Gold bugs see no end to rise in price

Fears over inflation and another slump drove up the metal in 2010 but hedge funds are very exposed

'Gold – gold – gold! Oh, let it be gold!' So goes Miss Kilmansegg in Thomas Hood's comic tale about her demand for a prosthetic leg made of gold, one that is "all sterling metal, not half-and-half". Those words would not seem out of place in London's dealing rooms where traders have been piling into the yellow metal, driving prices to record after record over the past 12 months.

The rush, which began with punters fearing the collapse of the banking system in 2008, has driven the price to about $1,380 an ounce from about $1,100 at the beginning of the year. Along the way, gold breached $1,400 in November and briefly vaulted to about $1,430 at the beginning of this month. You can almost hear the chant – gold, gold, gold – rising from the trading floors.

The spike is down to a confluence of factors that have led to what the billionaire investor George Soros recently characterised as "pretty perfect" conditions for rising prices.

Among the most cited is the combination of low interest rates and central bank moves to boost liquidity in the major Western economies, particularly the US. Slashed to stimulate flagging economies two years ago, the cost of borrowing remains at record lows. At the same time, policymakers here, on the Continent and across the Atlantic have poured billions of dollars in new funds into their economies. Last month, the US Federal Reserve unveiled plans for an additional $600bn (£390bn) of quantitative easing.

"The liquidity pumped out by central banks means that there is a lot of money sloshing around that needs to find a home," Citigroup's analyst David Thurtell says. Some of that money, he explained, is spilling into gold. "And [as] interest rates remain very, very low and are probably not likely to rise for some time... so the opportunity cost of investing in gold is very low."

Low rates mean investors are loath to hold poorly performing cash. Gold, on the other hand, offers the prospect of a healthy upside.

This expectation is based partly on fears that the excess liquidity will stoke inflation, and thus undermine the value of currencies, and partly on concerns that the economic recovery taking root in the US and across Europe may come to nothing if the world has to deal with shocks such as an escalation in the Continent's sovereign debt woes. There is also the worry of a slowdown in China.

The first fear, that of higher inflation, is apparent in movements on the bond markets, where the break-even rate for US government bonds has been climbing higher. The rate is the difference between yields on cash bonds and inflation-linked bonds over the same period, and is an indicator of inflation expectations. Earlier this month, the rate was at its highest since May.

The second set of fears – of sluggish growth and sovereign debt contagion in Europe – have been driving what is often referred to as safe-haven demand. Investors worried about the threat of a second worldwide slump have been buying into gold to hedge their bets, a trend that really came to the fore in 2009, when investment demand outpaced jewellery demand for the first time in 30 years. Cash is not attractive. Equities are likely to slump if growth stalls, economies decline and company profits take a hit. These worries aid interest in the yellow metal.

"Gold has performed its true function as the ultimate store of value in the turbulent economic seas of 2010," Peter Hambro, the chairman of Russian gold miner Petropavlovsk, said. "With the continuing uncertainties in the world's economic weather patterns, gold remains my lodestone for 2011."

He is not alone. A recent PricewaterhouseCoopers survey of gold miners revealed that a big majority – more than 70 per cent – expect prices to continue rising in 2011. The outlook is also supported by the fact that real prices remain well below the peak struck 30 years ago.

Adjusted for inflation, prices touched a high of about $2,423.8, according to figures from the World Gold Council. That leaves a lot of headroom to excite gold bugs. The PwC survey, for example, showed that miners were expecting prices of between $1,400 and $3,000 in 2011. Some 40 per cent are forecasting a high of $1,500, driven largely by the US quantitative easing programme.

Like any investment, however, these forecasts carry risks, particularly in light of the growing consensus regarding gold. Conditions may well be "pretty perfect", but as Mr Soros noted last month, "the big negative is that too many people know this and a lot hedge funds are very exposed... Gold has a tendency to go parabolic."

Silver lining

Gold may be hogging the headlines, but silver is shining, too. Earlier this year, the white metal touched the $30 per ounce mark – its highest level, in nominal terms, in 30 years.

Prices began the year at about $17 an ounce and fell to $15 in February before embarking on an almost uninterrupted upward march. The spike to $30 was, in part, down to the same factors that have been driving gold, namely increased investment demand against the backdrop of what remains an uncertain economic backdrop and growing fears of higher inflation.

But other, silver-specific trends have underpinned the rise. Unlike gold, silver is widely used in the manufacturing sector, so much so that though better known as a precious metal, it is also classed as an industrial commodity.

The past 12 months has seen a pick-up in industrial activity as the global manufacturing sector, battered and bruised during the recession, began to recover. And that in turn has pumped up demand for silver, aiding prices, which, despite easing since the recent peak, remain within striking distance of the $30 mark.

An excellent conductor of electricity, silver is used to produce batteries, while the anti-bacterial properties of silver ions are often employed to make water purifiers. It is used in coating mirrors and windows, and in the production of photovoltaic cells, the most common type of solar cells. At the other end of the spectrum, silver-coated ball bearings are stronger than the simple steel variety and can be found in jet engines.

The unrelenting strength in gold prices, some suggest, has driven consumers to buy silver instead.