Citi’s Alan Heap warns that gold could soon lose a lot of the factors supporting its price right now.
That’s because a stronger U.S. dollar and rising interest rates would be bad news for gold, based on history.
Also, investment demand for physical gold is abating when measured by slowing demand for physical bullion and a levelling-off of gold ETF demand.
Most importantly, Mr. Heap reminds investors that gold hasn’t been a hedge against inflation despite the traditional view that it is one. Historically, gold prices haven’t been related to realised inflation:
Rather, gold prices have historically been driven by an expectation of inflation, which is different. This relationship is shown below using inflation-linked bonds as a proxy for inflationary expectations:
Citi: More convincing is the relationship between gold and inflationary expectations as measured by M2 (Figure 5) and inflation linked bonds (Figure 7).
By comparing the two charts above it is clear that inflation expectations (at a 10-year+ high) differ substantially from the inflation we’ve seen recently. (at a 20-year+ low).
Thus gold is in a precarious position. If inflation picks up, it has to meet current inflation expectations, and thus maintain current expectations, just to support gold’s current price. We would then need to see even higher inflation expectations (higher than they are now) for gold to move up to a higher in price. If the relationship in Figure 7 above holds of course.
Yet if inflation expectations are merely missed (maybe inflation picks up, but by not as much as markets expect), then gold prices could be in for a tumble. Worse yet, if inflation remains benign for too long, thus causing inflationary expectations to collapse, then gold could be in for a complete rout.
Bulls will be rewarded only if inflation fears escalate even beyond the 10+ year highs they are already at, and the U.S. dollar appears in crisis. Moreover, if it’s going to happen then it better happen soon, since super-elevated expectations only hold up for so long.
(Via Citi Investment Research, Gold: Paper Problems, Alan Heap, 3 February 2010)