Being limited in supply, gold appeals to The Economist

Burnished by Bad News, Gold Looks Like a Good Each-Way Bet

From The Economist, London
Thursday, February 26, 2009

http://www.economist.com/finance/displayStory.cfm?story_id=13185396&sour...

It is 1979 and Harry "Rabbit" Angstrom, the hero of John Updike’s series of novels, is explaining to his wife why he has just spent more than $11,000 on 30 gold krugerrands. "The beauty of gold is, it loves bad news," he says. Three decades later, gold is once again thriving on despair. Before Christmas, a troy ounce could be bought for around $800. By the third week in February, gold was trading at close to $1,000 an ounce.

A surge in demand for gold as an investment lies behind the jump in prices. Flows into exchange-traded funds, which buy and store gold for their shareholders, rose from 105 tonnes in January to 208 tonnes in the first three weeks of February, according to Suki Cooper at Barclays Capital. At that rate, inflows will soon surpass the total of 322 tonnes for the whole of 2008. Buying by investors has more than made up for a slump in gold-jewellery purchases in key markets, such as India and Turkey, where higher prices and wilting exchange rates have crushed demand.

People have long viewed gold, rightly or wrongly, as a hedge against high inflation and a weak dollar. So when the gold price briefly broke through the $1,000 mark in March last year, it was easily explained by fears that rising commodity prices (and, in America, a weak dollar) would feed inflation. An earlier run-up in gold prices, between 2002 and 2005, coincided with a sustained fall in the dollar. But now gold is strong even as the dollar thrives and economies face deflation.

Gold's recent progress seems to be a response to generalised fears of economic turmoil. When supposedly safe savings vehicles, such as bank deposits, look shaky and offer scant returns, gold has greater appeal as an alternative store of wealth. It also looks like an attractive each-way bet. If drastic cuts in interest rates work too well, that will fuel inflation. If they do not work, prices of assets, such as stocks and houses, will sink further.

Like Updike's protagonist in "Rabbit is Rich," the new wave of gold investors typically have wealth to preserve, according to Adrian Ash at BullionVault, an online service for gold investors. "Gold is something you buy if you have something to lose," he says. What links today's gold fever with the 1970s rush is negative real deposit rates. Many savers now prefer a claim on gold in a vault to one on cash in the bank. There is less risk that a counterparty blows up, and the "carrying cost" of gold in terms of lost interest is, in any case, vanishing.

How high might the gold price go? Gold bugs talk excitedly about it reaching $2,300, which would match the January 1980 peak in real terms. Already the gold price is above its average since 1972 when calculated in today's money. There is a limited supply of gold and lots of potential buyers -- ideal conditions for a bubble, says Stephen Jen at Morgan Stanley. If gold is burnished by grim news, it seems likely to become still more alluring.

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