Regular readers will know that I have been bullish on gold, or at least its trading surrogate, GLD, on several occasions over the last year or so. The main reasons have been technical; each time the commodity has dropped to below $1200 it has looked like a solid buy, at least from a trading rather than a long-term investment perspective.
Picking the absolute bottom of moves is nearly impossible, but by waiting for signs of a turnaround and being patient once you execute the trade it has been possible to make some nice profits, as the chart at the bottom of this article shows. The recent panic in the stock market, and this morning’s PPI numbers that confirm suspicions that there is at least some inflationary pressure, add a fundamental case that makes gold once again a buy at current levels.
Fundamental reasons to buy gold are rare. As I have said in the past, it is the Kardashian of commodities: good to look at, fascinating to follow, but of little or no use to society. It is hard to formulate a fundamental case whose primary utility is that it looks pretty, as that means that nobody is ever compelled to buy it. There is, however, one thing that is perceived as a real life use for the yellow metal. It is seen as a hedge against inflation.
To fully understand why that is so, you must understand the essential nature of inflation itself. Ask most people what it is, and they will tell you that is all about rising prices. To some extent that is true, but ask a market participant, particularly those in the bond and forex markets where I used to work, and the chances are you will get a different answer. They see rising prices as a manifestation of the real problem, which is a currency that is declining in relative value.
If you think about the causes of inflation, that makes perfect sense. It is generally accepted that there are two types of inflation: demand-driven and supply-driven. Demand-driven inflation is when, due to a tight labor market, the competition for workers increases, driving wages higher. Those workers with more money in their pockets go out and spend more, increasing demand for goods and services and therefore pushing prices up.
Supply-driven inflation is the result of production capacity and productivity falling behind economic growth. Lower supply, just like higher demand, leads to higher prices.
In both cases though, what is happening is that the relative value of the currency is falling. The rise in demand that comes from higher wages is the result of more money in circulation, and the more of something there is available, the less each unit of that thing is worth. It should be mentioned here that a contributory factor to demand side inflation is a central bank that is adding large amounts of money to the system, and anyone who has been paying attention knows that that has been happening for a long time.
Supply side inflation is essentially the opposite. There is a shortage of goods and services that makes them more valuable, and as they are priced in a currency (let’s say U.S. dollars), that makes the currency less valuable.
Inflation can therefore be seen as a decline in the dollar’s intrinsic value, rather than anything else, and that is where gold comes in. Most of the goods and services that people spend more to get in an inflationary environment are consumed, and money saved loses value every day. Something like gold, however, that cannot practically be used, is stored and benefits from rising prices.
Interestingly, and somewhat puzzlingly, gold’s initial reaction to this morning’s CPI print was, despite the logical case for the opposite, to drop. It has recovered quickly, but it still means that GLD can be bought at a discount to where logic says it should be right now. A full understanding of the causes, effects and true nature of inflation makes that seem like a smart move.