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Why gold is rising: Fed taper, emerging markets and..deflation?

Why is gold rising?

Why is the price of gold rising when inflation seems benign? For years, investors have been told the yellow metal is a hedge against inflation; so why is gold rising with little or no inflation?

Charles Gave may help explain this conundrum. Gave, who founded the GaveKal research firm after managing money for many years, is trying to puzzle out the price rally in gold, which this week shot back up over $1,300 an ounce after a steep correction from $1,600 last year.

Gold is rallying for reasons that make little sense: on news that the Federal Reserve is cutting back on its long, huge bond-buying binge, and despite low consumer prices and flagging money supply. “This is particularly hard to understand for investors, who think of gold as an inflation hedge,” Gave notes.

But two things could explain it: emerging market currency turmoil, and the Federal Reserve’s low interest rate policy.

First, divide the world into two categories: those countries that keep a tight lid on foreign-currency exchanges; and those that don’t. The first includes mostly emerging economies, the second mostly those of developed countries. “If you are a rich person in one of the countries with capital-account restrictions, it can be difficult to diversify your assets abroad. In quite a few of these countries, one can buy gold. So gold becomes the substitute for international assets in a diversified portfolio.”

Since such emerging markets as Brazil, Russia, and India have experienced hyperinflation, defaults, taxes on capital flows, and devaluations, “gold becomes the best available hedge against bad policy, as well as against a bear market in the local stock market,” Gave says.

Second, Fed monetary policy has added to the volatility of exchange rates, and so, Gave concludes, “this is how we get the bizarre situation where holding gold protects against devaluation and growth/deflationary pressures in the emerging markets. Gold will keep rising as long as U.S. policy is exporting volatility – we see no imminent change in this situation under Janet Yellen’s Federal Reserve.”

We may have missed the significance to gold of wildly moving exchange rates in countries that now make up a significant portion of the world’s growth: Brazil, Indonesia, India, China. And Gave thinks if the volatility continues, then gold may keep rallying as a hedge against uncertainty.


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