Once again as turbulent times unfold, investors have sought the comfort of the ultimate safe haven — gold. The climb to record nominal price levels can be attributed to the confluence of many factors including soaring crude oil prices, the chronic political instability in the Middle East and the weakening value of the U.S. dollar. In recent history, gold prices soared in the months prior to the year 2000 when concerns were high whether computers would be able to cope with the century change. Similarly, in the days immediately after September 11, gold prices were elevated until the markets sorted out the new political risks. Now the immediate reasons for the soaring price are focused on the depreciating dollar and the prospect of negative U.S. real interest rates as the Federal Reserve loosens policy to fend off rapidly slowing growth. With the credit crisis and the Fed’s response — cutting interest rates and injecting huge sums into the banking system — the emphasis on gold's value has focused on market dislocations and inflation of late. The precious metal is considered a hedge against inflation and protection during periods of financial market turmoil.

In recent years the gold market has seen only a few rallies over $300 per troy ounce mark and all were short lived. The U.S. dollar seemingly had replaced gold and was considered a safe haven for risk averse investors. As other investment products came into wider use, gold lost even more of its luster as a dollar alternative. But once again, there is stirring in the gold market. What is causing gold prices to rise now and why should investors care? And despite continuing central bank gold sales, the price continues to climb to new nominal highs.

With the explosion of subprime woes in August 2007, gold soared to its highest price since January 1980 — and then kept climbing. A combination of the declining value of the dollar and surging energy costs boosted the appeal of the precious metal as an alternative investment. Over 28.6 percent of gold's 32.4 percent gain in 2007 occurred in the second half of the year as the subprime mess unfolded. Other commodities joined the party and the dollar plumbed all time lows against the euro.

Once upon a time…

Gold was currency and not a commodity. Indeed, that was the case in the years prior to August 1971 when the U.S. left the gold standard for the last time. President Richard Nixon closed the ‘gold window’ making the dollar no longer convertible to gold. By 1976, no major currency retained a link to gold. Until the U.S. dropped the gold standard gold was considered a currency and not a commodity.

Central banks and supranational organizations hold around one fifth of global above-ground stocks of gold as a reserve asset — a figure that is decreasing steadily over time. These stocks are owned largely by central banks in Europe and North America and were acquired predominantly in the context of the classical gold standard. On average, countries hold 10 percent of their reserves in gold, although the proportion varies widely from one country to another. The chart below from the World Gold Council shows how these stocks are distributed between countries and supranational organizations.

Although a number of central banks have increased their gold reserves over the past decade, the sector as a whole has been a net seller. Since September 1999, the bulk of these sales have been covered under the Central Bank Agreement on Gold (CBGA). A new CBGA, covering the period from September 2004 to September 2009, was announced in March 2004. Nearly all central banks report their gold holdings monthly to the International Monetary Fund (IMF) and the data are published in the Fund’s publication International Financial Statistics each month.

Today, gold is back in fashion but as a commodity

In today’s uncertain world, investors are seeking gold once again against a background of political and economic uncertainty. Bullion prices set new highs in January 2008 propelled in part by the assassination of Benazir Bhutto in Pakistan which added to nervousness about the world economy. The metal is benefiting as investors diversify their assets and look for alternatives to equities. Commodities have emerged as a distinct asset class, with billions of dollars poured into exchange traded funds or ETFs that facilitate these investments. But demand is not the only reason for gold’s soaring value — declining South African output has also supported spot prices. Gold has also benefited from strong jewelry demand in emerging market countries such as China and India.

But it is the relationship between the dollar and the reaction of the world’s central banks to the credit squeeze that some say is making gold attractive today. The Federal Reserve’s ongoing aggressive rate cutting response to the credit squeeze has created a risk of a sharp increase in U.S. inflation. That in turn has created the risk of an accelerating drop in the dollar’s value and thereby making gold more attractive as a hedge. A sharp decline in U.S. real interest rates could mean that the low yield on gold would matter less. Some analysts think that although gold may have been a poor hedge against inflation in the past, the current the combination of rising consumer prices and economic stagnation may make it a better store of value today.

Not really a hedge against inflation

Gold is often described as an inflation hedge, but in fact there are few instances in the past 20 years when gold has moved in sync with either core or headline inflation. Gold prices surged 32.4 percent in 2007 as the dollar sank against the euro and oil prices challenged the $100 a barrel level. Meanwhile jewelry demand remained strong in spite of high prices, particularly in India, China and the Middle East. Investors in commodities enjoyed strong returns, outperforming both global equities and global bond markets.

Gold reached a record high of $850 an ounce in January 1980. Since then if the spot gold prices kept pace with U.S. inflation as measured by the consumer price index, gold would now be selling for well over $2000 a troy ounce. With gold at just over $900, it has a long was to go to be a truly effective inflation hedge. With the 1997 introduction of U.S. Treasury Inflation Protected Securities (TIPS) and similar products elsewhere, there is no reason to use gold as an inflation hedge. TIPS are U.S. Treasury bonds whose principal increases at the same rate as the CPI. The interest payment is then calculated from the inflated principal and paid at maturity.

Nonetheless, gold bullion has no direct link to economic growth as do other commodities — it does not earn a return but offers limited hedging advantages and has not kept pace with inflation. And the world's biggest holders of gold — the major central banks — are not overly eager to keep owning it and continue to sell off their stockpile.

Then and now

As Soviet tanks rumbled into Afghanistan in January 1980, panicked investors sought refuge in gold and in the process boosted prices to a record $850 a troy ounce. At the same time, oil prices were shooting up thanks to instability in the Middle East. And the dollar was falling dramatically amid fears of a recession.

Now 28 years later, all appears almost the same. Again, trouble in South Asia — the assassination of Pakistan’s Benazir Bhutto combined with the perennial instability in the Middle East — has pushed gold to a new nominal high. Once again, oil prices and fears about the U.S. economy along with the direction of the dollar are supporting the rising price of gold. The similarities end there however. In 1980, after a surge from $400 to $850 in just five weeks, prices collapsed to as low as $300 a year later. The record of January 21, 1980 was the peak of a very volatile market in which the price had risen nearly $300 in just three weeks from the beginning of the year and subsequently plunged sharply, giving up all this gain by mid-March.

This time, the price surge has been slow and fairly constant since a low in 1999 of about $250 an ounce and this time support has come from factors other than gold's status as a safe haven. It follows a sustained six-year rise in the price and was built on a combination of strong investment and jewelry demand. Lower production especially in the world’s number one producer South Africa also contributed to higher prices.

Analysts point to the introduction of exchange-traded funds linked to gold as a potent new catalyst for interest in gold. ETFs trade on exchanges like stocks, but their performance can be tied to almost anything, from the value of commodities to the performance of stock indexes like the S&P 500 index or the Dow Jones Industrial Average.

Bottom line

John Maynard Keynes once called the gold standard a barbarous relic. ‘Barbarous’ could be applied to some of the logic in today’s market especially as it applies to gold’s role as a hedge against inflation. Gold is at best only a loose proxy for the economic cycle and market instability. Gold is costly to hold and subject to impulsive, volatile price moves with supply and demand dynamics that are often mystifying. So while some think a new golden age may be dawning, investors lured by gold's recent ascendancy should approach it with caution.

When gold reached its previous peak of $850 a troy ounce in January 1980, it did not stay there long. Just 10 days after hitting that record, spot gold dropped below $700 — and less than two months later it traded under $500 an ounce. The latest surge has been more robust even though virtually all of the 2007 gain occurred in the second half of the year. In real terms however, gold would need to be well above $2,000 to match the price achieved in 1980.