The price of gold is at a critical juncture. What happens in the next couple of weeks can determine whether the metal's spectacular rally will continue or fade.
Since late 2008, gold prices have been primarily driven by monetary policy. [CHART ON BOTTOM OF ARTICLE]
The current gold rally started in November 2008, when the U.S. Federal Reserve commenced its initial round of quantitative easing by offering huge amounts of credit to banks.
Back then, gold was priced as low as $700 per ounce.
By mid 2009, gold prices jumped to $950, or a gain of 36 percent.
In September 2009, the Fed announced a new quantitative easing program in the form of purchasing agency mortgage-backed securities and debt -- and gold rallied some more.
By the end of 2009, gold had risen to $1,100, a gain of 57 percent from November 2008.
From late fourth quarter 2009 to early first quarter 2010, gold prices briefly plunged. During that time, many were fooled by the rapid economic growth in fourth quarter 2009 that was fueled by inventory adjustments and government stimulus.
The fear (for traders who were long gold) was that the Fed will slowly begin to withdraw its extraordinary level of liquidity. Indeed, on February 10, Federal Chairman Ben Bernanke gave a testimony to lawmakers titled “Federal Reserve's exit strategy.”
During that time, China also began to withdraw liquidity by raising its banks’ reserve requirement ratios.
From peak to trough, the price of gold fell about 17 percent during this span.
In subsequent months, the U.S. economy sputtered, Europe’s sovereign debt crisis erupted, and concerns arose over China’s overheating economy.
It became abundantly clear that accommodative monetary policy is here to stay. As the economy further deteriorated, the markets also began to anticipate a second round of quantitative easing (QE2).
By Nov. 3, 2010, when QE2 was officially announced, gold prices had bounced back to $1,360, or up 94 percent from late 2008 levels.
After the announcement, gold rallied to a high of $1,432 on December 12.
However, in the following weeks, it fell to a low of $1,310, a loss of 9 percent.
The main reason was that analysts and investors became highly optimistic about the economic recovery. A major factor was Obama’s tax compromise (a form of mini-stimulus).This expectation caused some investors to shift money from gold into equities and brought up the possibility that the Fed might become more hawkish.
Concurrently, China raised interest rates and continued to raise its banks’ reserve requirement ratio.
In addition, some gold investors and pundits at the time began to wonder if the gold rally had run its course. When traders saw irregular activities in the gold futures market, some feared it was a big hedge fund (John Paulson, for example) getting out of the market.
(In reality, it was a small hedge fund liquidating a large spread position).
Currently, gold trades at $1,350.
How fast China tightens monetary policy and whether the U.S. adopts a hawkish tone will likely determine gold prices going forward.
For China, food and property inflation are key indicators to watch -- if they remain high, China will be forced step up contractionary measures.
For the U.S., the jobs market is key. The Federal Reserve is mandated by law to promote maximum employment. Secondly, the jobs market drives consumer spending activity, which is an important component of the overall economy.
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