Four reasons for gold to hit $1,000 an ounce

published 22 June 2006

The gold price has doubled in the last three years. It has now settled at around $550 an ounce, after some profit taking. The World Gold Council expects that it will go to $600 an ounce by the end of the year. I am never sure about such short term market predictions; it is always hard to get one's timing right.

Yet the long term factors which have caused the rise in the gold price are still in place. It seems likely that the gold price will continue to rise; another doubling of the price in the next three to five years is entirely plausible on the known facts. I have expected the price to go above $500 an ounce since the rise started and I now expect it to reach $1,000 an ounce by the end of the decade. Then we can ask whether the main factors are still in place.

1: Expansion of US debt

The first factor is the expansion of the US debt, both in terms of the Budget deficit which is not under control and the trade deficit. The rise in US debt has been accompanied by an expansion in the money supply.

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As in the US inflation of the 1920s, the dollar has been inflated in terms of assets, including housing, but not in terms of the costs of manufactured goods. In the 1920s, the expansion of production capacity in the US accounted for the stability, or actual decline, of the costs of the new products, particularly automobiles. In the 1990s and early 2000s, the same effect has been produced by the expansion of Chinese manufacturing.

Yet asset values have risen sharply, particularly in real assets. In the 1920s, gold was at a fixed price, but US housing prices rose substantially, including the speculative boom in Florida land for building. Spain in the last three years has experienced a rather similar housing boom. Speculators always like the construction of houses, oranges and sunshine. The present consumer boom, in the United States, has been built on rising house prices.

Excessive debt and an inflated money supply make the dollar a weak currency, at a time when other currencies, particularly the euro are also unattractive. There is every prospect that the weak currencies will remain weak for the next five years. Democratic parties have to win elections, and elections are not won by policies of monetary discipline.

This is the primary reason for the rise in the gold price in the last three years. When the dollar is weakened by excessive debt, inflation of real assets, including gold and housing, follows as a natural consequence. One should remember that gold, though it does not generate income, is the only asset which is both real and liquid. Most assets are either one or the other. Houses are real enough, but cannot be sold overnight; shares are liquid enough as are bank notes but neither has a real value. With all paper assets, one may be left with nothing at all. Gold has enjoyed real value for three thousand years. The current purchasing power of gold is quite close to its purchasing power a hundred years ago. Indeed, the capital value of good English farm land in 1900 was about £30 an acre, or 7.5 ounces of gold. It is now about £3,000 an acre, or ten ounces of gold.

2: Demand for gold jewellery

The second favourable factor is the strength of the demand for gold as jewellery, particularly in Asia. In 2005, the jewellery market absorbed 2,736 tonnes of gold, with a value of about $40 billion. That was an increase of about 4 per cent in tonnage. In terms of value the rise is considerably greater.

The rise in sales for jewellery has been particularly marked in India, where there is a middle class of some 250 million people of rising wealth. In India, gold jewellery has traditionally been a form of investment, where it is seen as an important ornament for women, as a display of status and as the reserve asset of Indian families.

3: Fear of terrorism

I am not a great admirer of Alan Greenspan, who was the Chairman of the Federal Reserve who lost control of dollar debt not a prudent thing to have done. Greenspan is still a defender of the dollar. He blames terrorism for having pushed gold 'beyond its underlying strength as a commodity'.

There is no doubt that terrorism, or the threat of war, is a political cause for purchases of gold. However, I can see no reason to expect terrorism to decline over the next five years. Certainly the situation in Iraq remains intensely threatening. Unfortunately, fear of terrorism and war is likely to remain a constant, if it does not actually get worse.

4: Oil market

The final factor is the oil market. The impact of the local troubles in Nigeria has shown that the oil market is very precariously balanced. Any major political or security problem in the Middle East could push the oil price above $100 a barrel. At present a barrel of oil costs the same as an ounce of gold. I do not expect that to be reliable as a constant, but it is worth noting. If Iraq or Iran gets much worse, gold will rise.

There are, therefore, several long-term, underlying reasons to expect a higher gold price. I can see no immediate downside risks, though the re will always be profit taking. Even the hedge funds are likely to accelerate the present upside movement, since they badly need the opportunity of a major speculative trend.

Gold is still on its way up.

By Lord William Rees-Mogg for The Daily Reckoning