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By Stuart Burns

A review of the gold price written by Robin Bew, chief economist at HSBC Bank, proposes that the gold price is in danger of entering bubble territory and predicts a sharp correction by year-end. Determinedly, Robin examines the main drivers behind the price over recent months while acknowledging by use of this graph that the price has been on the rise for much of the last decade:

[Click to enlarge]

Source: The Economist

Courting controversy from a few sides, the bank states there is nothing special about the nature of gold that makes it an ideal safe-haven asset. Were it not for its widely perceived role as just that, gold would behave like most commodities — rising in value during good economic times, when demand for its industrial uses increases. Of course, gold has limited industrial uses and if that were the only source of demand, the price would behave exactly as he suggests.

The problem is this quasi-financial role that gold has — not quite a currency, but treated as if it were. This imparts it with a special status; like all currencies, though, it can rise or fall depending on circumstances. Upon accepting that the world has somewhat arbitrarily assigned gold this role, we must review a number of factors that support gold’s price prior to predicting how these may develop in the year ahead.

First, its safe-haven status, as he points out; since Lehman Brothers collapsed on Sept. 15, 2008, the price of gold has more than doubled. Demand from investors rose from 692 tons in 2007 to 1,200 tons in 2009 and 1,487 tons in 2010, along with demand for other safe-haven assets like US treasuries and the Swiss franc. The yield on all such government debt – US, German, Japanese — has been historically low for much of the last three years with the exception of early 2011, when the community went risk-on and moved out of safe havens and into commodities and other riskier assets.

Recently, though, sovereign debt has been very much back in the news and gold has benefited from its safe haven status as the euro has seemed on the point of collapse and the US government seems unable to reach agreement on budget cuts.

The other major support for gold, which almost runs counter to fears about sovereign debt and another financial crisis, is the fear of inflation. Indeed, in 2009-10 many were attracted to gold as a hedge against the potential for rising inflation as the global economies bounced back in an extremely low-interest and loose monetary environment.

HSBC’s opinion is the US will reach a deal that avoids default before Aug. 2 and that European leaders’ decisions this week will paper over the cracks, if not actually solve the indebted positions of Greece, Portugal, Spain and Italy such that they can continue to function within the euro. The bank does not see any significant risk of a rise in inflation in the early stages of what will be a weak and prolonged recovery phase. They are expecting a gradual US recovery starting later this year and observe that Japan is already returning to some sense of normality after the natural disasters early this year. As interest rates rise, the attractions of financing investments in gold will be reduced compared to other asset classes. As a result, the bank expects the price of gold to average $1,390/troy ounce in the fourth quarter of 2011 and to fall to $1,000/troy ounce by mid-2013.

Naturally the bank adds caveats that this is based on the recovery occurring as expected and inflation remaining subdued, but on the balance of probabilities, that is how the bank sees the next two years working out. As such, some may question if gold at $1600/oz really represents such great value, or if they would be better off taking profits while they can.

Source: Gold: Asset or Bubble?