Gold's Ascent is Fuelled by Dollar's Decline, but How High Can Gold Go?

Sep 16, 2011, 13:07 ET from Valbury Capital

LONDON, September 16, 2011 /PRNewswire/ --

In January of this year the gold bull market had its 10th birthday. Investors who've had the patience and fortitude to hold gold since 18 January 2001 when it made its low of $257 have been richly rewarded since today the yellow metal trades at $1,784 an ounce.

A 7 fold move in a little over a decade certainly isn't bad but given that this bull market shows no sign of stopping, the question is: How High Will Gold Go?

In order to answer this question, it's first necessary to understand what's driving gold.

What's Driving Gold?

Gold has two primary drivers, currency debasement (which shows up as inflation), and interest rates.

Currency Debasement

As a response to its unsustainable levels of state and federal debt, and in an attempt to stimulate economic activity, the United States has adopted a deliberate policy of currency debasement.

As with any market currency prices are set by supply and demand and as the Federal Reserve creates more dollars their value falls, and since gold is denominated in dollars, as the dollar falls, so the price of gold rises. Gold then is the anti-dollar, and gold's decade long advance runs counter to the dollar's decade long decline.

Back in 2007 the US dollar index [DXY] broke down through 80 - a level which had acted as support for 34 years - and with the likelihood of QE3 not too far away, the outlook for the buck is distinctly negative. In fact, famed technical analyst Louise Yamada, has a long-term downside target for the DXY of 60.

Mark Hanney, Valbury Capital Chief Executive Officer, says "Given the Fed's announcement that it will keep interest rates low until at least the middle of 2013, investors who are long gold and short the dollar might well feel comfortable staying that way."

It is just over 40 years since Richard Nixon took America off the gold standard and over that period the greenback has lost more than 98% of its value compared with gold. Buyers of gold are simply trying to protect their wealth by moving out of paper currencies into the ultimate hard currency that cannot be created at will by central bankers. The question of how high gold can go is really a question of how low paper money can go.    

Interest Rates

Gold becomes attractive to investors when the rate of return they can achieve on their savings falls below the rate of inflation - a condition faced by most of the world's savers today. The persistence of negative real interest rates - a form of financial repression - erodes the wealth of those holding cash on deposit and forces them to go in search of better returns. The attraction of gold in this environment is easy to see especially since gold has risen for 10 years in a row and has returned on average 18% with no down years.

A Different Animal

Although some of the conditions that drove gold in the 1970's also exist today - namely high inflation and negative real interest rates - today's bull market is a very different animal. Today gold is also being driven by fears over sovereign debt default, the solvency of the banking system and the threat of global recession.

Inflation Adjusted High

One popular method for calculating the target for gold is to take the 1980 high of $850 and adjust it for inflation. Many in the mainstream tout the inflation adjusted figure as being equivalent to $2,400 an ounce in today's money but if we use the same methodology for calculating inflation as was used in 1980, we find the true inflation adjusted high is $5,467.

The Last Gold Bull Market

Another way to gauge the length of gold's current bull market is to compare it with the previous bull market which ran from early 1970 to early 1980, exactly one decade. In January 1970 gold was $35 an ounce, ten years later on 21 January 1980 gold reached an intraday price of $850 - a 24 fold increase in price. If gold were to match that increase, based on its January 2001 low it would reach $6,245.

Even if gold simply achieves the gains made in the previous bull market, we can expect a price in excess of $6,000 an ounce. However multi-decade bull markets almost always end in a mania and in a mania gold could far exceed $6,000.

 

This article does not constitute investment advice or a recommendation to enter into an investment transaction.

Notes to Editors

Valbury Capital

Valbury Capital Limited was established to provide Asian clients with a London based broking service fully regulated by the FSA, and to give European clients a doorway into Asia - one of the world's fastest growing marketplaces. Valbury Capital's investors bring with them over 20 years' of corporate experience and their Asian heritage gives it unique market insight and expertise.  Valbury Capital Limited focuses on providing individuals and institutional clients with a premier service. Go to: http://www.valburycapital.com for more information.

Trading Foreign Exchange (FX) and commodities such as gold on margin carries a high level of risk, and may not be suitable for all investors. The high degree of leverage can work against you as well as for you. It is possible to lose some or all of your initial investment and to be required to deposit additional funds and you should not invest money that you cannot afford to lose.

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SOURCE Valbury Capital