After a record ten straight years of annual gains, gold has entered a critical phase in one of its longest rallies. Markets are abuzz with contradictory views on whether gold will continue to rise in 2011. Signs of a slowdown are apparent in the short to medium-term. However, we investigate two compelling factors affecting gold prices and find out why there is no reason that the prolonged rally does not continue well into this year as well.

Interest Rates and Gold Prices

The Fed fund rate maintained through open market operation (OMO) shares a positive relationship with gold. However, in spite of the fact that the overall correlation of fed rate with gold is considerable, it is not strong enough to impact gold prices single handedly. An analysis of gold prices and the Fed fund rate suggests that the metal price moves do not depend entirely on the Fed OMO, but rely on the investor sentiment and their interpretation of the Fed OMO rather than Fed numbers. Change in the Fed fund rate has always influenced gold prices, but not in a systematic way. Our analysis indicates that the excess liquidity inflow into the system, in terms of reduced fund rate, does not necessarily find its way into gold investment. The relationship between rates and gold prices depends on the economic scenario.

Throughout the global recession, rate cuts to infuse more liquidity, found its way into gold investments because of its safe haven appeal and the weaker equity markets. Will gold prices remain sensitive to the interest rates in 2011, even as the economy stabilizes and the equity markets provide opportunities of higher yields at current levels? What’s the outlook for Fed rates in 2011? These are perhaps more pertinent questions in the mind of the investors than Fed rates itself.

Inflation and Gold Prices

Gold’s appeal as an inflation hedge has been one of the primary reasons for the rise in prices in many instances in history. Gold is no doubt a preferred asset during times when investors fear sustainable inflation to erode their wealth; the reverse scenario, particularly in the presence of a strong equity market, renders gold less attractive to investors. However, the relationship between inflation and gold prices has been historically unsystematic. This shows that like Fed rates, inflation is also not a single factor model that can describe gold prices.

A historical post mortem shows how gold prices soared on the back on high inflation in the early 1980s. As inflation slowed down, gold prices did not immediately retrace to lower levels. Gold continued to be strong under the impact of opposing factors – inflation alone was not a key determinant of prices. Investors who had kept away from the stock markets returned to stocks. The interest in the stock markets dried up investments in gold; however, concerns about sustainability of the lower interest rates endured investor confidence in gold’s safe haven attribute eventually. The result was a mixed appeal for the metal with prices remaining firm, despite lower inflation and better performance of the stock market. Gold continued in the same price range for some months before tumbling below USD 400/oz during Oct83 when investors were assured of no further inflation in the near-term – investor sentiment and perception of future inflation drives prices, not current inflation numbers alone. Apart from the sample historical analysis, the interim period till the global recession in 2008-09 has also witnessed considerable inflation fluctuations, but gold prices have been on an overall positive trend. Inflation is a key attribute in determining gold prices, but investor sentiment takes the front seat.

Our scatter plot between monthly CPI (using real unaltered numbers, not the official ones) and gold prices over the past ten years shows no well-defined relationship between the two.This emphasizes the fact that gold prices react more to expectations of inflation than current inflationary data. We also observe that gold is up on more occasions than down when CPI is up – inflation and gold prices go up together. In deflationary markets, the relationship is not in the same direction- we observe that with CPI down gold prices do not plunge (safe haven). In such regimes too, gold rises more than it plunges.

In recent times, gold has been rallying on the back of the depreciating U.S. dollar and the fear of inflation in spite of the negative y-o-y CPI inflation data. Although, most analysts will agree that this is a period of deflation, if we consider the classical definition of inflation, the oversupply of money itself indicates inflation. The investor’s perception of an imminent inflation supports gold price. Our analysis suggests that inflation and gold prices are dependent on investor sentiment (inflation expectations rather than current inflation). The perception of investors about future economic conditions is the determining factor correlating gold prices and inflation. Investors do not react to changes in the ongoing inflation scenario and do not immediately shift their preferences toward or against gold. However, the perception about the ongoing economic situation is bolstered when inflation prolongs. Therefore, gold prices lag inflation for most of the time and sometimes precede on the expectation of an inflation.

