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As it became increasingly obvious in December, 2013 that the Federal Reserve was this time committed to reducing the volume of monthly asset purchases in a gradual manner from its $85 billion a month commitment, I wrote an article on the effect this should have on gold prices. I argued back in December that the reduction in asset purchases by the Federal Reserve will lead to a decline in stock market gains, which in turn will lead to investors gradually moving back towards gold.

My theory was based on the assumption that investors abandoned gold once it reached $1,900 an ounce because it was increasingly obvious that stock the market offered a better rate of return. Looking back to 2009, when stocks started rising again, some people may be tempted to argue that my theory is flawed because after all gold prices continued to rise for another few years, despite the stock market turnaround. There are two reasons why that line of thinking is flawed. The first reason is that in 2009 there was enough cash on the sidelines to keep both the gold and stock market momentum going. Gold prices reached an all time record high of $1,900 in August, 2011. First year on year decline in prices happened much later. 2013 was the first time in twelve years that gold did not manage to gain in price. 2013 was also the year when the S&P and the Dow Jones indexes both reached a new all time high, shooting past the old records reached in 2007. Until 2013, investors had enough cash to take advantage of the gains on the stock market, while still maintaining a position in gold in order to keep a small safety net in the form of some gold, in case things went wrong with the paper asset holdings in their portfolios and in the economy overall. Once new all time highs were reached, increasingly people had to choose and they chose the asset class which seemed to offer better returns. 2013 was also the year when it seems people were finally able to shake off the trauma of the recession. Confidence is back in the system, so less demand for the anti-system insurance policy. This is the second reason why gold lost ground.

2014 promising beginning for gold.

Gold data: Link S&P data: Link. Note: Chart shows end of week closing price.

Expecting gold to do better in a monetary tightening environment may seem counterintuitive. Gold is seen among other things as the antidote to the dangers of fiat money printing. Inflation is forecast to remain low for quite some time to come in the developed world. EU, Japan and the United States are all seeing deflationary pressures rather than inflation. Commodity prices such as oil are not likely to contribute much to creating an inflationary environment either, because current $100 price range is about all that oil prices can do in current economic environment. The price going much higher from here will not lead to inflation as it did in 2000-08 period, but demand destruction, thus economic slowdown instead. Gold is seen as an inflation hedge, but there is little inflation aside from some countries in the developing world.

What does make gold very attractive right now is the recognition that monetary policy has had much to do with stock market performance for the past few years. Stock market performance is set to be sluggish from this point on as monetary stimulus is gradually being pulled back. With stocks no longer offering returns that might be worth the risk and bonds still yielding historically low interest, especially in the high-grade investment category, cash is seen as a good place to park it for a while. When it comes to currencies however, given the fiat nature, thus the uncertain future of any currency, gold is seen as a currency with a solid backing. The average price of producing an ounce of gold is now around $1,200, which is very close to the current spot price (link). As far as future availability of supply goes, it is true that the slide in the spot price from the record high of $1,900 to the current levels did not cut mine supply just yet, which should be expected. Many companies invested in building up supply capacity during the more than decade-long gold price bull run. At the same time, few companies are looking to open new mines at this price level. Many major gold mining projects such as the abandoned Alaska Pebble mine will probably require a spot gold price in the $1,500 range before production will commence. Preliminary assessment of the deposit estimated a spot price of $1050 in 2011 as the profitable gold spot price level (link). Since then, various other estimates put the breakeven price higher

Projects such as Rosia Montana in Romania, which would have become Europe's largest gold mine if project would have gone ahead, might need a higher price as well, not so much in order to cope with production costs, but to win over the fierce political argument related to allowing the project to go ahead. A higher state royalty payment per ounce might help sweeten the deal enough to turn around the current hostile mood of the Romanian electorate. Romania had a bad experience with a previous gold mining investor. A massive cyanide spill in the year 2000 caused great environmental damage in the region (link). Given that lower and lower gold ore concentrations will inevitably lead to higher volumes of cyanide use, environmentalist opposition will most likely increase, justifiably because the environmental disasters will inevitably become more severe. Paying higher royalties will most likely become necessary in order to overcome environmentalist resistance in Romania and elsewhere, thus adding to the breakeven costs of production.

There is no doubt that long-term gold mining production costs are headed up, therefore the long-term price floor is also moving higher. There is therefore little chance of gold prices trending much lower from here for the long-term. There may be some short-term downward moves, which will most likely last a relatively short time. Gold is therefore by far the safest currency out there. All other fiat currencies are dependent on stability to keep long-term exchange rate and purchasing power. Unfortunately, in large part due to slower economic growth path since 2008, stability is not a word that properly describes our world today and going forward. Slower growth makes it harder to cope with debt. It makes it harder to prevent working class from suffering a drop in real incomes. It makes it harder for many people to cope with rising soft commodity prices, which due to low demand elasticity can spike aggressively every time there is even a relatively small drop in production. In the face of this, gold becomes the currency of choice when it comes to currency's role as store of value. In the face of diminishing return on risk as a result of the Federal Reserve tightening trend, a safe store of value for at least a portion of capital is likely to be in high demand.

Source: Fed Taper: Good For Gold, Bad For Stocks