A Golden Showdown

There has been a near record drop in the price of gold in recent days. For gold bugs and speculators it has been concerning. Market observers couldn’t help but think such a swift decline is an impressive demonstration of the wisdom of investment banks like Goldman Sachs.

Goldman Sachs predicted a fall in the gold price and told their clients to aggressively short gold. For the non-financial analysts reading this, that means to sell gold you don’t own in the hope of buying it back at a cheaper price in the future.

It was a ‘big call’ given that gold has had a dozen years of consecutive price gains, rising from a low of $242 oz to a high of $1921 oz.

The important role of gold as an investment or store of wealth has been demonstrated across the centuries. More recently, when the US dollar was declared to be no longer redeemable for gold in 1971, it lost its lustre, replaced by the full faith and credit of the United States government.

Gold’s rise from 2001 reflects a change in sentiment about the long-term prospects for the US dollar and puts a question mark over its future as the currency underpinning the global financial system. With governments printing a plethora of money in the USA, Japan, the UK and Europe, the ‘value’ of paper money diminishes as the supply goes up.

This increase in the money supply is fuelling stock market gains that are scarcely justified by the economic outlook. Interest rates are being held artificially low to preserve governments’ ability to repay the interest on their debts while simultaneously encouraging savers to put their money to work in the economy to achieve a higher yield.

Thus far, many private investors have been loath to commit to the increased risk attached to stocks and have chosen the return of their money over the chasing of returns. Some of that security has been sought through their investment in gold.

In forecasting a drop in the gold price, groups like Goldman Sachs are effectively backing a shift from the perceived security of gold and physical assets into financial assets – like the stock market.

Naturally, such a shift would advantage investment banks like Goldman Sachs and in the parlance of the market ‘they are talking their own book’; this means they are suggesting the outcome that would benefit them most of all.

But there may be something more significant demonstrated by the almost unprecedented fall in the price of gold in recent days. In the last five years, we have seen two other such instances of big falls in gold.

The first was in July 2008. Gold dropped 21 per cent to a low of around $700 oz. This seemingly pre-empted the Lehman Bros collapse and what came to be known as the Global Financial Crisis (GFC). The GFC effectively froze the financial system and saw the collapse of many banks and the near collapse of the entire Western banking system.

The second significant recent drop in gold prices was in September 2011. Gold fell about 20 per cent to around $1600 oz. This pre-dated a big stock price slump as the risks attached to European debt became evident to more than just a few insiders. Ultimately this led to a globally co-ordinated central bank intervention, the likes of which we have never seen before.

Having now seen a similarly sized fall in the gold price in recent days, a student of recent history may well ask if there is some other financial crisis in the wind.

The central banks and stock jockeys will tell you that everything is fine and people are just moving their money out of unproductive gold into the productive financial markets.

But that doesn’t explain why the recent gold sell-off saw demand for the safety of Swiss government bonds increase. Such was the demand that the yield (or return) on these bonds is now a negative one.

Yes, that’s right; people are actually paying for the right to lend the Swiss government money. That doesn’t sound like investors have a great deal of faith in the global economy.

Only time will tell whether the central and investment bankers or the annals of history will prevail in the most important financial battle we have seen in the last century.

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