All that glitters: the golden delusion

24 January 2012

Stephane Rouschmeyer

Had you invested £1,000 in gold this time last year, you’d now be able to sell that gold for over £1,250. Not a bad return for a commodity universally deemed as ‘safe’. Since the recession that crippled financial markets and institutions in late 2007, the price of gold has soared three fold due to a combination of issues, most notably a devaluation of the dollar, poor investor confidence, and of course poor performance of financial markets. Up until the beginning of the year, everything was ‘normal’. Gold prices have an inverse relationship with market performance and so it was expected that the price of gold should increase. But as the shroud of economic contraction cleared and markets rallied back to pre-recession figures, the price of gold continued to climb.

Silver was the first victim of the summer. It suffered a violent correction (-26%) in May indicating that investors were beginning to leave safe havens to please a re-found appetite for risk. Everything was set for the global recovery to begin – until trouble began to brew in the West. The general consensus in the market was that western nations were racking up debt beyond their abilities to repay their obligations. It started with Athens, Dublin and Lisbon, but soon Washington and Paris alike were all implementing austerity measures of their own. Instead of reaching for the fire extinguisher, the ECB and US Treasury hit the snooze button while Euro-zone leaders looked for someone to blame – temporarily banning short selling to curb speculative trading.
In moments of crisis, markets turn to the major safe havens. These are the Dollar, Gold and Government bonds. With the dollar losing value, and questions over governments’ abilities to repay debt, the price of gold soared.

The improvements in market confidence lead to violent corrections, and gold fell by over 10%. Investors are now standing once again looking into the abyss. For sure gold was, and still is, over-priced and its correction was inevitable, but European bonds may not come to fruition, and austerity in the US may not yield growth. Pessimism over Greek debt now sits like a tree across the road to a European recovery, and until a genuine solution is implemented, it would take a leap of faith to bet against the price of gold. But once market optimism gathers momentum, the next correction in the price of gold will be as violent and aggressive as it is inevitable. The price of gold is sitting on a hair trigger.