Gold Bugs Have Fed to Thank for Recent Rally

By Don Miller
Contributing Writer
Money Morning

The currency markets reaction to the Federal Reserve’s recent interest rate cuts has ignited a rally in gold, as investors weigh the benefits of owning the yellow metal versus U.S. Treasuries and the dollar.

As a result, gold has started to shine again as a stable source of value at a time when the dollar and other commodities – like oil and copper – have fallen hard. The spot price of gold has climbed above $870 an ounce on the New York Mercantile Exchange, up about 20% from its October lows.

Gold has been on roller coaster ride in 2008, moving from its all time high of $1035 in March, to as low as $681 an ounce. Some of that decline occurred during the recent stock market plunge. Many investors were forced to liquidate profitable gold positions in order to raise money to cover their paper losses.

Its decline was then accelerated by the recent onslaught of financial bailouts, as many investors held a preference for liquidity and safety in the form of cash holdings guaranteed by the U.S. government.  That was reflected in the skyrocketing prices of government bonds and investments in government-backed banks, which also lowered yields.
But with the Fed’s recent decision to cut its target interest rate to a range of 0% to 0.25%, the dollar has suffered a significant decline. Suddenly, foreign investors who were scooping up dollars have cut back on their flight to safety, knocking the dollar index (NYBOT: DX) down 10% in the last month.  The index reflects the dollar’s value against the Euro, Japanese Yen, British Pound, Canadian Dollar, Swedish Krona, and Swiss Franc.

The Fed's interest rate cut may also have given gold a comparative boost in the eyes of investors. Gold, which never pays interest, suddenly doesn’t look so bad when compared to T-bills, which also are paying zero interest lately.

Volatility has risen this year compared to previous years, and the last few months have been the most volatile of all – an indication of investor ambivalence. But any uncertainty about the increasing price of gold may have been waylaid by the Fed’s recent rate cut and its dampening effect on the dollar and Treasuries.

Consequently, don’t expect this rally to be short-lived. As we pointed out in our 2009 Outlook Report on Gold, the fundamentals in the market hold the promise of more gains ahead.

It appears unlikely central bankers around the world will stop stimulating economies, printing money and doing whatever it takes until growth and confidence are restored – even if the cost is rampant inflation.

Consider these wild card inflation indicators that Money Morning Contributing Editor Martin Hutchinson believes will carry gold prices to $1,500 an ounce by the end of 2009:

• Over $7 trillion of freshly minted U.S. dollars are now in circulation with the aim of saving the global financial system.
• The incoming Obama administration has promised another $1 trillion or so stimulus package is on the way.
• It’s likely the Fed’s interest rate cuts will soon be followed by central banks around the world.

These economic stimuli are designed to do one thing – get the consumer spending again. 

The bailout of the banks was the first step, but the banks are still keeping a tight rein on credit. Now the government is trying to get easily available, cheap money back into the hands of the consumer by running the printing presses around the clock.

“The government is pumping money in so many banks, and that money has to come out somewhere,” said Hutchinson.

Some of that money will “come out” into the economy in the form of higher stock prices. That will make consumers wealthier, and could give them more confidence in the economy. More confidence means more spending. As that happens, prices for goods should begin ticking upward, giving another booster shot to gold prices.

For instance some of that money is already going into gold bars and coins. In fact, the U.S. Mint was forced to suspend sales of the popular American Eagle and Buffalo gold coins for extended periods twice in the last year. The mint was unable to secure enough gold blanks from suppliers to match demand.  

“I’ve never seen a case where demand was so high and supply was so short,” Chicago coin dealer Harlan Berk told the Associated Press. 

With massive amounts of capital floating around, the time it takes to re-inflate the global economy will be far shorter than most analysts expect. Governments fear deflation more than anything.  It appears they will only fight inflation when they are assured they have won the first battle, which is growth at any cost.

When inflation kicks in, the dollar’s buying power will suffer long-term.  In fact, we expect a decline in all the world’s paper money, over time.  Historically, investors in gold have prospered during periods of weakening fiat currencies.

That leaves gold as a bright light in the investment world, making it an odds-on favorite to open a new leg of a long-term uptrend
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News and Related Story Links:

• Fortis Metals:
  Fortis Metals Monthly – December 2008

• Associated Press:
  Woes on Wall Street coincide with gold coin rush

• Money Morning:
  Five Ways to Play Gold’s Rebound to $1,500 an Ounce