Are there fundamental reasons to buy gold?
Historically, the correlation between the price of gold and the stock market has been negative. This meant that when the stock market appreciated, the price of gold declined and vice versa. With debt problems in Europe and in the US, can gold be used as a downside hedge? Are there fundamental reasons to buy gold?
- Unlike stocks, gold, and other commodities, produces no cash flow. When the fixed return on bonds – especially US government bonds – is high relative to inflation, then gold becomes unattractive due to high real interest rates. In contrast, when the fixed return in bonds is low relative to inflation, then there is a lower opportunity cost for holding gold. In today’s low interest rate environment, the latter situation has occurred. With the 10-year Treasury yielding less than 1.80 percent and the Consumer Price Index up 2.3 percent over the past 12 months, this amounts to a negative real interest rate of 0.5 percent . With the real rate of return on many short and medium-term bonds low or negative, there is little opportunity cost for holding a non-yielding asset. Historically, low real interest rates bode well for the prices of commodities.
- In the past two years, central banks have also increased their physical gold holdings: in 2010 central banks were net gold purchasers for the first time in two decades, and in the first half of 2011 central banks bought about 208 metric tons of gold, which is on pace to shatter the record of 276 metric tons bought by central banks in 1981 .
- While the US and Germany both hold over 70 percent of their total reserves as gold, the percent for China and Russia is just 1.6 percent and 8.2 percent, respectively. Instead of gold, approximately two-thirds of their reserves are in dollar-denominated securities . Over the past decade, the value of these securities has declined because of the weak performance of the dollar. Weighed against a basket of other currencies, the dollar hit a 40-year low in 2011 . In order to improve their diversification and hedge themselves against any future dollar weakness, the central banks of many developing nations have begun to increase their purchases of other assets, including gold.
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Farchy, Jack. Central Banks Polish Gold’s Shine. 15 Aug 2011. The Financial Times. 26 Oct 2011.
Batson, Andrew. China Takes Aim at Dollar. 24 Mar 2009. The Wall Street Journal. 26 Oct 2011.
Thomas Jr., Landon. Some See Rise Ahead for Dollar. 17 May 2011. The New York Times. 26 Oct 2011.
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