End of QE will damage gold prices

26th April 2012

Gold is already down over 10% over the past eight months. Received wisdom suggests that the end of quantitative easing is bad for gold and could send it even lower.

The reason gold tends to do well from quantitative easing is that the latter acts as a drag on currency. Gold benefits from its position as a ‘store of value' at times of currency weakness. The release of the minutes from the last Federal Reserve meeting, showing that the committee would not undertake another round of quantitative easing, prompted a chunky fall in the gold price: "Gold fell 2 per cent on Tuesday for its biggest one-day drop in a month, tumbling suddenly after the Federal Reserve released minutes of its March meeting."

However, a piece on Seeking Alpha shows that gold may not be vulnerable this time: "Despite the widespread perception that gold rises with Fed stimulus and declines without it, this has not been the case throughout the financial crisis. To the contrary, gold has demonstrated the ability to rise with or without Fed stimulus." It even has a chart to prove it.

The reason? Author Eric Parnell acknowledges that gold tends to strengthen at times of currency weakness: "Gold stands to benefit over time in a world marked by competitive currency devaluation including a secularly weak U.S. dollar policy dating back over a decade." However, he also points out that gold tends to benefit at a time of crisis: "With the destabilizing threat of crisis mounting in Europe coupled with persistent pricing instability, gold also represents an attractive safe haven and store of value." It is easy to forget that gold is not only a store of value against the dollar, but against the Euro, which has seen some significant weakening in recent weeks as the French election results have raised issues over its future.

Parnell's views found plenty of support. For example, Uncle Pie comments on the same site: "According to published reports, the government has to borrow 42 cents for every dollar they spend. Also, the Fed is buying 60% of the Treasury debt as it is issued. One branch of the government printing money for another branch of the government to "borrow"? If that isn't a Ponzi scheme, what is? (I'm) long GLD, a few miners, some oil companies, etc." A number of commentators suggested that ultimately the US Government would have no choice but to do more quantitative easing, therefore supporting the long-term case for gold.

The question, therefore, is if gold does have a temporary unfavourable reaction to the Fed's decision, might it be time to buy again? Moneyweek has been a bull on gold for some time: "Gold is only useful at protecting purchasing power when the monetary system is in danger. At almost all other times, you're better off with stocks, businesses, farmland or another productive asset. That's why Buffett now prefers stocks. And it is why we now prefer gold. Buffett willingly gives up the protection of gold in order to the get the upside from stocks. We willingly give up the upside from stocks in order to get the protection from gold." Notably, author Bill Bonner suggested that investors might want to switch out of the richly valued social media names such as Facebook and LinkedIn.

This piece on Mindful Money highlights the support for gold at current prices.

FT Alphaville quotes the work of Professor Lew Spellman, from the McCombs School of Business at the University of Texas at Austin, who suggests that gold is starting to look very attractive. If it remains a liquid store of value, widely accepted as collateral, there is little to differentiate it from a zero-yielding Treasury bond. The piece adds: "the market may unwittingly be moving towards a collateral-backed global currency (of its own accord). Possibly, even, a new gold standard altogether"

But it is worth having some balance, and who better than the Sage of Omaha? Warren Buffett's views on the matter: 

"Gold, however, has two significant shortcomings, being neither of much use nor procreative. True, gold has some industrial and decorative utility, but the demand for these purposes is both limited and incapable of soaking up new production. Meanwhile, if you own one ounce of gold for an eternity, you will still own one ounce at its end."

A number of things are inescapable: The gold price has moved from over $1800 per 100oz in August last year, down to just over $1,600 now. The global financial system is still far from fixed and – between the French elections and the Spanish economic problems – the Eurozone may well be careering towards another crisis. There may be no more quantitative easing, but there are still plenty of things to support gold prices at their current level.

 

More from Mindful Money:

Gold – Will the bulls come back?

Growth beyond crisis – Investment themes reshaping our world

Paradigm Lost: Rethinking our global economic system

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