How to Interpret the Rise in Gold Prices - The Daily Reckoning
The Daily Reckoning by Bill Bonner
On This Day - 10 September 2011
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How to Interpret the Rise in Gold Prices A  A  A

- By Asad Dossani, Author, The Lucrative Derivative Report

Asad Dossani
Gold has been one of the best performing assets over the last year, as prices have skyrocketed to record levels. It seems as though we are talking about a new record in prices nearly every week, and the trend appears set to continue going forward.

So how can we interpret the rise in gold prices? There are two issues to discuss here. The first is, why is it that investors want to buy gold, and the second is, what is the impact of rising gold prices on the rest of the economy. The two issues are obviously linked, but let's discuss each one in turn.

Investors buy gold primarily as a safe haven. Gold is known to perform well when the rest of the economy is in a poor state, and thus investors buy gold to protect themselves financially. Thus, we see gold prices rise whenever there is uncertainty about economic prospects or in financial markets. For example, both the American and European debt crises have led to increases in demand for gold.

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From this perspective, we can interpret the rise in gold prices to mean that investors are worried about economic prospects, particularly the global economy. As gold is an internationally traded commodity, its movements are driven by global rather than local factors. So rising gold prices does not necessarily mean that Indian economic prospects are poor.

The second reason investors buy gold is to protect themselves from currency debasement. In general, central banks can print as much money as they wish and inflate away the value of the currency. On the other hand, gold cannot be created at will, and so its value should rise if excess currency is printed. Gold prices have increased whenever there has been talk of quantitative easing by the US Federal Reserve, as this involves printing dollars.

From this perspective, we can interpret the rise in gold prices to mean that investors expect future inflation to be high. That is, they expect that current money printing by central banks will lead to higher inflation in the future, as the fiat currency is debased. Lower interest rates have also contributed to higher gold prices, as this also creates additional cash in the system.

To summarize, rising gold prices mean that investors are fearful about economic prospects and are fearful about excess inflation or devaluation. One factor that is very interesting and perhaps inconsistent with the above explanations is that Indian investors are leading the way in gold buying. That is, much of the gold demand is coming from investors in India.

This is puzzling for two reasons. First, prospects for economic growth are fairly strong in India, as compared with the rest of the world. Economic growth has been slowing, but it is still above 7%, and well above growth rates in most other countries. In addition, India does not face the same debt problems that Western economies face, and so safe haven concerns are minimal.

Second, the RBI has been raising interest rates and tightening monetary policy. In an attempt to reduce inflation, the RBI is reducing the amount of rupees in circulation. This should mean that in rupee terms, gold prices should be falling rather than rising, however the opposite is occurring. Hence, the fact that gold demand from India is strong runs contrary to the usual explanations for rising gold prices.

The most we can extract from the high gold demand coming from India, is that investors are fearful that the Indian economy will suffer if the rest of the world suffers, and for this reasons it is sensible to buy gold. The current economic situation does not justify increased safe haven demand, but perhaps the future economic situation will, and thus it may be sensible to buy gold now. We can interpret higher gold prices to mean that investor confidence is low. That is, investors are not particularly confident about future economic prospects, even domestically.

Let's consider the impact of rising gold prices on the economy. In general, the impact is negative. This is for a few reasons. First, the more money investors are putting into gold, the less money investors are putting into businesses and productive investment. Money invested in gold does not create output or employment, whereas money invested in businesses in the economy would do so. Thus, investment in gold is negative for economic growth.

Second, as India imports its gold, the more money investors put into gold, the worse the current account deficit becomes (that is, the wider becomes the gap between imports and exports). This also is negative for growth, as imports are subtracted in the calculation of GDP.

Finally, and this is perhaps the most important factor, investment in gold is a sign of low confidence in the economy, as discussed previously. Low confidence in the economy can itself hurt economic growth in a significant way, as people put off making investments and making large purchases. As long as gold prices are rising and investors are fearful about economic prospects, the impact on the overall economy will be negative.

is a financial analyst and columnist. He actively trades his own and others' funds, investing primarily in currency, commodity, and stock index derivative products. Prior to this, he worked at Deutsche Bank as an analyst in the FX derivatives team. He is a graduate of the London School of Economics. Asad is a keen observer of macroeconomic trends and their effects on global financial markets. He is deeply passionate about educating investors, and encouraging individuals to take part in and profit from financial markets. To put it colloquially, he wishes to take Wall Street products and turn them into Main Street profits!

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4 Responses to "How to Interpret the Rise in Gold Prices"

Kunwar Narayan

Sep 12, 2011

Very few people are talking about a 3rd reason for increase in gold. Supply of gold is lagging nominal GDP growth significantly.......and even more significantly in China & India. As over all disposale incomes are increasing in Indi, gold supply is increasing more slowly. People due to cultural issues are buying gold more and more.

While other reasons are euqlly important, they are not sustainable long term. If USA undergoes deflation, gold will drop; but if India and China cotinue to show increases in disposable incomes, Gold price drops will be more than off set. Gold has risk only from a short to medium term perspective. If you are bullish on India from a long term perspective, you will need to be bullish on gold. Gold is a good investment, but secondary to equity markets in India. Gold is a very good investment because it can go up, as well as provide down-side risk of international collapse. suggest a 20-25% allocation to gold. Makes me think of Gurjarati rule of thumb investing 1/3 realestate, 1/3 Gold, 1/3 Markets.

I dont believe any analyst is yet more inelligent (long term) than 1000's of years of culture and tradition. These traditions have been formed over many cycles of good and bad nad can withstand storms better than any 30 year old harvard analyst can.

Like (1)

kalabairava

Sep 12, 2011

absolutely true. Sentiments are negative. India is on its way to hell and make no mistakes about it.

There is no socio-economic justice in India.

No political party talks about equality, they keep extending quotas on the basis of caste. Even the Supreme Court finds that there is nothing wrong in denying equal opportunities for others castes. The Supreme Court is busy formulating their own reservation policy to bring dalit judges.

The Govt. denies us equal opportunity is every sphere of life. right from education to employment. It feels like India doesnt like non-dalits and continue to cheat us in the name of caste.

The politicians are now deciding to procure at least 30% from dalit owned companies. Even to remove creamy layer there is a big issue.

In such a scenario only a fool would have any hope of economic develpment.

The only way is to convert all indians into dalits. How do we declare all indians as dalits so that we can all live in a society of equality.

Like (1)

Abhay Kothari

Sep 10, 2011

Indians, individuals at least, are great believers in common sense. We all know that the interest we receive from banks is almost always lower than inflation and we are always having trade deficits. If there was no capital transfers from abroad, rupee would crash out of sight. Capital transfer means mainly selling our assets(equity) to cover deficits. Solution for common man is to buy gold and gold and gold. If we have larger capital then we'll buy land.BUT NEVER STORE TRASH CALLED PRINTED CURRENCY.

Like (1)

Ramakant

Sep 10, 2011

Is it simply the amount of black money generated in India which supports demand for gold?

Like (1)
  
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