Deflation may be good for gold prices

Gold prices were getting crushed on Wednesday down as much as 5% on deflation panic.

Although gold is typically viewed as an inflation hedge — a wealth preserver as paper currencies lose value — it is also a solid hedge against deflation.

Gold tends to get hammered right out of the gate when deflation panic takes hold, but it doesn’t last. Take 2008, for example: From the beginning of October 2008 to Oct. 24, when prices hit a yearly low of $695 an ounce, gold tanked 20%. The low was a 32% selloff from 2008′s high of $1,023 an ounce.

But over the next year, gold climbed 52% as the S&P 500 rose 23%.

There is a “classic scenario underway right now,” said Richard Hastings, macro and consumer strategist at Global Hunter Securities. “A severe correction in gold prices and then, after we get about a 10% selloff, and assuming other conditions are met, then gold would resume a significant rebound back to the $1,725 level and possibly higher.”

Gold prices are down 8% this week and Wednesday’s price is still only 17% lower than 2011′s intraday high of $1,923 an ounce, which means that prices could have more room to fall but doesn’t mean the gold trade is dead.

According to a recent report by the American Institute for Economic Research, there have been 15 deflationary events in the U.S. in the past 221 years during which the purchasing power of gold increased by 31%. The average deflation cycle lasted five years, which implies an annual average gain in purchasing power of 6% from holding gold during these times.

“Gold is a store of value even during deflations,” wrote Gregg Van Kipnis, chairman, American Investment Services, which authored the report.

“The purchasing power of gold rises because it does not go down in value to the same extent the price level declines,” the report said.

“The worse it gets, the better it gets,” said Hastings. “The bigger the selloff, the cheaper the entry price for new positions.”

The question is where will the gold bulls step in and defend the price. Volume in the biggest gold exchange-traded fund, SPDR Gold Shares(GLD_), was huge Wednesday at 25 million. The trading volume is the highest level since Sept. 26 when gold prices tanked $45 and the GLD dropped six tons. So far this week the GLD has shed less than one ton, despite the steep decline in the gold price.

One factor lurking around the corner that could support gold is that many governments like the U.S. and the U.K. fight deflation with inflation. Although the Federal Reserve didn’t hint at more monetary easing Tuesday, many analysts expect the central bank to pump more money into the system in 2012 and keep rates low beyond 2013. If the Fed ties rates to economic indicators like the unemployment rate, cheap money could be available for a longer period of time.

“I think central banks are going to continue extremely easy monetary policy and why it’s probably very likely that we see a quantitative easing round three come through the Fed,” said Nick Brooks, head of research and investment strategy for ETF Securities.

“In a deflationary environment you tend to see government fiscal accounts and debt levels deteriorating,” said Brooks, “and the combination of these factors often lead investors to move towards hard assets with gold being the first port of call.” – TheStreet.com

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Posted by admin on Dec 15 2011. Filed under Gold predictions. You can follow any responses to this entry through the RSS 2.0. You can leave a response or trackback to this entry