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As I've written many times, I am not comfortable with either of the following two popular theories on the price of gold:

  • Momentum/Relative-Strength Theory: Gold will rise because it has risen strongly and that is sufficient evidence that gold has strength and strength means future additional rises in price.
  • Bubble Theory: Gold has risen too far, too fast and the short-term charts of this rise look like bubbles of the past, therefore the bubble-evidence proves that it must come down -- only a question of when and how far.

My basic premise on exchange rates (the price of gold in any given currency) is that the rate of exchange is proportional (over an extended period of time) to the amount of any currency in circulation adjusted for the value of the aggregate wealth produced in the country that is issuing said currency. The more of any currency being passed around (for any given aggregate wealth produced per currency note in any given country), the higher the exchange rate relative to any other currency (or gold) with lower rates of money supply growth. Print more currency in excess of wealth produced, and each note in circulation is worth less relative to a stable supply of gold in the world (annual production = 1.5% of world supply).

Look at this chart of gold prices (in USD) vs the U.S. monetary supply M1 since 1971, the year that the United States took the world reserve currency off the gold standard:

[Click images to enlarge]

Around the world, you can predict with some accuracy the price of gold in any country's currency by measuring the quantity of paper currency in circulation. So, then, why the big periodic discrepancies in 1979-83 and in 1997-2005? In 1980, it would have been accurate for a mine operator to sell their future supplies of gold. The money supply was not driving that gold price surge.

Beginning in 1995, it would have been a bad strategy to presell future production of gold, but apparently it was a common one as miners were commonly trying to accelerate cashflows by selling gold out 2-4-5 years into the future. The period 1995 through 2005 were flat years for gold's price while M1 was climbing rapidly -- something that was only made possible by the reserve status of the USD and the oversupply of gold bullion being sold.

The annualized return on holding gold in 2000-2005 was 12-15% and has climbed steadily since 2005 to what now appears to be an annual return of which baloons are made. But, gold is only playing catchup after a long period of selling too much gold into a market by miners at sub-par prices. Miners finally awakened from 2005 through today to the weaknesses of this policy; large examples are Anglogold Ashanti (AU) (in June-Nov, 2010) and Newmont (NEM) (mid 2007) and Barrick (ABX) (Late 2009).

The following chart shows this de-leveraging tsunami through 2009. Today, the world hedge stands at a measely 4.8 Million ounces or 300 tonnes.

Notice in the first graph the uptick in gold prices that began in 2002, the same year that the world gold mining hedgebook began to drop. I would contend that world gold prices in 1995-2002-2005 were held artificially low due to the high preselling in 1985-2002 which was the equivalent of 1.5-2 years true production. Prices have been rising steadily since then as this excess paper supply of gold has been retracted. The relationship is not the other way around - that gold miners began to withdraw their hedgebooks as they saw prices rise.

The gold miners are not speculating in higher gold prices - they are merely astute observors of worldwide monetary policies and fiscal policies.

So, what can we predict about gold prices based on monetary policy trends?

This quote from a recent Seeking Alpha article:

Gold prices will not necessarily continue their climb to prices at which the metal would be overvalued relative to OECD M1.

Yes, it should not. But, it could. When it does, then we can start a countdown toward bubble bursting time. Today, that price might be $2200-2500 if, at the same time, there were reason to believe that the currency debasement (printing) was going to subside. So, can we stop with the incessant “bubble” cries? That is not the question. The relevant question is, will the money supply plateau or decrease and give gold any reason to stop rising? Money supply growth has been the engine powering this rise in gold -- that and the high likelihood that the tsunami of world-wide paper currency printing must continue.

Will the money printing and use of debt to solve political/economic problems continue? It simply MUST. It is a war of currencies and nobody can decline to participate. (Apparently, not even the Swiss.) That is what is so sinister about the process, particularly during a period of high unemployment. Once the war ensues, nobody can seem to stay out of it or their exports will decline, which will cause unemployment rates to rise even further than they have due to the underlying recession. Revenues in businesses will drop and they will go under or go into a weakened survival mode, banks that have loaned to these unemployed people or weakened/failed businesses will run low on reserves or will violate ratio requirements, their home loan and commercial loan portfolio will start to default and, they will stop funding other processes in their economies and finally, voters will eventually vote the politicians out of office due to all of these problems.

