The Case for Trading Gold

11/27/2009 12:01 am EST

Focus: COMMODITIES

Boris Schlossberg

Managing Director of FX Strategy and Co-Founder of BKForex LLC, BK Asset Management

As gold continues to set daily record highs, it is encountering a rising chorus of criticism from skeptics who view it as the latest asset bubble to burst soon. However, while the precious metal may be vulnerable to a near-term pullback in order to consolidate its latest gains, we believe the long-term case for gold remains bullish.

Contrary to popular perception, gold is not a hedge against inflation. Most investors make that association because the last time the yellow metal experienced a secular bull market in the late 1970’s and early 1980’s, US price levels rose at double-digit annual rates. However, gold’s actual correlation with inflation is relatively weak. Indeed, in today’s economic environment, price levels in the G-10 are at multi-decade lows, and deflation, rather than inflation, is a far greater concern, yet gold rises relentlessly.

Why then the sudden strength in gold? As its many critics point out, aside from wedding demand from India, gold is now a near-useless commodity replaced in industry by better, more efficient substitutes. Gold, however, remains a strong psychological store of value and more specifically, it is the primary asset for expression of no confidence by investors in the fiscal policies of the state.

As investors look ahead to 2010, the debate between the recovery bulls and the double-dip bears remains at a standstill, but markets are in near universal agreement that fiscal deficits in US, UK, and to a smaller extent, in the euro zone, will continue to mount as the gap between expenditures and tax revenues widens alarmingly even as GDP growth rebounds.

With the exception of Australia and Norway, governments in all other advanced industrialized nations are under enormous pressure to keep their spending policies in place in order to assure the sustainability of the recovery in 2010. Furthermore, in an atmosphere of extraordinarily high unemployment rates across much of the industrialized world, politicians will find it exceedingly difficult to raise taxes next year as they face the full wrath of voters who are already pinched by stagnant wages and high debt burdens.

Investors are clearly sensing that this dynamic shows no signs of improvement and it is this realization that has been the primary catalyst behind the rally the gold. Some skeptics have pointed out that while gold may continue to perform well during times of financial stress, it will be near worthless as an asset in case of true political turbulence (world wars, economic doomsday, etc.) as investors lose faith its real world purpose. We completely agree. However, before any real doomsday scenario takes hold, it is likely to be preceded by a protracted period of financial turbulence that will only enhance the yellow metal’s appeal in the near term.

There is no doubt that any rally in gold will ultimately end in tears as the asset goes parabolic and then crashes, but any concerns about such a move are premature. For the time being, the rally in gold is climbing a wall of worry while the growing fiscal problems in the G-10 universe continue to raise doubts about fiat currencies. If 2010 does not see a marked improvement in economic activity that quickly replenishes the tax coffers of G10 nations, the financial stress of the situation will likely result in fresh record highs for gold.

By Boris Schlossberg of GFTForex.com

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