In recent weeks, a number of market watchers and media headlines have declared that the gold “bubble is finally bursting” and the “gold rally is over.” I disagree. First, I’ve never believed that gold was in a bubble. Second, I believe that prices for the precious metal are likely to remain high for the foreseeable future.
As I pointed out in a recent post, “Why Gold Prices Are So High,” there are three long-term factors supporting gold.
1) The Negative Real Interest Rate: The real interest rate is the nominal rate minus the inflation rate, and it’s one of the key drivers of the price of gold and other commodities.
When the real interest rate is high, assets such as stocks and bonds can generate a return that is unavailable in commodities like gold, which produce no income. In contrast, when the real interest rate is negative like it is today, the opportunity cost of owning gold (as opposed to owning income producing stocks and bonds) is very low.
Looking ahead, the Fed will likely keep interest rates low for some time. Assuming it also uses monetary policy to help keep inflation positive, real rates are likely to remain negative — and support gold prices — for a while.
2) The Race to the Bottom: Gold tends to do best when fiat currencies — paper currencies without any intrinsic value — depreciate. In recent years, many governments, including the United States, have been content to allow their currency to depreciate as a method to stimulate economic growth. The thinking is that a lower currency will lead to strong exports, which in turn will boost home-country gross domestic product.
But another side effect of such dollar deprecation is support for gold prices. The dollar has strengthened recently and is likely to remain strong as long as risk aversion is high. But longer term we’re likely to see the dollar’s decline resume, which should prop up gold.
3) The Deficit: Finally, uncertainty over the endgame of the US deficit is helping gold prices. Investors are rightly worried that the government could ultimately deal with the deficit problem by boosting the money supply and eroding the purchasing power of the US dollar. Such worries aren’t likely to go away anytime soon. I don’t expect the US deficit to be adequately dealt with until after the next presidential election.
Disclaimer: Gold and other precious metal prices may be highly volatile. The production and sale of precious metals by governments, central banks or other larger holders can be affected by various economic, financial, social and political factors, which may be unpredictable and may have a significant impact on the supply and prices of precious metals.