GILT- EDGED ARGUMENT / THE ECONOMIST BUTTONWOD COLUMN ( A MUST READ )

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Gilt-edged argument

The battle to explain the remorseless rise of the bullion price

Apr 28th 2011

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THOSE people who thought that reaching $1,000 an ounce was a sign that the bull market in gold was about to collapse have been proved wrong. The price of bullion recently passed $1,500.

Gold can be viewed in many ways: as a “barbarous relic” that is currently the subject of a speculative bubble; as the one reliable source of value over history; as a harbinger of hyperinflation; as a hedge against global financial or economic collapse; or even as a sign of the rising power of China and India.
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Whichever factor you choose to explain gold’s bull run, it is not a short-term phenomenon. Since 2002 the average annual price of gold has risen by double digits in percentage terms in every year bar one (2005, when it gained 8.7%). As yet gold’s price chart does not display the classic bubble characteristic whereby the pace of increase seems to accelerate (although silver has been conforming to that pattern lately)..

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Gold does exhibit another bubble-like feature, however—the increasing participation of the public. When the last gold bull market peaked in 1980 speculators took part by buying jewellery or coins, complete with retailers’ markups. This time round they are able to buy exchange-traded funds (ETFs) which promise a return linked to the bullion price. As the chart shows, the largest gold ETF has a gold hoard that places it on a par with the reserves of central banks.


Another sign of bubbles is a change in the basis of valuations. Dotcom shares were assessed in terms of “price per click” rather than anything tangible. Here gold presents a problem. It has no earnings or cashflow so it is harder to come up with a fair price.


One approach is to use gold’s purchasing power in terms of life’s essentials such as energy and food. An ounce of gold was worth 12 barrels of oil at the start of 1986; now it is worth around 13. Its purchasing power in terms of wheat has risen more sharply over the past quarter-century but is much lower than it was a year ago.


Mostly, however, gold’s price is expressed in terms of the dollar. So its strength may simply be down to a lack of confidence in paper currencies rather than its own merits. Whereas a strong currency was once a symbol of national pride, few countries appear to relish the prospect today. Central banks have slashed interest rates to almost zero, expanded their balance-sheets (and thus the monetary base) to buy government bonds and, in the case of Japan and Switzerland, intervened to weaken their currencies.


The Swiss franc is usually seen as a very strong paper currency. Gold is 17% higher in Swiss-franc terms than it was at the start of 2010. Remember that, until 1971, the value of most currencies was expressed in terms of gold or silver. On that basis the Swiss franc has just experienced the kind of devaluation that would have been the mark of a crisis in the 1930s or 1960s.


In the eyes of many commentators this lack of confidence in paper currencies makes sense only if high inflation is on the way. But in the developed world measures of consumer inflation are very low. There is spare capacity in the economy and no sign that a wage-price spiral is taking hold. And government-bond markets show no sign of alarm at the inflationary outlook.


Then again, since central banks are such big players in government-bond markets these days, is the yield a true “market price”? The banks are buying bonds as part of their foreign-exchange policies, or as a way of injecting liquidity and bringing down yields, rather than as a way of maximising their returns.


Then there is the issue of higher commodity prices. Jeremy Grantham of GMO, a fund-management group, has compiled an equally weighted index of 33 commodities. This fell by 70% between 1902 and 2002 in real terms. It has regained all that ground in the past nine years. The rise of developing nations is generally deemed to explain this commodities boom. Since raw materials have greater weight in the inflation baskets of such countries, it makes sense for investors in China and India to buy gold as a hedge against this phenomenon.


If it turns out that China (rather than gold) is a bubble and that growth in developing nations disappoints, then you would expect commodity prices to fall sharply and gold to follow suit. But in the absence of such an event, gold’s strength is not entirely irrational.