Bling! Time for gold to glitter?

A weaker dollar and possibly higher inflation herald renewed interest in the still-precious metal

By Darcy Keith


Globe Investor Magazine online, Jan. 19, 2009

Gold has lost a bit of its lustre since catapulting to above $1,000 (U.S.) an ounce last March, but bullion bugs have fared better in the financial crisis than holders of other commodities.

The threat of deflation — one of gold’s worst enemies — and the strong performance of the U.S. dollar have kept prices for the yellow metal under pressure in recent months. But as signs emerge that the greenback’s advance may have reached its climax and consumer prices are unlikely to spiral down out of control, gold may soon mount a comeback.

Many analysts suggest that the downside risks appear minimal – and that by itself may be reason enough to consider shining up your portfolio with a bit of the precious metal in this hideous investment climate.

The case for gold to shine.

While a lot of recent focus has been on deflation — a natural inclination given consumers’ reluctance to open their wallets during a recession — the rate at which governments have been printing money to help rescue their economies suggests it is actually inflation that could rear its ugly head in coming months. And that is good for gold, often used as a hedge against the upward price movement of goods and services.

Donald Coxe, the former BMO Nesbitt Burns strategist who recently left to open his own shop, Coxe Advisors, notes that the U.S. Federal Reserve alone has quadrupled the size of its balance sheet since the financial crisis erupted.

“There’s going to be an inflationary price to pay for this, but right now governments are prepared to pay that price because they are so scared of the collapse in the economy,” said Mr. Coxe.

“Once people realize the economies have stopped going down and have started coming back, then they are going to look at all the liquidity in the system, and that will be the point we’ll probably start seeing the substantial rally in gold.”

When that happens is difficult to predict, but Mr. Coxe believes gold, as well as grains and oilseeds, will be the best-performing commodity sectors over the next six months.

There doesn’t seem to be any immediate threat of inflation, at least in the world’s biggest economy. The U.S. consumer price index fell for the fifth month in a row in December, edging down by 0.1 per cent from November, with core CPI inflation — which excludes the impact of lower energy costs — flat. But with the recent move by the Federal Reserve to slash interest rates practically to zero, making borrowing attractive even in a sickened economy, inflation may not stay out of the picture for too long.

Part of Mr. Coxe’s optimism over gold stems from his “ultra-bearish” view of the U.S. dollar. As gold is priced in U.S. dollars, a stronger greenback makes buying the commodity more expensive in other currencies, which has a natural tendency to weaken demand.

Mr. Coxe attributes the U.S. dollar’s strong performance this past autumn to the intensifying credit crisis that sent investors racing to U.S. dollar-based Treasuries as a safe haven. Once the panic subsides, Mr. Coxe expects the greenback to return to a long-term bear market — and that alone, he says, will be sufficient to propel gold upwards.

Patricia Mohr, a vice-president and commodity market expert at Scotiabank, says this scenario of investors cashing out of U.S. Treasury securities may begin to play out in the second half of 2009.

But Ms. Mohr believes it may be premature to ring the alarm bells over inflation just yet. “I think it will be quite contained for some time. I think the problem is industrial capacity utilization is going to be quite low in the first half of next year. You don’t typically get inflation moving up unless there is a real reason in the real side of the economy and we just don’t see that happening for some time.”

Ms. Mohr predicts gold will stay above $800 next year, but doesn’t see a retest of $1,000 any time soon.

Monica Bonar, a director with Fitch Ratings who covers the North American mining and metals industry, holds a similar view. Ms. Bonar believes gold will stay well supported near current levels of around $800 but doesn’t see any significant rallies until inflation fears return. That, she says, could be a year away.

The steps taken by the world’s leading economies to shore up their financial systems should be sufficient to dodge any serious deflation risks. But central banks will also be quick to stamp out any signs of inflation through hiking interest rates and using other tools at their disposal. “If they see any signs of inflation they’ll be sucking it out like you wouldn’t believe,” she said.

Some risks that could dull gold’s performance.

The collapse in oil prices is worrisome for gold, which tends to trade in the same direction. As crude rises, the threat of inflation rises with it. With gold near $840, and crude in the doldrums at around $35 a barrel, the ratio seems a bit out of whack.

“That is a huge difference in price, so therefore, it is something to look out for,” said Mr. Coxe. “If oil prices were to collapse again, that would be a constraint on gold price activity, unless we’re going into a totally new era where the ratio of gold and oil is out of line.”

Another risk is that the greenback could keep on strengthening. Ms. Mohr says it’s possible when President-elect Barack Obama takes office tomorrow and comes armed with a massive stimulus package, there may be a sudden improvement in sentiment over the economy. That may provide the U.S. dollar with a jolt of adrenalin that could send bullion prices southward.

If that were to happen, however, Ms. Mohr doesn’t see it lasting long.

“Later in the year, when investors start to refocus on the absolutely extraordinary budgetary deficit in the United States of over $1-trillion, the U.S. dollar could come down and gold up.”

Watch for these signs.

Mr. Coxe suggests monitoring the KBW Bank Index, a barometer that measures the big U.S. banking stocks.

“When that index turns up decisively, which should happen just before the economists realize that things are getting better, then I think that’s the point at which gold will really outperform,” he said.

Over the past few months, as the market braced for financial conditions to get worse, the index fell from a high of about 87 to a low of about 31.5 Friday.

Ms. Mohr suggests staying alert for two things that could foreshadow a new significant rally in gold: When attention is refocused on just how big the U.S. budgetary deficit is going to be; and any comments from China’s central bank that it may want to diversify its holdings away from U.S. debt.

Special to the Globe and Mail