Interest Rates and Inflation Scenario in 2011

In the current situation, the Fedis still more concerned about deflation than inflation and the impact of flooding the US economy with more dollars is yet to find its way into an expected hyperinflation. In contrast, bigger gold-consuming economies like China and India are going through relatively strong economic growth and therefore higher inflation.Prices in China are 5.1% higher y-o-y, while India is expected to show inflation numbers close to 5.5% by March 2011.

The inflationary scenario in India and China should overshadow the deflationary scenario in the US, given that these two nations account for a vast majority of gold purchases. As investors in the region anticipate inflation, gold prices should be well supported. We have observed earlier that current inflationary trends do not dictate gold prices; it is the investor outlook for the future that holds the key. If we take the classical definition of inflation, the US is showing signs of inflation and the oriental economies just at the onset of inflation, it is the perfect time for gold to rise before real inflation kicks in worldwide.

Inflationary concerns are likely to be the biggest support for gold prices in 2011. With commodity costs having recovered significantly post recession, higher costs for materials or staffing is already evident in the US as well, but these costs are not being passed on to end customers yet. Inflation is an even bigger concern in the East and investor sentiment in the region typically diverts to gold even on the hint of an upcoming period of inflation.

Inflation is a bigger concern in developing countries than already developed countries because a larger portion of the average person’s income goes into spending that would be regarded as basic necessities in developed regions. So, rising inflation is not seen as means to erode mortgage (people do not carry a lot of debt). Rather, it wreaks panic in the markets as inflation hits the very survival of the masses. In a way, therefore, the inflationary scenario in China and India are more important for gold than in the US.

A negative impact on gold that the East may have in the near-term is a possible easing up in China’s growth story. The latest manufacturing survey shows that the rate of expansion has slowed for the first time in five months. The biggest impact of a slowdown in the East will be on the commodity markets. If investors perceive a slump in demand from China, then commodity prices are likely to fall back. And if China's economy really crash lands, then chances are we'll see a return to the dollar and a panic that could plunge asset prices across the world. What we would hope is the Chinese growth story is going nowhere dramatic soon and that China will be able to balance any slowdown if imminent without crash landing.

On the other side of the Chinese story, if commodity prices keep gaining, inflation is likely to cause problems in the West as well. Inflation in the US will lead to higher interest rates and possibly impact investments in gold. For the present though, interest rates are not going anywhere and inflation is more a concern in the East than the West (although the West may also be on the verge of hyperinflation according to the classical definition of oversupply of money). As Fed rates remain down, bullion appetite will remain strong and the dollar will continue to be fundamentally weak. With currencies not getting any stronger and inflationary pressures continuing to build, gold is likely to be well supported in 2011. As we have observed, gold does well in the shadow of an impending inflation (which is the current case) than a continuing inflationary market. Inflation comes with higher interest rates that deter investments. So, unless a dramatic shift in the equilibrium in the developing nations occurs, signals for gold are very much bullish in the long-term.

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Thank you for reading.

Mike Stall
Sunshine Profits Contributing Author

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There were too many risks for 2011 to list them all at once last week, so we saved some for this week's Premium Update. There is slowdown in China, social unrest around the world due to rising food prices, hyperinflation and a few other things that can keep even the soundest sleeper awake at night. We can only take a small measure of comfort in the fact that the 2011 outlook for precious metals is very bullish.

Meanwhile, stocks have just reached a high that in 2008 marked the last stop before the epic plunge. What impact is it likely to have on the stock market and on the precious metals? Will the recent reversal in the USD Index be a bullish or bearish factor as we move forward? What about the Hindenburg Omen that we have just seen? This week's update includes replies to the above question and more.

We have examined the situation in gold, silver and mining stocks, and all of them moved below very important support levels or have just reached them. Will they still provide support, or is this a beginning of another serious decline? In addition to our regular analysis, we also explain how and why resistance levels work. Being aware of the psychological phenomenon behind it makes one less likely to follow it, which should ultimately translate into higher profits.

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