Inflation risk and economic instability are the primary drivers for gold. Worries about European debt have driven gold to break its all-time nominal highs this week. However, this does not mean the end of the line for the yellow metal. I expect gold to reach if not exceed its real high, adjusted for inflation at $2,284 per ounce.
Real Interest Rates Still Negative
One of the main drawbacks for investing in gold is that holding gold does not pay any interest coupon or dividend yield. However, real interest rates are currently negative at -3.22% (0.25% federal funds rate - 3.57% inflation rate) or -2.02% if using the five-year treasury yield. As a result, investors do not lose anything holding gold versus just holding it in the bank. Negative real interest rates also discourage savings while encouraging asset bubbles through investors seeking risks to gain higher yields.
Economic Uncertainty Overhangs Market
Gold rises when macroeconomic trends are volatile and fundamentally weak. Whether it's sovereign debt issues of the PIIGS in Europe, the risk of a double dip recession/long term high unemployment in the United States, and/or high inflation in emerging markets, there are a variety of variables that can bring the economy down at any moment. In addition, the debate of the debt ceiling will also be beneficial for gold. If a debt ceiling raise is approved, gold will rise as investors become more skeptical of the US's ability to pay its debt in the future; if the debt ceiling does not rise, an immediate hit to the Treasury market will drive conservative investors into gold for safety.
Central Banks Continue to Devalue Major Currencies and Inflationary Risk is High
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Ever since the financial crisis in 2010, the US money supply has grown exponentially. According to the St. Louis Fed, the money supply has more than tripled. Two rounds of quantitative easing and drastic money supply increases to bring the Federal Funds rate down to 0.25% in 2008 will eventually come back to strike the economy through high inflation.
To keep their currencies low versus the dollar, many emerging market countries such as China, Argentina, and Vietnam have imported our inflation. However, this game will not last, as these countries will have to correct their currency imbalances to prevent their economies from seriously overheating. The dollar is not the only currency in trouble. The pound, euro, and yen are in nearly as weak shape as the US dollar, so these currencies do not serve as a safe alternative. Since gold supply is constricted by the rate of new mining outputs, it will appreciate against fiat currencies whose money supply is growing with a few zeros typed into a computer.
Overall, I expect gold to continue to rise due to negative real interest rates, dollar debasement, and continued economic uncertainty. These issues will be addressed eventually, but not be solved quickly, which makes gold an excellent buy until central banks regain monetary discipline.
Disclosure: I am long GLD.