As per usual, the Federal Reserve killed my buzz by leaving interest rates unchanged. I lost a $0.25 bet to my colleague Moe Zulfiqar who correctly predicted the Fed would hold steady, but the real loser is our so-called economic recovery. My only consolation is that investors will flock to safe haven assets and that means a resurgence in gold prices.
Gold has had a depressing few years, starting in 2011 when prices peaked near $1,900 an ounce. The yellow metal now hovers around $1,131—a dramatic fall with only one explanation. There is a distortion in the market keeping gold subdued.
Before I get to why gold prices are deflated, it’s important to understand the relationship between gold and capital markets.
Gold: The Ultimate Economic Hedge
For centuries, gold was synonymous with money. The first gold coin was minted in Florence sometime around 1250 A.D. Florins, as the coins were called, was acceptable currency across all of Europe. (Source: The Telegraph, October 20, 2014.)
Hard currencies provide more durability than paper money, guarding their value from wear and tear, fire, and water damage. Yet the practical difficulty of producing and transporting gold eventually led to the creation of paper money.
Originally, the paper was simply a promissory note that could be exchanged for gold. But as time wore on, the relationship between gold and money began to fracture.
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Economic theory matured and told us the money supply should be free to fluctuate without constraint. Gold was officially decoupled from the American dollar in October of 1976, when prices were still under $45.00 an ounce.
Hence, the fiat money system was born. Some argue it was mistake, but I am not among them. Central banks are necessary for the safe and responsible governing of a nation. An inherent feature of capitalism is the business cycle, and central banks help smooth the journey from peak to trough.
However, it’s possible to have too much of a good thing. The Federal Reserve continues to resist a normalization of interest rates, forcing them to stay near zero. They’re doing extraordinary damage to the economy by refusing to rip the band-aid off, but at least that bodes well for gold.
Why Gold is Set for Huge Gains
On Thursday September 17th, markets were eagerly awaiting a rate hike from the Federal Reserve. Over the last eight months, policymakers dropped not-so-subtle hints that the central bank would raise interest rates after their September meeting.
Bringing interest rates back to normal was supposed to be a sign that the economy was nearly recovered and could stand on its own two feet. By not raising rates, the Fed sent a clear signal to markets: despite seven years of stimulus we still aren’t ready for a normal investing climate.
What does this have to do with gold? I’ll tell you.
When the United States finally weaned the U.S. dollar off the gold standard, gold prices shot through the roof. Take a look:
Chart courtesy of www.StockCharts.com
It’s at this point in our story that gold became a hedge against economic calamity. If the U.S. dollar collapsed, or we had a sudden stock market crash, investors could count on gold to retain its value.
In the span of a lifetime, gold went from providing a foundation for the U.S. dollar to being a bet against the U.S. dollar. And considering that America’s central bank is bearish on the country’s economic health, now seems like a very good time to take that bet.