$1,200 beckons for gold as oil hits $128

Posted on 19 May 2008 with no comments from readers

Spot the correlation? Well it is not a perfect match but oil and gold tend to track each other with around a 90 per cent correlation depending on your formulae. And the rule of thumb is that the oil price is gold less one zero.

On this simple analysis then with oil at current prices gold should be above $1,200 and not hovering at $900. Perhaps this gap will be closed over the next couple of months, and the seasonal low point for gold has already past at $850 an ounce.

Not that gold paused long at $850. Those automated hedge fund trades kicked in and sent the yellow metal bouncing back from its sell-off. Gold reached an all-time high of $1,030 on March 17th and then got caught by a rebound in the US dollar to which gold has an inverse relationship.

As I write the US dollar is weakening again. It is hard to see how the greenback can sustain a rally in an environment where the Fed is creating billions and billions of dollars to counter the impact of the US housing crash and financial crisis on the US economy.

For the unavoidable side-effect of the Fed’s medicine is higher inflation, and once the inflation genie gets out of the box all hell can break loose. It happened in the 1970s, again in response to a stock market crash followed by a house price crash, and did not end before oil and gold spiked up to new all-time highs.

History does not always repeat itself exactly but the same policy moves do tend to produce the same effects. Nero devalued the currency in ancient Rome and inflation resulted, and the price of gold went up. Gold is of course also money, and its purchasing power has remained remarkably consistent over the millennia. That is why central banks still hold it in their vaults.

Therefore in the current environment of an inflating money supply – at least for dollars, the European Central Bank has an anti-inflation bias – the US dollar looks doomed to further weakness. Indeed, the only way to have a proper dollar rally would be for the bond market to collapse or equities to sell-off big time.

That might take the shine off gold prices for a while. But the only practical policy response would be a further reduction in US interest rates, which would weaken the dollar again.

However, over the next few months gold is likely to retrace towards the psychologically important $1,000 and make another attempt to cross that line. Veteran gold trader thinks it might take two more attempts to finally put $1,000 into history, and then $1,200 is calling to catch up with the oil price.

Silver bugs might score even better as silver is a leveraged play on gold and has outperformed significantly in past financial crises. Silver is a little above $17 at the moment of writing.

But Jason Hommel’s Silver Stock Report notes that you need to allow for inflation to compare today’s price with the previous all-time high of 1980s. He shows silver peaked at $128 per ounce in 1980 as measured in 2008 CPI adjusted dollars but that does not allow fully for money supply growth.

A chart from SGS shows that silver peaked at $365 an ounce in 1980, as measured in 2008 SGS adjusted dollars. This does suggest that silver should have far greater upside potential in the future and is far from being ‘poor man’s gold’.

As a last thought perhaps we should heed commentators like Alan Greenspan or even the Fed’s great Ben Bernanke himself when they say that the current financial crisis is half-done.

That means there is a second half to come, and if past crises are any guide that ought to include a bond market crash (due to rising inflation which makes bonds very unattractive) and a stock market crash (why is the stock market so high when the economy is looking so bad?)

Indeed, the best is yet to come for precious metal prices as one by one alternative investment classes fall into disrepute and investors are herded into gold and silver. Eventually that crowd will become a bubble but at $3,000-$5,000 an ounce for gold and $365 for silver?