Wednesday, June 21, 2006

The 1970s gold bull market 0 comments

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Among all metals gold retains a mystical quality, with centuries of its symbolic value behind the common perception of it being the ultimate currency. This perception means that the metal retains its real value well; one would expect its price to be relatively stable. However, in times of crisis and inflation when there is a flight to quality, gold's qualities as the ultimate inflation and currency hedge (inversely correlated to the US dollar) plus its safe haven characteristics come to the fore.

The pressure for a revaluation of gold had been building up throughout the first few decades of the twentieth century. For a long time global paper currencies operated on the gold standard, meaning that they were backed by gold reserves; paper currency was fully convertible to an equivalent amount of gold at the appropriate rate, which meant the gold price was fixed. Up till 1944 it was fixed at US$20 per ounce, then under the Bretton Woods agreement it was revalued to US$35/ounce. But as gold demand continued to rise and its gold reserves dropped due to its rising trade deficit, the US faced increasing pressure to revalue its currency downwards (in terms of gold) by the end of the 1960s. In the end, President Nixon closed the "Gold Window" in 1971, ending the dollar-gold convertibility, and leading inevitably to "floating" of the world's currencies (because there was no longer an intermediary -- gold --- to which currencies' values could be fixed, hence they could trade against each other freely to find their true value). Given that the price of gold had been artifically held back via agreements before this move, it was like the opening of a dam to release the water behind. By the end of 1974, Gold had soared from US$35 to US$195 an ounce.

The mid-to-late 1970s was of course, the stagflation years where annual inflation rates were as high as 15%, partly due to cost-push inflation caused by the rise of the OPEC cartel. The last commodities bull before the current one was during then; commodities are the best inflation hedge, and chief among them was gold, partly because of nervousness about a possible collapse of the global financial system (still adjusting to floating rates) causing a flight to safety. Despite attempts to keep gold prices down by sales of gold from the US Treasury, and aided by a drop in the US dollar's exchange rate against its main trading partners, the price of gold doubled to US$400 in the space of one year in 1979, then doubled again to US$850 by early 1980.

Anyone vested in gold in the early 1970s would have seen his investment rise >2000% within the space of a decade. Hindsight, of course, is 20/20, but while the super-inflation in the late 1970s could not have been foretold, the reformation of the dollar-gold convertibility regime in 1971 would have suggested a strong catalyst to buy into gold for the astute investor. Without an artificial peg to gold prices (to the US dollar), and given the difficulties faced by the US Treasury in maintaining the regime prior to Nixon's repudiation of the long-held policy, the demand-supply dynamics that were released into play drove gold prices inexorably upward.

As it was, 1980-81 marked the high point of gold prices for the next 2-3 decades. Gold and commodities went into a long swoon as the world went into a golden period of low inflation and high growth. As money flowed back towards equities, gold prices fluctuated between US$250-400 (rarely above). That is, until 2006, when it recently touched US$700/ounce before retracing amidst the global commodities correction.

(1) The Privateer Gold Pages
(2) Wikipedia entry: Gold




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