A bad year for bullion – by Buttonwood (The Economist – December 17, 2013)


AS ENGLAND’S cricket supporters are discovering, every good run has to come to an end. For more than a decade, it seemed as if gold could only rise in price. But with a couple of weeks to go, bullion seems set to record its worst year since 1981, according to Adrian Ash of BullionVault – a 24% loss against 1981’s 32% decline. It is an appropriate comparison in more ways than one; 1981’s plunge followed the long 1970s bull run that reflected high inflation after the break-up of the Bretton Woods monetary regime and the loss of the last currency link to bullion.

It was also the year when it became clear that Paul Volcker broke the back of inflation in America. The rate peaked at 14.8% in March 1980 and was down to 8.9% by November 1981; although it edged back into double figures in December of that year, the trend was clearly downwards and the rate has been in single digits ever since. Bond investors were slow to appreciate inflation’s demise so real yields were very high.

That was bad news for gold which offers no yield; the opportunity cost of holding bullion increases when real yields rise. The same process has been happening, albeit less dramatically, this time round. US inflation has fallen from 2.9% to 1.2% since the start of 2012, while the 10-year bond yield has risen a full percentage point.

The net effect on real yields is not far short of three percentage points. Gold’s very success during its long bull run may also have turned out to be a weakness; many holders were momentum investors who had bought because of the seeming inexorability of gold’s rise and who have since turned sellers because of their disappointment.

When (and at what price) will the bear market end? In principle, gold could fall a lot further; there was a fall of around two-thirds in nominal terms from the 1980 peak. There is no objective level at which one can say that gold has value. Gold’s appeal lies in the restricted nature of its supply; it is a fixed point in a financial system where all other assets can be created ad infinitum.

It seemed (to some) the obvious asset to hold in a world of quantitiave easing, but it turns out that overall money supply has not expanded rapidly (because commercial banks have been shrinking their balance sheets) and high street inflation has not surged.

Yes, QE may well have led to asset price inflation in the form of higher equity, corporate bonds and property prices. But that is an argument for holding those assets directly, rather than using gold as a proxy.

Gold’s resurgence may require a moment when central banks explicitly agree to a higher inflation target or when they declare that inflation is now subordinate to their unemployment mandate. That moment may yet come.

For the original version of this article, click here: http://www.economist.com/blogs/buttonwood/2013/12/investing

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