All that glitters in tough times probably gold

Conditions still favour gold. Gold prices rose in recent weeks as record oil prices and continued weakness in the dollar encouraged investors to buy into bullion. With crude prices touching a record, gold's role as a hedge against rising inflation has seen the precious metal move higher.

Prices are also taking support from the American dollar's continuing slump, with investors using gold as an alternative to the most common form of currency reserves.

United States commentator Adrian Ash says you can link the historic surge in gold prices starting in mid-August last year to many apparently disparate things. Pick the right link, and you might be able to tell whether it's worth you buying or holding gold today.

One such link, he says, is the price of money, as decided by the US Federal Reserve. "Gold's stellar 58 per cent gain in the seven months starting 18 August began with the Fed's first change to US interest rates in 18 months.

"Last August's 0.25 per cent cut to the Fed's 'discount rate' – the interest rate it charges commercial banks to borrow short-term funds – was the Fed's first interest-rate cut since July 2003.

"By the end of March 2008, it became a 3 per cent cut to the bank's key Fed Funds target."

And gold's initial jump turned into a pole vault. The real cost of borrowing US dollars – or rather, the real returns paid to anyone saving money today – clearly has an impact on the demand for investment gold.

You can measure this real rate of interest quite simply, Mr Ash says.

"Just subtract the rate of consumer price inflation [cpi] from the Fed Funds interest rate, then compare this changing value to the price of gold, and you'll see that when the real returns paid to cash sink below zero, investors and savers tend to pay more – or demand more – for gold."

That's what investors and savers did in the 1970s. It's what they did not do again till real US interest rates sank toward and below zero during the first six years of this decade.

Why choose gold when real interest rates sink?

Because if central bankers, driven by a fear of "deflation" in asset prices and consumer spending, try to stop the public hoarding cash, then people will seek out reliable stores of value instead, led by hard assets.

Unlike real estate, however, gold bullion remains a highly liquid, easily priced asset that can store huge quantities of wealth in a very small space. Unlike corn or crude oil, it need not cost you a fortune to store or insure.

Gold, as Mr Ash points out, has acted as a reliable store of wealth for more than 5000 years.

In times of monetary destruction, or so history says, it's human nature to seek an escape from fast- shrinking currencies.

What does this tell us? That the gold price is behaving much more like a currency than it is acting like a raw material. This is a function of gold many people have forgotten about during the recent years of relatively stable financial markets.

While it may seem hard to believe, it is conceivable that one day people will accept only gold for goods and services instead of intrinsically worthless paper currency or its electronic equivalent.

* David McEwen is managing director of Investment Research Group. He can be reached by e-mail at davidirg.co.nz

- © Fairfax NZ News