So, once the war ensues, I don't see any other eventuality. How can anything else happen once the Chinese, U.S. and most of the other top currencies participate in this? During a period of high unemployment, they must weaken as fast as their trading partners (see below) or risk that their unemployment problem grows into a serious political problem.

And, there are other compelling reasons to participate in this game. When paper currencies are printed, it dilutes each country's debt problems (debts owed to both their own citizens and to other countries) and it solves immediate domestic problems (like unfunded or underfunded social entitlement programs like social security) and it replaces the funds lost due to lost tax revenues in the recession.

What we see here is that the recession lit the fuse on a bomb that was already sitting there waiting to explode...a bomb of excessive consumption and debt. The major economies needed to limit their debts over the last 30-50 years to 30% of their GDP and to fund their social programs, not borrow that money with promises of future repayment from FUTURE tax revenues. But, they did not.

They continued to borrow well into the danger zones during periods of high GDP to levels of 50-70-80% debt/GDP to win voter approval and re-elections. Whenever any party began to warn that social security or welfare benefits needed to be limited, the other party would use it as a club to beat them at the polls. Too many politicians have been putting their own careers before the interests of long term fiscal viability of their respective nations. So, nobody could put their name on it; the debt kept rising and the money kept flowing, just like a disfunctional household where neither parent trying to win favor of the children wanted to call an end to the vacations, flat-screen TVs, fancy restaurants, 5,000 SF homes, $100,000 backyards, or new clothes every month and new cars every year.

So with no money saved and every credit card full, a big problem happened; a recession happened which simultaneously created a high need for reserves and a drop in revenues. For the highly-leveraged household, this would be like losing a job with no savings and huge debts, and then encountering a large uninsured health problem at the same time.

Indeed, the recession may actually have been precipitated by all this crazy fiscal and monetary policy around the world. Higher levels of worldwide debts led to lenders seeking higher interest rates which cooled economic expansion. Higher levels of risk in loans made by banks were not compensated by loan rejections or higher rates charged. Eventually, the wheels came off.

So, now it has become commonplace for countries to owe 100% or more of their annual GDPs, a very unhealthy condition.

In the household analogy, when a family spends 50% of their annual budget on interest payments alone and continues to borrow 10-20% of their annual budget because they don't want to cut back on anything, they soon don't have enough money to light the lights in their 5,000 SF home or to pay to heat (or the pool guy to clean) that $100,000 pool in their backyard. Today, in Las Vegas, there are thousands of empty 5,000 SF homes that are not selling for $55 per SF, down from $150-250 per SF in 2005. Landscaping is dying and and those swimming pools are filling up with dead leaves and drowned mice.

In the national example, things are very different. Households CANNOT print their own cash; they must go out and earn it or sell something they own. Countries CAN continue to print money to address their political problems and to fight one another for the few exports/imports that are being passed around from country to country. They cannot raise taxes because that would only worsen the unemployment problems by taking more wealth out of the private sector in the form of spending and investing and hiring people. They can continue to raise their debt levels to ever-higher extremes of instability and ever-higher drains on future annual budgets. They can continue to weaken their currencies to continue the stalemate over exports/imports/jobs. They cannot unilaterally extricate themselves from the practices of ever-higher debts and money printing.

Therefore, can gold continue to rise? Yes, because the onslaught of money printing cannot be stopped.

But, that is not the only possible outcome. If this all leads to the failure of the eurozone or the loss of the world reserve status of the USD, gold and silver will rise in price to inflation-adjusted levels not seen in human history. The world's sovereign reserve banks hold 74% of all of their reserves in euros or USDs. As the faith in either of these falters, this also will cause a continued flight to gold and other PMs.

Source: Can Gold Continue To Rise?