Gold traded at a new record high Wednesday as the USD declined to a 15 month low. Gold is considered a store of value. Investors buy gold when they're worried about the value of other assets or as a hedge against inflation. Because inflation is not currently rising the main driving factor for gold is the weakening of the USD.
Weak USD/carry trade
The weakening of the USD is attributed to ultra accommodative Fed monetary policy and concern about rising US debt outlook. Last Friday's report that the US unemployment rate rose above 10% contributes to speculation that the Fed will maintain low yields for some time to come. The Fed has tied monetary policy to US employment. Wednesday the Fed's Fisher said that the Fed has no immediate plans to raise interest rates or withdraw stimulus because the economic recovery will likely be weak. Fisher said that the weak US economy calls for lower rates and he sees the prospect for a weak recovery. Fisher went on to say that he is aware that Fed policy is pressuring USD but USD decline has not been disorderly and inflation remains subdued. His comments suggest that the Fed does not plan to support the USD. The USD has emerged as the global funding currency because of low Fed interest rates. It is now cheaper to borrow in USD than JPY. Investors are borrowing in low yielding USD to invest in higher yielding assets. This contributes to the liquidity fueling gains in gold, commodities and global equities. This liquidity and USD decline supports the price of gold.
Accommodative Fed policy coupled with extraordinary government fiscal stimulus measures have pressured the USD and increased liquidity. The Fed has significantly expanded the monetary base and pumped over $1 trillion of liquidity into the US economy. G-20 nations including China the US, Japan and UK have increased fiscal spending to boost growth. This liquidity fuels demand for a number of asset classes including equities, commodities and gold. Monday the G-20 pledged to maintain fiscal and monetary stimulus until the recovery is secured. The G-20 pledge to continue fiscal and monetary stimulus helped fuel this week's rise to a new high for the year in US equities and a record high in the price of gold. There is significant debate about whether Fed policy and government fiscal stimulus is creating a liquidity bubble in a number of asset classes including gold. Gold may be experiencing additional demand from fears that if central banks and the governments of the industrial nations fail to remove fiscal and monetary stimulus in timely manner inflation may begin to rapidly rise as the global economy recovers. Fear about the USD and possible threat of inflation supports the price of gold.
Central bank demand
Gold is also supported by demand from central banks. The Chinese and Russian central banks have been increasing reserve holdings of gold over last few years to help manage their finances. No currency is backed by gold. Last week the Central Bank of India purchased 200 tons of gold from the IMF. Central banks hold a large amount of USD reserves. The IMF estimates that over 62% of reserves are held in USD. Concern about the risk of devaluation of the USD encourages central banks take action to try to diversify USD reserves and seek safety in hard assets like gold.
Speculation and portfolio demand
Gold has been in the headlines for a number of months and many of the articles about gold suggest that the price of gold may continue to rise. These headlines encourage speculation and demand for gold from those seeking to gain financially from the rise in the price of gold. In addition, portfolio managers are increasing their exposure to hard assets through exposure to commodities and gold anticipating that the global recovery coupled with continued fiscal and monetary stimulus will lead to higher prices. Investment demand for gold is likely to continue to increase significantly through instruments like gold-backed securities (Exchange Traded Funds ETF's). The use of gold ETF's to diversify risk by portfolio managers has increased demand for alternative assets like gold.
Recent demand for gold may also be attributed to investor fears about geo-political turmoil. Investors will often buy gold as a safe haven and to hedge against risk that may emerge from geo-political risks. Concerns are growing about global flashpoints particularly Iran and the possible development of a nuclear weapon by Iran and the possible escalation of the war in Afghanistan.
The price of gold may continue to rise until the USD recovers, the Fed tightens monetary policy and the G-20 withdraw stimulus. The risk to this outlook is gold is very popular now and bullish sentiment is at an extreme. Gold may be vulnerable to a technical correction. In addition, gold has risen over 20% in 2009 measured in USD terms but has rallied by a much smaller amount in terms of European and Asian currencies. This is further confirmation that the price of gold is closely tied to the USD.