Gold rush is unlikely to last long

In recent weeks one of the features of an otherwise dull period for stock markets has been the sharp bounce in the price of gold. The impact of sales by the Bank of England and other central banks had driven the gold price to as low as $260 (€244) per ounce.

The catalyst for this turnaround in sentiment was a surprise announcement from the world's central banks at a G7 meeting setting out voluntary restrictions on gold sales for the coming five years.

At one fell swoop the statement from the G7 meeting removed uncertainty as to potential future gold sales from the IMF, European Central Bank, and the Swiss Banks. Within days of the announcement, the gold price hit a high of $340 per ounce and the price is currently trading around $320 an ounce.

A clear beneficiary of this development is the Bank of England, which had previously announced a series of gold auctions. These will go ahead but the Bank of England can now expect to receive a higher price for its gold because of the reduction in future supply from other central banks.

Not surprisingly, the sharp rise in the gold price has been reflected in very sharp rises in gold shares. The Johannesburg Gold Index has risen by approximately one-third over the past month, while in the US the S&P Gold Index is up by about one quarter. In the Irish market the limited number of specialist gold shares, such as Glencar and African Gold, have also risen sharply.

However, Irish investors who have an exposure to gold are probably invested in some of the larger international shares given the extremely limited liquidity of the few small listed Irish companies.

Now that the gold price has stabilised many market analysts are predicting that the price can reach a level of $340 per ounce or even higher. Despite this sudden burst of euphoria, investors should reflect upon the fact that the longterm trend in the gold price has been downwards for more than 20 years.

This most recent recovery in the price still leaves the current gold price below the average price experienced in 1997.

During the inflationary 1970s, gold was seen as the classic hedge against the declining value of paper money and the price of gold rose sharply during this period. However, once central banks begin to squeeze inflation out of the global system from the early 1980s onwards, gold lost its allure.

The extremely high real interest rates available from the banking system meant that the opportunity cost of holding gold became penal. Furthermore, as inflation rates fell the demand to hold gold as a hedge against inflation also fell.

The end result has been a steady decline in the price of gold throughout the 1980s and 1990s. From a very long-term perspective, there seems to be little chance that the conditions which made gold an attractive asset during the 1970s will return in the coming decade.

Inflation rates throughout the world are very low and central banks are likely to remain extremely vigilant as regards future inflation risks. The upshot of this is that real interest rates (i.e. nominal interest rates minus the inflation rate) should remain relatively high. Therefore gold, which produces no income a dividend yield, is only attractive if it can produce capital appreciation.

The short-term outlook for the gold price now seems benign because of the recent announcement from the 15 central banks to limit supply. However, in the medium to long term, the economic and financial conditions which would generate a bull market for gold, are unlikely to materialise. Therefore, the current euphoria in the gold price could well prove to be short-lived.