Deflation and Gold

19th July 2010

The gold price retreated on Friday, giving up the rise it experienced earlier in the week.

Flat inflation figures, dropping consumer sentiment and weaker than expected corporate earnings reports were cited as possible causes.

On Friday gold, priced in US dollars, took it’s biggest drop since July 1st.

Elsewhere crude oil dropped and the stock markets also sufferred. The Dow Jones ended the day over 250 points down.

"The [inflation] data was a bit disappointing, and it created a deflationary scare. There was a move out of paper assets and equities into Treasuries, and precious metals were caught in the middle," James Steel, chief commodities analyst at HSBC, was quoted on Reuters.

The weekly price of gold dropped 1.6 percent (according to London PM fix).

IMF and Hungary

On Sunday more bad news struck in Europe… the IMF and the European Union (EU) disagreed with Hungary officials over the extent of their budget deficit controls.

This crisis looked on the cards after we reported a few months back that the Prime Minister was up to some unorthodox leadership. Read more here.

Hungary need to agree with the IMF and EU to access the next phase of credit. Any jitters will be closely played out in the euro despite the fact that Hungary has not adopted the currency.

Euro bank stress tests

Friday sees the results of the Euro bank stress tests published. With German and Irish banks brushing these tests off already we can only imagine what dressing up the authorities intend to give to reassure the markets. If the market reacts positively to the results we could see a drop in the gold price as riskier assets are played back in. However these will probably only go to mask the deepening trouble our banks are really in. Watch out on Friday – and see which way gold gets pulled. It could be a good entry point if a sharp sell off pursues.

Read about the stress tests and it’s criticisms here

Deflation and Gold

As deflation starts to persuade investors risk tolerance it’ll be interesting to see how the gold price performs. Deflation would typically drive investors away from equities and into cash. Investors fear the market. This drives them to seek capital preservation rather than capital growth. But with the currency alternatives available, including the unstable euro, can gold benefit?

The behaviour of gold under deflation depends on the perceived value of currencies.

Both the dollar and the euro have been rattled recently, take a look at their respective charts below…

The big question is where do investors think their capital is safest?

Arguing the case for gold we dug up this excellent report which describes in detail exactly what sort of economic climate we could be looking at and why gold may still do well.

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The Behavior of Gold Under Deflation

"Deflation is defined as falling levels of both economic activity and falling price levels on an absolute basis. The contraction of economic activity is generally preceded by an unsustainable boom period and is usually kicked off by an event which causes economic confidence to be lost. Deteriorating credit quality, the shift from capital growth to capital preservation, and the hoarding of capital are characteristics of most deflationary periods. Deflations typically end after crisis conditions force policymakers to enact large-scale inflationary policies designed to counteract deflationary conditions."

"In historic US deflations, individuals had the choice between paper currency or gold as hoarding vehicles. The historical record demonstrates that loss of confidence in the issuer of paper currency is often a sufficient reason for individuals to choose gold over paper currency. We attach a detailed review of the behavior of gold under each US deflationary period since the Post-Jacksonian deflation of 1837- 1843."

Read more here

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It still remains to be seen exactly what happens but we cannot discredit a possible decline in the gold price if deflation hits. Gold has in the past been a risky play and it is difficult to shrug off this reputation. If investors look to cash then the dollar could rally and the gold price may suffer. But as the report above suggests this bout of deflation is often followed by inflationary actions by governments. So in the long term we’re still bullish on gold.

Keep a watch on the gold price over this week. And we’ll be back next week with another edition.

Regards,

Digger
Gold Price Today

P.S Please feel free to send me any articles you find interesting during the week and, if they are good enough, we will include them in next week’s email.

Important

Information in Gold Price Today is for general information only and is not intended to be relied upon by individual readers in making (or not making) specific investment decisions. Appropriate independent advice should be obtained before making any such decision.