A range of factors affect gold prices and the impact of each is not always uniform. Primarily, these include the strength of the dollar against a basket of major currencies, interest rates in developed economies, inflation, global security and financial stability. Depending on market perception at the time, one factor may be more dominant than the others.
All these factors are inextricably linked, for example, low interest rates can trigger inflation which could weaken the currency and push up gold prices. This time around, there is no contest; the dominant factor is financial stability of the world's reserve currency.
The Bill to raise the US debt ceiling temporarily might have been cleared on Thursday, but it only gives momentary relief because it will fund the US government only till January 2014. Gold prices are already sensitive to this and are straining at the leash.
A default will lead to a US ratings downgrade and money will rush towards the safest asset the world has offered over thousands of years - gold. In 2011, when the US credit rating was downgraded, gold had shot up by about $80 per 10g in a matter of weeks, and if history repeats itself, it could mean a potential up move of almost Rs 5,000 per 10g. Gold also rose to its record high in 2011, immediately after the debt ceiling was raised. A Chinese credit rating agency has already cut US credit rating.
The delayed US economic data announcements will particularly impact gold prices as they will show up the effect of this crisis on the economy and the likelihood of it affecting the stimulus programme is a clear and likely outcome. Both these factors also point towards strengthening of gold prices.
The debt limit in the US has moved from $12.4 trillion in 2010 to almost $17 trillion now and every year of deficit adds to its total debt. The US also currently borrows about 40 per cent of its annual spend. By some accounts, US debt could rise by $1 trillion every year if no spending cuts are made. This maths puts medium-term pressure on the dollar that supports gold prices.
This is not a doomsday scenario but a typical situation to buy gold in, if financial security is your driving force. The US economy, struggling to move up, would have already lost billions of dollars due to the two-week shutdown. Though gold prices in dollars are significantly down this year, the devaluation of the rupee has made gold expensive in India. Increased demand globally due to this crisis and festival demands in India and China make gold a must-have in your portfolio today.
So, what's the price target? Well, it's always hard to put a number on it, but my view is that this is one of those special situations which warrant that investors look to be a little overweight in gold in the near term. If push comes to shove, we are looking at gold at a record high in rupee terms. If the US is unexpectedly able to tide over this smoothly, then you can always depend on a falling rupee to shore-up prices.
But do take your financial advisor's view on the latest developments before making any investment.
The author is president, retail distribution, Religare Securities
