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Matthew Lynn's London Eye Archives | Email alerts
Jan. 4, 2012, 12:01 a.m. EST
By Matthew Lynn
LONDON (MarketWatch) "” No one ever said gold was an asset for the faint-hearted. Or indeed, for anyone who doesn't enjoy an argument.
To some it is the only true form of money, a king over the water just waiting to be re-installed on its rightful throne once the impostors are cleared out of the way. To others, it remains, as the economist John Maynard Keynes described it, a "barbarous relic," of no more relevance to the 21st century that the canal or the telegraph.
Still, even by its usual standards, it was more contested than ever as 2011 closed out. After running all the way up to $1,916 an ounce in the autumn it dropped all the way back to $1,550 as the year ended. So has the great gold bull market, which started in earnest all the way back in 2000, finally blown out?
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Not quite. Gold will tip over into bubble territory one day. But it won't move into a bear market until central bankers start hammering down on inflation as they did in the early 1980s. And that moment is still some way off.
True, it is not hard to make a bear case for gold.
Any asset that has been rising fast for more than a decade has to treated with suspicion. Back in July 1999, gold hit a 20-year low of $252.80 an ounce. The International Monetary Fund was a seller, and so were central banks in Australia and Britain. It looked as if time was finally being called on its role as the ultimate repository of value. As it turned out, that was the bottom of the market. Since then the price has climbed and climbed. Even give the correction before Christmas, gold is up six-fold in a little over a decade, while stocks and most other assets have gone nowhere.
That bull market has entered the popular consciousness. Ordinary people who hardly follow the markets, and have no idea what bond or currency markets are doing, now discuss gold in much the same way they used to discuss property prices. There are endless adverts offering great prices for unwanted jewelry. Gold funds pitched at ordinary investors are being launched all the time, and the bullion companies are building new vaults to store all the stuff. It even trends on Google.
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If that isn't a sell signal, it is hard to know what is. On top of that, some of the smartest players in the markets have jumped off the bandwagon. George Soros, the hedge-fund guru, has said he has sold most of his gold holdings. Like him or not, Soros is always worth listening to: he's been right more often than most of us, and has the bank balance to prove it.
Against that, the bull case is not hard to make either. Inflation is still a threat. Central banks are still minting money. The dollar is in steady decline as the world's reserve currency. Perhaps most importantly, the euro remains in crisis. Either the European Central Bank will print lots of money "” which is good for gold "” or else the currency will collapse chaotically "” which would be good for gold as well. Little surprise then that the bulls are sticking to their forecast of the price soaring past $2,000 an ounce during the course of this year.
Who should you believe? One useful way of cutting through this argument is to ask this question. What it would actually take to drive the price of gold down?
We have one major example to look at. Between 1980 and 1982, the price of gold collapsed from more than $840 an ounce to less than $320.
Why did that happen? Well, because there was a sustained rise in interest rates. In the U.S. interest rates went from 11% in 1979 to 20% in 1980. In the U.K. rates went up to 16% in 1980. Even in that haven of low inflation and monetary stability, the old Bundesbank-controlled West Germany, rates went all the way up to 11.5%. Gold peaked at roughly the same time, but then went into a sustained decline.
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The reason for that is not hard to understand. Rising interest rates do two things to gold.
First, they reduce inflation "” and since gold is primarily a hedge against inflation, that reduces its value. Once the central banks have made it clear they are going to raise rates to whatever level is necessary to bring prices under control again, there is not much reason to protect yourself from inflation. You are better off moving into other assets "” such as stocks, for example "” that will flourish as the economy becomes more stable. Investors don't catch on immediately, but they get the message soon enough.
Second, as interest rates rise, it becomes more expensive to own gold. The precious metal pays no interest. Indeed, you have to pay to store it. When interest rates are zero, as they are now, that doesn't make much difference "” cash doesn't pay any significant interest either. But when interest rates rise, the cost of holding gold, in the sense of interest foregone, starts to rise. Back in 1980, you could get 20% on cash, so all that gold sitting in your portfolio looked expensive.
The point is a simple one. The gold price is not going to fall in any sustained way until interest rates start to rise significantly. Perhaps they don't need to go back to 1980s levels because they are starting from a lower base. But interest rates of 10% would be necessary to create a bear market in gold.
Is there any sign of that? Not yet. If anything, central banks are going to make money even cheaper this year.
The precious metal will turn into a bubble one day "” every asset eventually does. But it is a long way off that point now.
Matthew Lynn is a financial journalist based in London. He is the author of "Bust: Greece, the Euro and the Sovereign Debt Crisis," and he writes adventure thrillers under the name Matt Lynn.
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