Why gold prices are falling now

Why gold prices are falling now

Last updated on: September 27, 2011 13:37 IST

"So are you less bullish on gold now?" asked my roommate late on Sunday evening. "The price has taken some beating."

"Why do you ask ?"

"Well, for the simple reason that gold has given fabulous returns for each of the last 11 years."

"So? You have a problem with that?"

"What I meant was that there is something known as the reversion to the mean. Gold prices cannot keep going up all the while."

"Yes, they can't. And that's why the prices have been falling lately. The price of gold has fallen from a high of around $1,900 per ounce and is now moving in the range of $1,550-$1,600 per ounce (1 troy ounce equals 31.1 gm)."

"Oops! I have money invested in gold. But I am getting jittery now. I really don't understand the reasons behind why the price of gold is falling."

"So you want me to explain?"

"Yes."

"Okay, first order some bombil fry for me."

"Sure!" she said, and called for a home delivery.

"The world is now getting into a scenario where competitive debasement of currencies is happening and that was holding up the price of gold," I explained. "The markets were also expecting Ben Bernanke, the chairman of the Federal Reserve of United States (the central bank of the US), to announce QE III, and so the price of gold had been rallying."

"Hey, I am not an economist! How do you expect me to understand so much jargon at one go," she complined.

"Let me explain. See the thing is, as I have said in the past, the United States has printed nearly $2.3 trillion since the investment bank Lehman Brothers went bust in 2008 in order to revive a moribund US economy. The market was expecting that the US Fed will announce a third round of money printing which is euphemistically referred to as quantitative easing III, or QE III. The earlier two rounds were known as QE I and QE II. As you would know that whenever people see more and more currency being printed they buy gold."

"Yeah, that you have explained in the past," she said.

"Now, when anything is flooded into the market, it tends to lose value. So the US dollar has been losing value against other currencies. As Harvard economist Martin Feldstein, wrote in a recent research paper titled What's Next for the Dollar, 'The real trade weighted value of the dollar fell 11 per cent against the Federal Reserve Bank's index of major currencies during the 12 months through May 2011 and 31 percent during the past ten years'."

"So how does that help the Americans?"

"Well, when your currency loses value against other currencies, your exports become more competitive."

"Simple English, please!"

"let us consider an American exporter, who exports stuff to Switzerland and gets paid in Swiss Francs. Around a year back one Swiss Franc was equal to one US dollar. So if he had got paid 100,000 CHF (the sign for Swiss Francs) for exporting stuff, he could have exchanged it for 100,000 US dollars. Are we clear on that?" I asked.

"Yeah. So far so good."

"But now things are different. One Swiss Franc is 1.10 American dollars. So what does that mean? If he exports goods worth 100,000 CHF, he can exchange it and get 110,000 US dollars (100,000 CHF x 1.10) for it now. This is $10,000 ($110,000 - $100,000) or 10% more than last year."

"Yup. So the US is making more money through exports but how does that make them more competitive?"

"At the current exchange rate the US exporter can offer goods for around 90,900 CHF ($100,000/1.1) and still make $100,000(90,900 x 1.1), unlike a year back where he had to sell for 100,000 CHF in order to earn $100,000. So a US exporter can offer a lower price and thus become more competitive. As Feldstein writes, 'A declining dollar could have a powerful positive effect on the short-run performance of the American economy by raising exports (now more than $1.3 trillion)'."

"Okay, this part I understood, but weren't we talking about gold prices?" she interjected.

"Yeah. So when the US exports more, more money comes into America. As exports become competitive, imports into the US become more expensive, and this may lead to people switching to American goods and services instead of buying foreign stuff. This, in turn, benefits American companies," I explained.

"This is complicated. But I think I have understood everything that you have said till now," she said.

"But that's just one part of the story. When exports for the US get attractive, exports for Switzerland become unattractive. This has been happening for the last one year, as the value of the Swiss Franc has risen against currencies like the US dollar as well as the Euro. This is primarily because the Swiss Franc is seen as a relatively safe currency vis a vis the US dollar as well as the Euro. So with demand for Swiss Francs going up, it has appreciated in value against other currencies. This has made Swiss exports uncompetitive. Now the Swiss Central Bank has decided to fix the value of the Swiss Franc against the Euro. It will ensure that one Euro is worth around 1.20 Swiss Francs so that Swiss exporters do not suffer any further."

"But how will they do that?"

"By not allowing the foreign exchange market to operate on its own. When foreign money comes into Switzerland, the Swiss Central Bank will ensure that there are enough Swiss Francs in the market, so that the demand for the Swiss Franc does not go up and hence ensure that the Swiss Franc does not appreciate against other currencies," I explained.

"But how will they do that?"

"By simply printing as many Swiss Francs as are required."

"Oh!"

"The other currency that has appreciated big time is the Japanese Yen and currently one US dollar is worth around 76-77 JPY (the symbol for Japanese Yen). This is a record for the JPY since the Second World War. Japan is a major export economy and with the JPY gaining value it makes exports unattractive like it has for the Swiss. As Yoshihiko Noda, the current prime minister of Japan, recently said, "I have become more concerned about the worsening of the yen's one-sided movements. I will take bold actions if necessary and won't rule out any possible options." In simple English it means he is ready to print money if the need be."

"So what you mean is that the US is printing money and that, in turn, is leading to other countries around the world printing money, just to ensure that they play catch up."

"Yeah, that is pretty much the case."

"But what's all this got to do with gold?" she asked.

"Well, as more and more paper currency gets printed, and dumped into the financial systems around the world, there is more the danger paper currency will lose its value. So people are queuing up to buy gold. Unlike paper money, gold cannot be created out of thin air."

"So gold prices continued to go up because of all this?" she asked. "Is that what you are suggesting?"

"Yes, that's why the price of gold had been going up. Gold has given positive returns in each of the last 10 years."

"So why is the price of gold falling now?"

"The immediate reason is no announcement of QE III by the US Federal Reserve, which the investors in the gold market had taken as a given and so kept buying gold."

"Yes, that you told me," she remarked.

"Also prices had gone up for so long that a correction was due. As Bill Bonner wrote in a recent column: 'Our faith was never seriously challenged... It's still ahead for the year...Gold is still a winner. Gold investors are still winners. There is no reason to doubt that they will be winners this year...just like they have been every year this century. But that's not how it works. Not usually. The gold market needs to make its admirers feel like losers. It needs to cause them to wonder...and question their own faith and judgment. How so? By letting the price fall to...$1,200...or even $1,000. Then, we will be ready for the third and final stage of this great bull market'."

"That's some statement," she said.

"You see, every bull market has its shares of falls like every bear market has its share of rallies," I said as the doorbell rang.

"Guess that explains it," she said. "But is it the end of the bull run on gold?"

"As Bonner puts it, 'Besides, gold has had a spectacular 11-year run. It's time for a rest for the metal...and a test for the metal lovers. That's just the way it works. Markets and lovers always test their admirers. Gold should be giving its fans a test...before moving in the final stage of the bull market'," I said. "Hope that makes sense?"

"Yes it does," she said, as the doorbell rang again.

"Good you don't have any more questions," I replied. "Let me open the door. Must be the delivery guy. And now that you have had your explanation, I will enjoy my bombil fry!"