Eight Scenarios That Could Affect Gold and the Dollar

Gold seems to be unstoppable these days, reaching one new record high after another. The question is:  will it continue to climb, or are we in a short-term ‘bubble?’

Although I am a bit sceptical of a $2,500 level this year (as proposed by analysts at JP Morgan), I do think $2,000 gold is quite realistic for this year and we’re on track for an extended period of high growth, in both gold and silver. The world’s currency markets are more volatile now than they have been for years, and this is putting enormous pressure on the precious metals market.

The S&P downgrade of U.S. credit is one reason for the continued strength in gold prices – but the larger issue here is the value of the overall U.S. economy in comparison with other major economies. This comparison will have the biggest impact on gold prices and the value of the dollar going forward.

In the next 12 months, there are eight scenarios that could have a major impact on the value of gold and the dollar:

  1. EU Members Get Serious On Austerity:  Germany recently proposed that all 17 eurozone countries adopt a balanced budget amendment to their constitutions. Were that to go forward, with an emphasis on spending cuts not tax increases, would it lead to a solid economic recovery – particularly in terms of private capital and investment? A real austerity plan might strengthen the euro, and global gold futures could quiet down – with only nominal movements up or down depending on the euro-to-dollar valuation. If the EU recovers, gold might lose some of its momentum – but that vacuum could be easily filled by continued problems in the US economy. 
  2. EU Stays the Course On Bailouts:  It’s more likely that the EU will keep bailing out its members until it no longer can. As long as the European Central Bank keeps buying PIIGS bonds, or allowing European banks to use an expanded portfolio of assets as collateral, the EU will remain mired in economic problems. Continued ‘quantitative easing’ in the eurozone will debase the euro, boost the dollar and cause gold to become more favourable as an alternative.
  3. An EU Country Defaults or the EU Collapses:  The problem with the EU is that stronger countries like Germany and France are required to support weaker members like Portugal, Italy, Ireland, Greece and Spain (PIIGS). These bailouts will continue for only so long as the strong countries remain strong – and Germany is now tiring of this role.  At some point, the eurozone may just have to let one or more of its members fail. If that happens, the euro will plummet in the short-term, leading to a short-term spike in the dollar and gold. Once a member fails it could start a chain reaction as the first domino falls and hits the next.  If the EU collapses, the dollar and gold will rise until other factors intervene.
  4. EU Countries Get a Credit Downgrade:  The S&P’s credit rating downgrade of the US could be repeated in Europe. A credit downgrade of the U.K. or key EU members could have a significant impact on the euro’s value; it could also create a second negative effect on the dollar, even though these usually move inversely to one another. Either way, gold will soar.
  5. Quantitative Easing – Round 3:  A new round of quantitative easing in the US will have a predictable effect: the dollar will drop and gold will spike. However, unlike the first two times QE was implemented, a third round will confirm the desperate condition of the US financial system – and could lead to record-high gold prices over an extended period of time, as well as significant dollar inflation. Once QE2 was announced, silver went from $26 to almost $50 – silver even more so than gold seems hyper-sensitive to “easing.”
  6. Double-Dip Recession:  If the economy sinks back into a full-blown recession, the dollar will further devalue – but only so far as the US fares worse than other major economies. Whether it’s traditional inflation or stagflation, the dollar will devalue and gold will be pushed up for the foreseeable future.  
  7. Historical IMF Mandate:  If the U.S. continues to pursue quantitative easing and other financial interventions, and the Europeans follow suit, we could see the International Monetary Fund (IMF) step in. It is possible the IMF could come up with a mandate on how much money each central bank can have in the system. It may sound far-fetched for the IMF to intervene in U.S. financial affairs, but if the U.S. continues to pursue QE, it could become a real possibility. If the IMF ever takes such action, the U.S. dollar, or euro, or both, would most likely stabilise especially if gold were “used” in the mandate as a way to calm a very uncertain financial system.
  8. 2012 Election:  The US financial markets want stronger governance from our politicians. If we see a strong presidential candidate emerge in the 2012 election season, or better leadership from the current political class, we could see gains in the stock market, a stronger US dollar and gold prices stabilised.