What's Behind the Gold Price Surge

Editor's Note: This story was updated Tuesday, Sept. 8.

After spending the summer in the doldrums, the price of gold has started to perk up in September—enough to push the yellow metal near the $1,000-per-ounce mark. Last week, gold jumped 3.6% in just two days, peaking at $997.80 an ounce on Sept. 3. By the end of the week, it had pulled back slightly—the December futures contract on the New York Mercantile Exchange settled $1.60 lower, at $996.10 on Sept. 4. On Sept. 8, the December contract moved above $1,000—gold's highest level since March, 2008—amid a further decline in the U.S dollar.

There's no shortage of rationales that investment strategists and economists have offered for the biggest price spike in gold in six months—from increased purchases by China's central bank to inflation fears—but these seem like mostly after-the-fact justifications for what's occurred, according to Philip Klapwijk, chairman of Britain-based metals consulting firm Gold Fields Minerals Service (GFMS).

If gold fails to decisively break through $1,000 an ounce, it will be the third time since February that the metal has fallen short, and that could lead to a fairly quick reversal in investor sentiment, says Klapwijk. The retracing of crude oil prices back to $67 a barrel since failing to break through $75 the week of Aug. 24 augurs a similar pattern for gold if it can't break above $1,000, says Jacob Oubina, currency strategist at Forex.com.

Rumors of Chinese Demand Klapwijk at GFMS says he's bullish about gold in the medium term and believes the "very lax" fiscal and monetary policies of governments trying to lift their economies out of recession eventually will result in inflation and lead to a much broader group of investors pushing gold prices above $1,000. But he doesn't see anything to justify such a move right now. "I'm a bit skeptical about this move, I must say, because I believe speculative positioning is already long. Commodity prices in general are overbought," he says. "There's room for a correction. I don't sense this is the long-awaited, decisive push through $1,000 an ounce."

What's driving the current rally? First, there's demand for the metal tied to its monetary value in times of uncertainty. The Chinese government is allegedly trying to diversify away from its massive U.S. dollar reserves by buying physical gold, but from its own production, not on the world market.

Some argue that gold is reacting to the likelihood of sustained deflationary pressure, with real interest rates remaining below zero, rather than any hint of inflation related to the ballooning federal deficit. It's hard to make the case for a looming inflation threat with the consumer price index down 0.2% in July (before seasonal adjustment), and 2.1% lower than a year ago, thanks to a 28% decline in the energy component of the CPI that has trumped a 0.9% rise in food and a 1.5% increase in the index for all items excluding food and energy.

Gold Could Hit $1,200 There was scant hint of any spiraling wage concerns in the August nonfarm payrolls report released on Sept. 4, which accompanied news that the U.S. unemployment rate hit a 26-year high of 9.7%. In August, average hourly earnings of production and nonsupervisory workers on private nonfarm payrolls rose by 6¢, or 0.3%, to $18.65. Over the past 12 months, average hourly earnings have climbed 2.6%, while average weekly earnings have risen by only 0.8%, due to declines in the average workweek, according to the Bureau of Labor Statistics.

Nor is the dollar especially under pressure lately. The U.S. Dollar Index, a futures contract offered by the New York Board of Trade that reflects the dollar's standing in relation to other major currencies, rose 0.16%, to 78.56, in response to the nonfarm payrolls report on Sept. 4 but is far below the 88-90 range it reached back in February. Still, the index is above the 71 level it sank to during the first half of 2008 when gold first broke above $1,000. Frank Holmes, commodities fund manager at U.S. Global Investors (GROW), believes that if the dollar were to drop back to its 2008 lows, the price of gold would probably shoot to $1,200,

That's unlikely to happen any time soon, however. While the choppiness in the overall economy has worked against the greenback for much of the third quarter, there are signs of a reversal, at least in relation to the euro. The yield differential between 2-year U.S. Treasury notes and the 2-year German sovereign bond had narrowed from 56 basis points three months ago to just 17 basis points on Sept. 4. "We're seeing a very choppy quarter for all the [major] currencies," which may be one reason that investor demand for gold has strengthened lately, says Meg Browne, senior currency strategist at Brown Brothers Harriman.

Stronger Dollar Anticipated While currency fluctuations reflect shifting signals in the economic data, a more positive tone to recent economic reports "has tended to ease the sense of risk in the economy" and made investors gravitate toward higher yielding currencies than the dollar, she says.

But with the U.S. economy expected to recover ahead of Europe's economy, she sees U.S. interest rates moving up and supporting a stronger dollar over time. Apart from the monetary considerations, there's the impact of physical supply and demand shifts. Standard & Poor's analyst Sam Stovall said on Sept. 4 that S&P expects gold prices to continue to climb due to declining mine production around the world. With global mine output decreasing at a 0.8% compound annual rate from 1999 through 2008, according to GFMS, Stovall predicts "production will remain stagnant for the next several years, as old mines are becoming depleted and are not being replaced to the extent needed to lift output. This, combined with rising demand, should cause the chronic gap between production and consumption of gold to widen further, in our view, helping to lift the gold price." (S&P, like BusinessWeek, is a unit of The McGraw-Hill Companies (MHP).)

Royal Gold's Royalties Appealing September typically marks the start of an extended period of higher seasonal demand for gold, which spurs restocking of inventories to satisfy increased demand for gold jewelry, says Holmes at U.S. Global Investors. That began earlier than usual this year with the Muslim Ramadan celebration and will build with India's post-monsoon rural wedding season, followed by the Diwali holidays across Southeast Asia and then Christmas. The fact that September historically has been a time of weakness in the dollar also works in gold's favor, he adds.

For those who are optimistic about gold prices continuing to move higher, Ernest Hathaway, registered principal at Financial Strategies Institute in Midvale, Utah, recommends using the SPDR Gold Shares ETF (GLD). He has also begun to buy single mining stocks such as NovaGold Resources (NG), which covers its expenses through profits on its copper production. He doesn't suggest that conservative retirees invest in mining stocks, however.

Holmes says his fund's portfolio now has a bigger exposure to gold stocks than to physical bullion. Among his picks are Royal Gold (RGLD), which has a strong royalty business with high profit margins and whose management owns a big portion of the outstanding shares. Another favorite is Freeport-McMoRan Copper & Gold (FCX), which recently eliminated its convertible preferred stock and bought back shares when they were cheaper. He likes that Freeport gives investors exposure to China—now the world's largest producer—and that most of Freeport's gold is produced as a byproduct of its copper production at no extra cost.

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