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Gold: Investment or Hedge?

Gold has exceeded almost all other asset classes over the last 10 years. Yet, gold is viewed as a lousy investment, often not even keeping up with inflation. Lately though, gold has made quite a comeback due to the possibility of inflation and economic indecision.

During the 1900s, gold was systematically taken out of the monetary system.  The Federal Reserve, founded in 1913, began by issuing notes which were 100% redeemable in gold. In 1934 the Gold Reserve Act gave the U.S. government title to all the gold coins in existence and simultaneously ended the minting of any new gold coins. By 1971 the United States had discontinued backing the USD with gold. Due to its long use as money some still view gold as a medium of exchange--to be used in lieu of the dollar. I am not going to contend for or against a fiat or gold-based monetary system but just say that the use of gold-based money will not be instituted, it could not meet the demand of a growing economy, and it would not allow for the issuers of currency to maintain control over their monetary policy which if backed by gold would be in the hands of gold producers and local banks.

While gold is not an alternative to the dollar it is an important part of the economy. The central banks and other financial organizations, such as the International Monetary Fund, hold approximately one-fifth of the world's supply of above-ground gold. And yes, gold does have value as an actual commodity which is driven by supply and demand. Gold holds value because the supply of gold is limited. Because there is an inelastic supply of gold, a small shift in the holdings of banks and investors can significantly increase the price of gold while the gold supply increases slowly as more gold is mined. Demand has been rising because of investor fears of more difficult economic times to come. Many investors still cautious of inflation are going to gold, driving the price up to all-time highs. Gold is a hedge in times of inflation, when the government is inputting money into the economy. Gold is valued in dollars and thus appreciates as the dollar depreciates. When investors realize that the USD is losing value, they will start positioning their investments in an asset that holds its value, i.e. gold.

Invest in gold now?  As of this week, gold is back up. It had initially declined due to the unexpected and confident headline numbers but came back up as the unemployment rate showed signs that it is staying at 10%. With unemployment so high, it is unlikely that the Fed funds rate will increase any time soon. If the Fed models its past, gold will go up. Inflation is likely, though it will not be next week. Decreasing real interest rates is positive for gold as it lowers the opportunity cost of holding the metal. Though, it is not a linear relationship. With inflation, real interest rates will continue to negative numbers. At this time the dollar weakens daily. Even if now is the time to make money on gold I wouldn’t hold more than 1-10%. A lot of gold is bought in the short run leaving the price to quickly fall off. 



Disclosure: no positions