investors concerned about inflation, U.S. dollar depreciation, financial-market uncertainty, and other related fears that interest in gold as a store of value, hedge, portfolio diversifier, etc. seems likely to grow by leaps and bounds, pushing the price to progressively higher highs over the next few years.