Why gold bugs will get bitten by deflation

With commodities no longer driving inflation, deflation is a very real risk. This has huge implications for investors with big holdings in gold. James Ferguson explains why he believes the gold price is due for a fall.

A few weeks ago, I argued that inflation was no threat. At the time this may have seemed a little foolhardy. Britain's Consumer Price Index (CPI) inflation rate came in at 4.7% in August, the highest in more than 16 years. July's output Producer Price Index (PPI) inflation (manufacturers' selling prices) went above 10% for the first time in more than 25 years, while input PPI inflation (manufacturers' costs) hit a 35-year high of 31% in June. But I was focusing on the storm clouds of the credit crunch and impending recession, and recent events suggest I was right to although the turnaround has happened even more quickly than I expected. Now most pundits agree that disinflation looks a best-case scenario; and outright deflation is a very real risk.

This has huge implications for investors. While I had been imploring investors to buy gilts, preferably short-dated ones, the bond market has since gone vertical. The yield on one-year gilts, which had been 5.5% in mid-June (when the bond market was most worried about inflation) and 4.6% three weeks ago, is now just 3.5% and falling fast. While gilts rocket (prices move in the opposite direction to yields), money is pouring out of the commodity markets. Manufacturers' costs had been driven higher at first by industrial metals prices soaring during 2006-2007. But most of these ran out of steam some time ago. In fact, the contribution to inflation from industrial metals had become negative by this summer, and they are now trading well below their peaks. As I write, nickel is 72% below its peak, zinc is down 66%, lead 58%, stainless steel is 54% lower than it was, and copper, the king of industrial metals, is 37% off its peak.

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James Ferguson qualified with an MA (Hons) in economics from Edinburgh University in 1985. For the last 21 years he has had a high-powered career in institutional stock broking, specialising in equities, working for Nomura, Robert Fleming, SBC Warburg, Dresdner Kleinwort Wasserstein and Mitsubishi Securities.