Five Reasons Why Gold is the New Black – But Could Be Bad For Your Health

9 October 2009. It seems impossible to talk to investors at the moment without discussing gold. When I talk about gold as the latest fashion, Indians in particular will snort, since it has never gone out of fashion in Mother India.

9 October 2009. It seems impossible to talk to investors at the moment without discussing gold. When I talk about gold as the latest fashion, Indians in particular will snort, since it has never gone out of fashion in Mother India. Indeed for many in India and other parts of Asia where bank accounts may not be common, gold and jewellery are a form of currency that can be handed down and accessed in times of emergency. [br]

Which when you think about it, is exactly the same for western investors and even central bankers. Gold is a hedge against fear. It has no intrinsic value. Indeed, Warren Buffet famously said

It [gold] gets dug out of the ground in Africa, or some such place. We then melt it down, dig another hole, bury it again and pay people to stand around guarding it. It has no utility. Anyone landing from Mars and watching this would scratch their head.

So Gold is something we value because everyone else values it, and for no other reason. It has, however, been like this for millennia. Since before the dollar and pound sterling, there was gold.

This week, gold spot prices broke the all-time price record for three straight days in a row, reaching $1,061 today. But what is driving this action?

Let us look at the reasons, not all of which are obvious:[br]

1. The End of the US Dollar!!! The talk of it, that is. The US Dollar is far from finished. Its days of absolute hegemony are clearly numbered, but in the multi-polar world that will emerge the US Dollar is still likely to be the most important.

But that is a pretty boring fact, so everyone is ignoring it. Instead they are getting excited about talks that are going on about the future of the financial system. In particular a very misleading article in the British paper The Independent, by Martin Fisk, said the end of the dollar was nigh.

Mr Fisk reported that there were secret talks going on between China, Russia, Japan, France and the Gulf Arab states, to change the currency of oil trading from oil to a new basket of currencies within nine years.

There certainly are talks going on in many arenas, including BRIC country meetings, but let us assure you that all of them are based on a basket of currencies with the US Dollar remaining the central currency for the basket, and still the only game in town for certain key monetary activities.

Traders reacted with the excitement that only a quick profit can generate, and immediately bid Gold up and the Dollar and Treasuries down.

2. Massive Inflation is Coming in America!!! Again, this is the mis-informed talk, not what we are saying. Yes debt levels have gone through the roof, and yes, the chances of inflation growing in a few years are very real, but that is years out, and frankly the risks of a double-dip recession, and even of a second Financial Crisis, are much more immediate.

Still, if the fear of inflation story can make traders more profits, lets spin it, right? You see, gold is not that related to inflation if you look at historical analysis. But it is related to fear of inflation.

3. Gold prices rise between September and December, and have done so for at least the last 30 years. Now we are getting to more substantive reasons for the rise. The reason is simple: demand. The Christmas buying season begins in these months, as does the Indian wedding season, leading to big growth in consumer purchases.

4. Gold hedges (options contracts) are being abandoned. As the price of Gold goes up, the price of hedges goes up, and the positions are unwound. Bert Dohmen Capital is reporting that Barrick Gold Corporation (ABX) just made a public stock offering, of $3b, to cover a $2.9b hedge position. The simple reason is that in Q3 it booked a $5.6b one-time expense for its gold hedges, as a result of accounting changes.

These hedges now cost too much and need to be reported in full, so they are being unwound. Unwinding a hedge is like covering a short; in effect it creates more buying demand, pushing prices higher. As prices go higher, more hedges are unwound.

5. Central Banks have created a massive virtual short position in gold – and it could get unwound. Here is a scary thought: Dohmen explains that for decades central banks have ‘leased’ gold to bullion banks for 1%, who then sell the gold and invest in government bonds at higher returns. Made them vast amounts of free money, but created a huge virtual short position in gold. Now they still owe that gold to central banks, but they have simply used options contracts to cover that.

If the options contracts are abandoned, then they will have to buy back gold in the multiple billions.

Does this all sound depressingly familiar? Vast schemes were millions are made without full access to the underlying assets? Then a massive movement as that ‘confidence’ trick is no longer possible and the transactions are unwound, and then ‘pop’ as it all goes belly up?

Gold may be the new back for traders with short memories, and it will certainly have a nice run up, but you might be wise to stay out of this particular disaster-in-the-making.

Dwayne Ramakrishnan, EconomyWatch.com