How Quantitative Easing Leads To Cheaper Gold

by: Richard Tarjeft

The price of gold experienced a powerful and enduring bull market rally from a bottom of approximately $253 per ounce in July 1999 to an all-time high of $1,923 on September 6, 2011. During that 12-year period, the market price of gold rose persistently during an economic environment in which historic financial bubbles in technology and mortgages imploded as stock prices underwent an extremely volatile decade to end with negative inflation-adjusted returns. Notably, the growth rates in emerging economies soared while gross domestic product in developed nations essentially stagnated during the period. Gold prices steadily increased a staggering 760 percent over twelve years, defying critics and shattering popular investing myths about the ability of precious metals to deliver superior results over a sustained period of time. However, the important question currently facing gold investors is if the drop in price since 2011 is proof that the historic bull market is over and it is time to sell gold.

Since reaching its all-time high of $1,923 in September 2011, gold began a decline that resulted in a year-long consolidation phase in which it traded within a $300 range between $1,500 and $1,800 an ounce. After a brief rise to the top of this price range that peaked around October 2012, gold prices tracked lower for the next six months before plunging below $1,400 an ounce in mid-April 2013. This culminated in the largest one-day drop since March 1980 when gold prices fell over 9 percent to $1,348 an ounce on April 15, 2013. The fundamental causes for this 18-month slump in gold prices are numerous and when explored in their entirety indicate that it is time to sell gold before it trades below the $1,000 an ounce level of the market prior to 2010.

Gold prices increased dramatically in the early phases of the bull market based on booming economic growth rates in countries like India and China, expectations of higher global inflation, and the rosy prospects for higher commodity prices in general. By the time gold prices broke above previous all-time highs of $800 per ounce in 2008, mining companies around the world were ramping up operations to extract as much of the precious metal as possible to take advantage of the historically high prices. Around that time, so-called "cash for gold" companies began advertising heavily on television and operating storefronts out of shopping centers, offering owners of jewelry and other items containing large portions of gold cash payments in return for their wares. The frenzy was on and the result was a greatly enhanced supply of gold to capture the soaring market prices.

Among the key fundamental aspects to gold's historic rally and dramatic decline is the impact of policy decisions by the world's major central banks. In particular, those bullish on the gold market were able to make a reasoned case for the overly accommodative monetary policies of the dominant central banks creating rapidly increasing inflation and potential currency devaluations. Such actions were believed to send gold prices soaring as the diminished value of various global fiat currencies would require ever-increasing amounts of money in exchange for one ounce of the precious metal.

This investment theory assumed that gold was the primary alternative to the money created by the international banking system and that the foreign exchange markets operate in an absolutist manner rather than relative to each other. The gold bulls did not anticipate the surprising level of coordination by the world's major central banks in putting forth nearly identical forms of quantitative easing policies in the wake of the 2008 financial crisis. These policies had the initial effect of driving gold prices dramatically higher before the cold realization sunk in that there appears to be no end in sight to the extraordinary measures. Intuitively, endless money creation and a potentially infinite expansion of the global banking system's monetary base should lead to higher, as opposed to lower, prices for gold and most other commodities. In practice, the resolve of the central banks to battle the deflationary impact of the massive - seemingly insurmountable - debt burden in both the public and private sectors of the global economy appears to be the primary consideration driving the monetary policy decisions of the dominant world economies.

Evidence that the gold market began capitulating to the monetary policies of global central banks can be found in the curious timing of major market changes and the effect of massive debt purchase operations in boosting bond prices while gold prices plunged. The all-time high reached in gold prices occurred in early September of 2011, which was closely followed within a matter of two weeks by the announcement by the U.S. Federal Reserve Bank's Open Market Committee of its intention to begin an unusual monetary policy initiative known as Operation Twist. Market chatter and expectations of the Operation Twist installment of Federal Reserve monetary accommodation coincided almost exactly when gold hit the $1,923 level as the market began discounting its prospects ahead of the actual announcement. The bond purchasing program was intended to further reduce long-term interest rates in an effort to revive the moribund U.S. economy. Gold prices promptly dropped to the $1,500 per ounce level over the course of roughly one month while the price of long duration bonds rose and interest rates plunged. Gold briefly rallied in the early months of 2012 while bonds retreated in a nearly inverse relationship to one another.

The fundamental reasons for this correlation can be explained by the fact that gold has historically been an asset of choice for nearly all of the world's central banks. Massive gold reserves in the vaults of many of these institutions were designed to assure the financial markets that the banking system retains significant physical specie to nominally back the global money supply. The essential nature of that dynamic has changed in a profound way by the continuing insistence of major central banks to accumulate debt in the form of sovereign bonds and mortgage-backed securities as primary asset purchases to add to their increasingly bloated balance sheets.

Basically, debt instruments have officially replaced gold for central banks in ways that few could have ever imagined. The revelation that the collapsing Cypriot central bank may be forced to actually sell gold to provide liquidity if its bailout is insufficient has further raised the prospects that central banks will be more willing to part with gold before they stop purchasing sovereign debt.

Initially, the gold market bulls reacted differently to the introduction of the earlier iterations of quantitative easing. Gold rallied dramatically after the announcements of the first two installments of Federal Reserve quantitative easing programs in November 2008 and November 2010. It was the introduction of Operation Twist, followed the third and fourth installments of quantitative easing in September and December 2012, which resulted in significant drops in gold prices immediately thereafter. Further evidence that the correlation between bonds and gold are impacted by the monetary policy decisions of central banks is revealed in the dramatic two-week drop from $1,600 to $1,400 per ounce that coincided with the Bank of Japan's announcement that it will embark on its most ambitious quantitative easing program ever in an attempt to revive the nation's failing economy.

Eurozone nations remain mired in recessions while the U.K., U.S., and Japanese economies are showing signs of flat to negative growth. Chinese economic growth is slowing to unexpectedly low levels. The prospects for a surge of inflation are tempered against the stagnant economies and deflationary impacts of heavily indebted nations, companies, and households that are forced to reduce consumption in order to service the large debt loads.

Gold has traditionally been called a "hedge against inflation" and it is this belief that helped drive the bull market during the period of benign neglect in currencies such as the U.S. dollar over the 12-year timeframe. In fact, gold is ideally more of a prospective store of value under normal economic conditions than it is a traditional investment that yields a rate of return. Any value that can be preserved by investing in gold must come from the ability of prices to continue rising in the future since there are no dividends or interest payments distributed to those holding the precious metal. Therefore, the only logical basis for buying gold is built on speculation that its price will rise in the future. The impact of continuing central bank policies and the slowdown in the global economy indicate that the best conditions for buying the precious metal are in the past and now the time is right to sell gold.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.