The price of gold has been on a virtual downtrend since September 2011. Of course, we are referring to gold in dollar terms. From a high of $1900 / troy oz it has fallen closer to $1100 / troy oz in a span of 4 years. There are a variety of reasons attributed for the end of gold as an alternate currency. Firstly, the dollar has been on a constant tear and typically the US dollar has been negatively correlated to the price of gold. Secondly, with the entry of ETFs large global ETFs like SPDR have started holding over 1300 tonnes of gold to back their gold ETF units. One needs to remember that SPDR today is the 6th largest gold holder. This investment demand has created volatility in the price of gold.
So does that mean that gold will gradually lose its sheen as a store of value and a reserve currency? Not necessarily! One needs to understand the gold cycles over the past 50 years to actually understand the future of gold prices.
The first phase (1971 to 1980)
This was the golden period of gold. Till 1971 the price of dollar and gold were pegged to each other. This was an agreement under the Bretton Woods Arrangement of 1944. By 1971, the US realized that it was not feasible for the US to continue with the gold standard. The Bretton Woods standard broke off in 1971 and from then on currencies have been typically pegged to a basket of hard currencies. Interestingly, as central banks did not need to hold substantial gold, the idea of gold ETFs took off in a big way. During this 9 year period, the price of gold spurted from $42 / troy oz to $800 / troy oz, a stunning return of 1900% in 9 years.
There were many reasons for this phenomenon. The period of 1971-1980 was marked by severe global economic and political strife. Many investors preferred the safety and solidity of gold in these volatile circumstances. The decade started off with the Black September and then the famed oil embargo of 1973 which resulted in a sharp hike in crude prices. A spurt in oil prices led to a weak dollar and consequently strong gold prices. This period saw the peaking of the Cold War between US and USSR as well as geopolitical events like the Iran-Iraq war, Arab-Israel war and the Soviet Occupation of Afghanistan. This geopolitical strife created a vicious cycle of debt, deficits and an increase in money supply. As much as it eroded the confidence in the dollar, it made gold the priced currency.
The Second Phase – (1981-2001)
This was in a way the golden era for equities. With Alan Greenspan embarking on a massive plan of cutting interest rates, equities as an asset class took off in a big way. There were quite a few critical phases during this period. The 1986 oil prices crash added a lot of economic value to oil importers. The break-up of the Soviet Union and Eastern Europe post-1989 put an end to whatever fears of war were left. After all, with just one superpower, the prospects of a war were remote. Then in 1995 the internet was invented and global business was never the same again. All these 3 factors created huge equity wealth and it did not subside till the technology crash of 2001. During this golden era of equities, gold prices fell gradually from $800 / troy oz to $255 / troy oz.
The Third Phase – (2001-2011)
The price of gold went through a 20-year period of gradual downtrend. Post the technology meltdown in 2000-01, gold bottomed out at around the $250 / troy oz mark. The real spurt in gold prices came post 9/11 which once again forced many investors to seek refuge in gold. But the rapid upward movement in gold came post 2008 after the Lehmann crisis. The rally in gold prices, began in 2001 at $255 / troy oz and went on to peak in 2011 at $1900 / troy oz. Of course, from 2012 the US dollar has been on an upward move and gold prices have fallen from $1900 / troy oz to below $1100 / troy oz.
The million dollar question now is whether this is the end of the rally in gold or a temporary blip. While there arguments like dollar strength and alternate fiat currencies, it may be more of a temporary blip in gold prices before it resumes its uptrend. Let me explain…
- Dollar strength owes its origins to weakness across the world as well as cheap oil. Also the Fed decision to hike rates has been positive for the dollar. But the dollar has rallied for too long and has started pinching exporters.
- The rapid money expansion that we are seeing today is exactly like we saw in the 70s and that has to make gold more valuable. After all, Bitcoin may still be years away from being taken as a serious alternate non-fiat currency.
- We have seen more wars in the last few years than at any time in the last 20 years. Russia is battling Crimea and there is a battle for supremacy in the Middle East. 25 years after the demise of the USSR, China has started flexing its muscles and threatens to emerge as an alternative power centre.
The weakness of gold is largely attributable to the strength of the dollar. There is too much liquidity and too much debt sloshing around in the system. As sanity returns to markets (as it is happening in China now), the wonders of gold will be back in reckoning. That does not seem to be too far off!
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