Why Gold Prices May Soar

The soar has soured, the Midas touch faded: Gold prices no longer set records. That could change, however. The questions for investors are: Why and when?

Gold sold for as little as $256 an ounce in 2002 and shot to nearly $2,000 an ounce by 2011, turning a $1,000 investment in 2002 into a return of about $7,800 just nine years later. This last May, though, gold plunged to about $1,343 an ounce and generally continues its fall. Gold prices tumbled so far this year that the world’s largest gold producer plans to shutter almost half its mines and lay off a third of its corporate office staff.

Nevertheless, the Federal Reserve’s quantitative easing program to buy bonds from its own member banks, its “easy money policy,” sends gold prices skyward for several reasons:

Record-low interest rates. The easy money policy keeps interest rates low. Gold earns no interest as an investment. When interest rates rise, gold typically drops; when interest rates fall, the price of gold typically rises. But gold hit record highs when interest rates rose, most notably from 2003 to 2006.

Currency devaluation. The Fed’s easy money weakened the dollar. When the dollar falters, gold shines brighter to investors and demand triggers price jumps.

Hedging. Investors often use gold to shield, or hedge, overall wealth in a portfolio from potential losses, against inflation and sometimes against deflation. One of these conditions is almost certain.

If the economy strengthens and interest rates keep rising, the price of gold could keep falling. Is the economy strengthening? Unemployment remains stuck at 7.4% and will likely stay high for the rest of 2013. Europe’s economy continues in turmoil and economic doldrums continue globally.

If returns on bonds, stocks and other investments fail to stack up again risk and inflation, demand for gold historically increases, as does its price. Rising interest rates are already triggering sell-offs of bonds, and signs abound that stocks are overvalued. The Standard & Poor’s 500 (S&P 500) was recently up 25% from a year ago while corporate profits were up only 1%. Clearly, stock values and market performance are disconnected. Inflation remains in check, but for how long? One stated Fed goal is increasing inflation. And historically inflation balloons expand fast.

Add uncertainty about the dollar. More than a dozen states, concerned that Fed policy could cause the dollar to collapse, are pursuing policies to allow gold bullion to be used as money. Says Dr. Loren Gatch, professor of political science at the University of Central Oklahoma, “The legislation is about signaling discontent with monetary policy and about what (Fed chair) Ben Bernanke is doing. There is a fear that the government, or Bernanke in particular and the Federal Reserve, is pursuing a policy that will lead to the collapse of the dollar.”

Americans probably won’t lug gold bars to grocery stores any time soon, but don’t be surprised if the price of gold rises again.

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Brenda P. Wenning is president of Wenning Investments LLC in Newton, Mass.

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