Observers Look to History to Pin Gold Prices

Gold recently pulled back from its climb toward $1,900 an ounce and now investors are wondering if a correction will lead to a drop in value or if …

Gold recently pulled back from its climb toward $1,900 an ounce and now investors are wondering if a correction will lead to a drop in value or if the retraction is temporary and therefore a good time to buy. Speculators look to history to help predict gold’s next move, arguing that a convergence of circumstances will lead to yet more gold gains. These include the devaluing of the dollar and its eventual lapse as the reserve currency, the growing weakness of the euro, the distortion of actual inflation figures and the self-serving machinations of central banks. Critics are the center will not hold and when the system collapses the only thing left of value on the market will be commodities, and particularly precious metals like gold. For more on this continue reading the following article from The Street.

As the price of gold has pulled back from its recent run to $1,900 and silver continues to hold support and test medium-term highs, investors are left to ponder what exactly drives the movement of this commodity, and how bullion trading affect the medium-term outlook for the dollar.

Our take is that gold and silver have a long way to go before they find fair value. That said, investors shouldn’t blindly buy precious metals. Instead, they should be patient and use a strategy of buying on the dips.

We started sending signals to clients when gold was trading at around $950 an ounce. We issued signals again at $1,100, $1,250, $1,390, $1,470, $1,525, $1,590, $1,625, $1,745 and most recently at $1,795. All came with near-term and medium-term targets that covered all outlooks, and the buy-the-dip pattern has held steady.

Gold has once again pulled back, this time to the $1,820 area as expected, and is now being monitored for signals that momentum, sentiment, and price action are strong enough to buy the dip. As soon as confirmation is seen, we will issue signals. In the near term, $1,805 and $1,780 are support, and $1,860 and $1,890 are resistance.

Most people are aware that gold prices respond to inflation expectations and that central banks, as the largest holders of gold, are big players in the market. But people don’t always understand clearly why and how these players affect prices and what their ultimate goals might be.

Although few people actually know how central bankers from Bombay, Berlin and Beijing look to manage the global gold market, a better understanding of how our current system came to be provides some clue about gold’s recent behavior. World War I was not only catastrophic to an entire generation of Europeans, but it also left the international financial system in tatters.

After the war, the great powers met in Rome to re-establish a workable international financial system. The pound, the British currency, which had been fully convertible into gold, was selected as the official "reserve currency."

During the Great Depression of the 1930s, the collapse of Austrian and German banks triggered a run on sterling for conversion into gold. Unable to withstand the assault, sterling was replaced as the reserve currency by the dollar. Although the dollar was also convertible into gold, the Roosevelt administration had limited the risk to the U.S. Treasury by restricting redemption only to central banks.

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In 1944, the newly established International Monetary Fund (IMF) selected the greenback as its "international reserve asset," which enshrined a quasi-gold standard to undergird global financial transactions. However, the inflationary policies of most governments caused the market gold price to rise above the official price of $35 an ounce.

In 1961, as the price of gold drifted higher relative to the dollar, the major central banks formed the London Gold Pool, a "gentleman’s club" for coordinating gold sales in order to stabilize gold prices. But by 1971, the dollar’s devaluation had overwhelmed their coordinated interventions.

Ultimately, President Nixon was compelled to break the dollar’s last links to gold by closing the "gold window" to other central banks. For the first time in fiscal history, the world monetary system "floated."

Since then, major central banks have continued to debase their currencies at pace with the U.S. dollar. In 1978, via the IMF, there was a move to demonetize gold, which stood to expose the true rate of consumer inflation. This was first carried out by massive central bank sales of gold in exchange for Special Drawing Rights (SDRs) from the IMF.

When this failed, the U.S. gained support, in 1999, for the Central Bank Gold Agreement (CBGA) to coordinate the release of central bank gold into the market.

Officially, at least, this was meant to prevent central banks from dumping gold. However, it is highly suspicious that these nominally independent central banks would take coordinated action to support the gold price. This is especially true given that they’ve spent the last 40 years trying to do the opposite. It is likely that the CBGA was designed to covertly time purchases and sales to magnify gold’s price volatility in order to dissuade investors from holding it over the long term.

This intervention was probably the biggest factor in distorting the gold market, but the precious metals investor should understand that central banks can only pressure the market, not dictate it. Gold will continue to move higher as the following dynamics unravel.

First, the dollar has benefited from its reserve status, which creates demand for dollars to complete various transactions. However, the conditions that put the dollar on the world monetary throne have already changed, and it’s just a matter of time before it is forced to abdicate. Just as France endured as the international diplomatic language long after the nation’s power on the world stage had waned, so too is the dollar coasting upon its former glory.

When the dollar loses its reserve status, overseas demand for the greenback will decline and a reserve of a mix of bullion, rare earth and precious metals will likely flourish. The fact that U.S. government bonds now are slightly tainted by a downgraded credit rating only strengthens the gold holder’s hand in the long run.

Second, many holders of surplus currency have diversified into the euro. But the euro is a tower built on potentially uneven ground. Already it is showing cracks as Greece, Ireland, Spain and Portugal exhibit signs of economic failure, along with a banking sector that although strong is now susceptible to new balance sheet standards being implemented.

If the solvent states of the union succumb to pressure to bail out their weaker neighbors, the euro will lose a part of its newfound credibility in the global arena.

Third, we suspect the U.S government and Federal Reserve have been successful in distorting the official inflation figures and have attempted to convey the message that inflation is not actually going to impact the consumer for too long.

Fortunately for the government, people tend to think in "nominal" rather than "real" value terms. For example, investors still feel good buying stocks and bonds of American companies in dollars.

They don’t realize that when measured in terms of gold, or money unimpeded by fractional banking standards, the S&P 500 has lost some 20% over the past 10 years.

Fourth, and perhaps least understood, the massive inflation already created by the Federal Reserve remains hidden within the banking system. As long as banks are able to lend directly to the Fed and Treasury at no risk, they have no incentive to circulate their new dollars. Only when bankers leverage up and lend to industry, or have their hands forced to do so, as happened in 2004-2005, will the prices of consumer goods skyrocket, and reveal the already massive shadow inflationary pressures.

Lastly, by changing accounting standards for the banks’ toxic assets and making self-congratulatory pronouncements, the government has created the impression that the crisis has been averted and that faith has been restored in paper currencies. This feeling of relief is flawed fundamentally.

It will not be long before investors are brought to the devastating realization that a true recovery from a credit boom requires tightening and recession — that Washington did not avert catastrophe, but ensured it, and that the economic expansion that is being called for may still be a long way off.

As these dynamics unravel, the full consequences of U.S. profligacy are being felt around the world, as inflationary pressure builds in line with higher commodity prices, due in part to the synthetic weakness created in the dollar. Central bankers can sign any agreement they wish, but it won’t stem the meteoric rise of gold. By then, investors will understand that those left holding dollars will be left holding the bill in the long run.

This article was republished with permission from The Street.

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