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Gold smashes records on flip coin safe-haven/risk appetite

By Anthony Poole

October 13, 2009 - In contrast to those who express concerns about future inflationary pressure, Jim Steel, chief commodities analyst at HSBC, believes that fear of upward inflationary pressure is not the issue driving gold prices.

Being the first of the Dow Jones Industrials Average component companies to report, it was closely watched for what the Q3 earnings season is likely to bring. Alcoa delighted the optimists.

According to some gold analysts, Alcoa's performance confirmed a return to risk appetite, which had started earlier in the week when Australia raised its interest rates by 25 basis points to 3.25%, the first member of the world's top 20 economies to raise rates in the current cycle.

But the Alcoa news brought even more investment money out of the US dollar and into equities and commodities, including gold.

At the same time, fears about the size of the US budget deficit, now at $1.4 trillion, are also driving gold prices higher.

As one analyst said during the first week of October, "The motivation for investment in gold varies, but it always results in people buying gold."

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Gold certainly benefited from safe-haven buying, although there are two camps as to what is behind the so-called flight to quality.

On the one hand, some express concerns about future inflationary pressure, stoked up by ongoing fiscal stimulus measures, quantitative easing and historically low interest rates over a prolonged period.

In the other camp are analysts who believe that inflation is not the issue at all, and that increasing talk of replacing the US dollar as the global reserve currency has led to a flow of money from the dollar and into gold.

One camp cites inflation "Ponzi scheme"

Jeffrey Nichols, managing director of American Precious Metals Advisors, falls into the inflation fear camp.

In a recent speech he gave in Buenos Aires, he said that the root cause of the world's current economic woes stems from "decades of easy money, low interest rates and a persistently expansionary monetary and fiscal policy by the United States."

He likened this sort of financial policy to a Ponzi scheme, saying, "But like any Ponzi scheme, this greatest of all Ponzi schemes cannot go on forever. Now the jig is up and foreign lenders -- both private and official -- who have been financing America's budget and trade deficits are becoming increasingly uncomfortable, pouring more and more good money after bad."

Periods of rapid growth in money and credit and extended periods of negative real interest rates have always been "followed by a declining dollar exchange rate abroad and a rising inflation rate at home... With higher inflation and a depreciating US dollar, I think you can sense that I'm bullish on gold and silver," he said.

Global gold mine production is in decline, and has been since it peaked in 2001 at 2,645 mt, and it is likely to continue declining, he said.

"Over the long term -- looking out five to 10 years or longer -- mine output is a reflection of price versus the rapidly rising cost of production and the increasing difficulty and expense in finding new deposits large enough to offset the loss of production from the ongoing depletion of existing mines," Nichols said.

Last year's declines in stock markets have slowed funding and retarded mine exploration and development in many countries, he added.

Meanwhile, central bank attitudes toward gold are becoming increasingly positive, he said.

"After years of persistent net sales by central banks in the aggregate, the official sector is now becoming a net purchaser of gold from the market," Nichols said.

The European Central Bank and 18 of its member banks concluded a third agreement that capped the group's aggregate gold sales again at 400 mt/year for another five years, which he viewed as positive, adding that the cap could be irrelevant as sales by central banks have been considerably less than this in recent years.

While the International Monetary Fund has plans to sell 403.3 mt of gold to support lending to poor countries, it could easily be absorbed by Chinese purchases, he suggested.

China is encouraging its citizens to invest in physical gold.

"Imagine that just 1% of China's population each buys one ounce of gold next year -- that's 13 million oz, or about 404 tonnes of new demand, coincidentally about the same amount the IMF will now be selling," said Nichols.

Meanwhile, the vast holdings by the various exchange traded funds, which total more than 1,800 mt, amounted to an even larger holding of bullion by the central banks of Switzerland and China combined.

He said the future price of gold has more to do with its appeal as a financial and monetary asset.

The current bull run in gold, which began in 2001 with gold near $255/oz, has been a period of low interest rates, Nichols said, as was the bull run in the 1970s, culminating in a peak of $850/oz in January 1980.

"Today, real inflation-adjusted interest rates across a range of maturities are again negative, so, if history is a guide, we can expect the price of gold to trend higher over the next year," he said.

But, he said that as a result of demand destruction in jewelry and increased scrap supply, gold was subject to big corrections "that will, at times, cause some observers to wonder if the market has already topped out."

"Ultimately, thanks to the extremely expansionary monetary policy -- and with a little help from ETF investors, central banks and new or evolving markets -- like China and India -- gold will most likely climb into the $2,000 to $3,000 [per oz] range -- and it could go even higher given the right confluence of economic and political developments," Nichols concluded.

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