In one way, gold's surge to $1150 simply reflects the tidal wave of excess liquidity that is lifting all asset prices from US junk bonds to the most obscure emerging market indices.That unprecedented money supply growth, while largely insulated from the real economy thus far by excess reserve accumulation by commercial banks in most of the developed world, has nonetheless very directly buoyed financial assets. Central banks from the Fed to the BOE have gone into the markets and bid for government bonds and investment grade corporate paper with newly created 'virtual' money, and the cash finding its way into institutional balance sheets as a result is then being reinvested into riskier assets like equities and high yield debt. In China, the 29% annualized M2 growth has flushed directly through the banking system (where lending is only now slowing from an annualized rate over 30%) directly stimulating both the real and financial sectors. Constrained physical supply growth is another factor amid an underweight position at Asian central banks, which have built up vast piles of paper assets while allowing their share of gold to slide in recent years. India's IMF purchase, which was a key trigger for this latest rally, was inspired by this rebalancing, having seen gold drop to just 3.5% of total reserves. Gold has risen less dramatically in currencies other than the U.S. currencies, reaching its highest since late February in euro terms, since early March in GBP terms, and since early May when priced in the Australian dollar. It's still trading at about about half it's all time high in real dollar terms back in the early 1980's.
Although CPI inflation remains subdued globally (and TIPS are currently implying 2.25% 10 year US inflation, hardly a hyperinflationary panic), investors have clear misgivings on the outlook. The key underlying concern, which is still only vaguely articulated but is keenly felt by many private investors, is that the $20trn of deficits the CBO expects the US to accumulate over the next decade is simply untenable. That's particularly valid considering that many other nations from Japan to the UK are staring into a similar fiscal abyss, and once the current QE policies run their course in early 2010 the 'crowding out' effect of trying to fund these deficits with real demand may well precipitate a crisis, and at the least significantly higher long bond yields. It's notable that sovereign CDS spreads are rising again, Japan's having doubled in a month for instance. Gold as an asset offers better insolvency insurance than inflation protection.
China became the world's biggest producer in 2007, and has retained that status since, but the PBoC's intentions in terms of its desired gold holding from the current 1.9% of reserves will be key. A rise to 5-6% following India's example would probably push gold another $200 higher, although it would likely be a gradual policy shift. Leading hedge funds such as David Einhorn's Greenlight Capital and John Paulson's Paulson & Co have been actively accumulating gold exposure all year (Einhorn via physical bullion and Paulson via several billion dollars invested in key producers).
The general thesis among hedge fund investors is that monetary policy is now recklessly out of control, with soaring CPI inflation and interest rates the likely result over the next few years. Gold stocks have broadly lagged the bullion price move so far, despite average global cash production costs of $440 making the current move hugely profitable, especially as most have now removed forward hedges (Barrick being the last of the majors to do so).
The key for gold right now, as for most assets, will be the speed and nature of liquidity withdrawal by central banks, and particularly the Fed. Most commentators assume the current low utilization rate will stay the Fed's hand into Q4 2010, but they may be missing a key point. U.S. Industrial production rose 0.1% in October, far less than most economists had expected, but industrial capacity also dropped. The drop is biggest in manufacturing but can also be seen in mining (utilities capacity is still growing, but at a slower rate than last year). As a result, capacity utilization has increased faster than production. In October, manufacturing capacity dropped 1% while mining capacity was down 0.6%. I'd expect this trend to accelerate as much US capacity is simply written off or so degraded by underinvestment that it becomes unproductive.
The level of US business investment has been historically low all this decade and much of the current capacity reflects previous misinvestment (think GM's $100bn wasted over the last decade on physical plant)and can only produce products which are no longer wanted by consumers. As that capacity is written off, official industrial capacity will decline further. This will have have a stagflationary effect on the US economy by both limiting production into a recovery and reducing competition. Stagflation is the economic outcome I've been predicting since early this year, and I've seen little since to suggest otherwise. In the near-term, gold's next move fundamentally hinges on the dollar above all else, but given that it's now trading $100 above its 50 day moving average, and $200 above the 200 day, a correction seems inevitable to what has become a very crowded bet.
