Readers Question: Gold prices have risen tremendously over the past 12 months, nearly 40% this year in GBP, and has risen 225% in just 5 years. Are we seeing a gold bubble? If so, what is the future for gold?
Gold is highly volatile. From a historic graph, you can see in 1980, there was a gold price bubble, when the price reached over $600 ($2,500 adjusted for inflation). During the long period of economic stability from 1983-2003, the gold price fell.
There are definitely a few reasons to explain why the price of gold has increased in recent months, but whether these justify the magnitude of the price increase remains uncertain. See also: Factors that Affect the price of gold
Reasons to Justify Increase in Price of GoldUnprecedented economic instability
The credit crisis has resulted in deep seated economic problems for both US and Europe. Previously established conventions are being challenged e.g. credit downgrade in US, and real fiscal crisis in Eurozone.
Decline in Stability of the Dollar
Arguably, the US debt is currently manageable - if they made realistic changes to long term spending and tax plans. However, markets are questioning whether the US is able to make reasonable long term budget changes. The recent threat to veto the US debt ceiling showed how the partisan nature of US politics could destabilise the US economy in future years. If the dollar and dollar assets (such as US Treasury bills / bonds) are no longer seen as secure with increased chance of default (or partial default through devaluation), then gold becomes an attractive alternative.
The US dollar is currently the most traded currency and biggest form of foreign exchange reserves; there is currently widespread demand for US assets like Treasury bills, but if people lose confidence in the dollar, there may be no alternative but to increase gold reserves.
Lack of 'Safe Havens'
For a long time, the US dollar has been treated as a 'safe haven'. If that is being challenged, it is not certain another currency could take its place. The Euro is currently undergoing more challenging problems than the US. The Yen has been attractive, but the Japanese economy is still very weak and they will be keen to avoid this appreciation. Similarly, the Swiss economy could not cope with the Swiss France becoming a currency of last resort. No currency stands out as offering a strong investment, so in times of uncertainty people may choose the alternative gold.
Some argue that the unconventional monetary policy of quantitative easing (which involves increasing the money supply) could lead to future inflation. It is inflation that really makes gold attractive as it holds its value whatever happens to inflation.
However, at the moment, it is hard to envisage global inflation, if anything deflation looks a greater possibility. But, in the absence of alternatives, if countries embark on more QE, it may increase the risk of future inflation which makes gold more attractive. If nothing else, the uncertainty of what QE will bring is encouraging people to invest in gold.
In the post war period, government defaults have been confined to the odd emerging market such as Argentina. However, countries in the Eurozone now look very fragile, and Greece is almost certain to partially default. This has changed market perspectives on government default. There is a realisation being a member of the Euro or OECD is no automatic guarantee of solvency. Given how the financial system is interconnected, default in even a small country will adversely affect the global banking system and could lead to knock-on problems for other countries. This fiscal crisis is difficult to solve because even spending cuts create different kinds of problems - lower growth and more unemployment. The problem is also exacerbated by ageing populations and government entitlement spending. The increased threat of government fiscal policies (related to stagnant growth) is making gold more attractive.
Target of $2500
Given political and economic uncertainty, some gold analysts are already predicting the return of $2500 for gold.
Growth In India / China
The growth of the Indian and Chinese economy creates additional demand for gold. In the case of India this is also for consumer goods like jewellery. China has one of the lowest rates of gold reserves, but it has indicated it would like to increase its gold reserves.
Reasons Gold may by OvervaluedInflation is not a problem. Despite QE in US and UK, there is no immediate prospect of inflation, traditionally a phenomenon that makes gold more attractive.
Economic Recovery. In aftermath of financial crisis, recovery was going to be slow and the next few years will probably give anaemic growth. However, as the global economy slowly grows with low inflation, gold will start to give a poor return compared to stock markets and other more traditional investments (like in 80s and 90s)
ConclusionI can't see inflation being a problem. But, there are strong reasons for a double dip recession. The crisis in the Eurozone is quite serious as, given current set up, I don't see any easy solution to the twin problems of low growth and high deficits. I would imagine the uncertainty to continue for a considerable period. In this climate, gold is likely to keep rising. However, I do believe the global economy will return to more 'normal' rates of growth (may take a few years). Interest rates will return to normal levels and then gold may start a long decline like in 80s and 90s. But, it is hard to predict a few years time, as it depends on many factors that are unknown.