Opinion Not so glittering

First,let us look at the global drivers of the surge in gold prices. After the global financial crisis of 2008,the rise of global gold prices has been remarkable. From a trough of $700/ troy ounce (oz) in September 2008,it rose 2.7 times to a peak of $1900/ troy oz in mid-2011. One of the key drivers of this was negative real interest rates in the United States. US real interest rates,which is the interest rate minus inflation,have historically been one of the most important drivers of gold prices. Low rates reduce the opportunity cost of putting savings into hard assets such as gold. As US economic growth came to a halt,the Federal Reserve slashed interest rates to near zero. With inflation still positive,this drove real interest rates negative.

The Fed also pumped a large amount of liquidity into the system. Some of this liquidity flowed into gold. At the same time,concerns about currencies becoming devalued — from the US dollar to the euro,due to the printing of money,helped bring even more investors to gold. Exchange-traded gold funds (ETFs) saw record inflows,which spurred even more gold buying. This cycle now appears to have turned. US real rates are rising,liquidity injection is likely to slow,risks of a blow-up in the paper currencies are being reduced,and gold funds are seeing sustained outflows. Let us look at these in detail.

First,real US interest rates are rising. The US economy is recovering,with little sign of inflation. After sluggish growth for the past five years,economic prospects are looking decidedly better,based on a housing recovery and cheaper fuel prices. Reflecting this,the US stock market has reached historic highs. Bond markets have reacted to this through rising interest rates. With inflation low and interest rates rising,the real interest rate is going up. Further,the better US outlook is increasing the chances that the Fed will reduce the amount of liquidity easing as we go into 2014. This can reduce the amount of excess liquidity that can flow into gold.

Second,there has been a reduction in US fiscal and European sovereign risks. These are important drivers of gold as safe-haven flows. Relatedly,there is now less danger of paper currencies,such as the US dollar and the euro,becoming devalued,and therefore the rush to safety that gold affords. Indeed,the recent sharp rise in the US dollar relative to all currencies,including the rupee,is indicative of that fact.

Third,in recent months,ETFs — which,at the peak,were the third-largest holders of gold,have turned sellers. After the US and German central banks,ETFs are the largest holders. In the year to date,they have sold gold equivalent to 10 per cent of the annual gold supply. As ETFs continue to sell,it is releasing supply into the market.

Fourth,closer home,the need to guard against high inflation is becoming less important. In the last three years,gold demand spiked in India — from an annual average of about $20 billion to $50 billion,in part due to a sustained period of double-digit inflation and sharply negative real rates. As alternative asset classes,such as stocks,were generating poor returns,the attractiveness of gold as a protection against inflation increased. As inflation has begun to come down,the need for an inflation hedge is being reduced. New products,such as the inflation-linked bonds by the RBI,will also help. In the US as well,there is little risk to inflation in the near term. Higher inflation as a catalyst for the next up-move in gold prices may be some years away.

The recent bout of gold buying is not very different from what we saw in equities in early 2008. After a five-year-long bull run,equity prices fell sharply in mid-January 2008. This led to a rush by retail investors to buy stocks and mutual funds. The inflows into mutual funds reached a record during that period,as retail investors saw an opportunity to get into equities after a correction. It is instructive to remember that more than five years later,equity markets have still not reached their early-2008 peaks.

There is little truth in the argument that gold has always been a safe asset. Before the current bull market in gold,between 1980 and 2000,gold prices in US dollar terms nearly halved. In rupee terms,adjusted for inflation,the return on gold over this period was negative 160 per cent.

There will still be demand for gold for consumption purposes and even as a hedge against a weakening rupee. Gold also affords some protection against a depreciating currency,but only if it holds on to its value. If gold prices continue to fall,as they have in the past six months,it can continue to act as a drag on household wealth. Periods of improving global growth and rising US interest rates are normally periods of weak gold prices. Therefore,it is time to rethink if gold is still a “safe” investment.

The writer is managing director and chief India economist,Goldman Sachs.

Views are personal