Gold Basics

In The picture A Roman gold bar from the 4th century is shown at the Bank of England museum in London. Gold, a scarce metal that has incited wars, expeditions and conquests throughout history,

Nothing buffs gold better than a thick coat of fear. Gold futures soared to record levels last March and investors have shown renewed interest in investing in the commodity that has typically been used as a bulwark against inflation and other currency risks.

"Gold is a very effective hedge against uncertainty because even as investors are watching the value of their equity investments plummet, gold still has value. In that way, gold can help diversify away some of the risks in an investor's portfolio," said Tom Pawlicki, a precious metals and energy analyst at MF Global.

Gold, a scarce metal that has incited wars, expeditions and conquests throughout history, has retained its value and investment appeal largely because of the gold standard, which dictated that all paper money would be backed by gold reserves. Even though U.S. President Richard Nixon quashed the U.S. dollar's direct convertibility to gold in 1971, the precious metal only gained popularity as a safe-haven investment since the double-digit level of inflation that plagued the economy during the period undermined the value of the U.S. dollar. In January 1980, gold hit US$850 -- its long-standing record until the current financial crisis led investors to run the price up to US$1033.90.

Inflationary threats have been supporting strong gold prices as investors become increasingly wary of the Fed's plans of pouring money into the financial system in hopes of rebuilding asset values and evading deflation.

The risk, of course, is that anti-deflationary actions will go too far, resulting in high levels of inflation or even hyperinflation.

The U.S. Federal Reserve has been buying assets including government bonds to lower interest rates and ease the de-leveraging process. In order to mitigate remaining debt that's clogging balance sheets, the Fed has the ability to increase the money supply until eventually enough inflation is created to absorb outstanding debt.

"However, it is not clear, with a failed banking system incapable of transmitting the Fed's 'high-powered money' into new loans, how well or quickly such a 'reflation' policy would work," said UBS analyst Daniel Brebner. In such an instance, Brebner expects gold to track inflation since it isn't tied to currencies.

Dr. John Mathis, a professor of global banking and finance at Thunderbird School of Global Management acknowledged that hyperinflation is a threat given the massive dollar value of bailout actions. He said the challenge for central banks will be determining the right rate at removing excess liquidity from the system.

Hyperinflation concerns are shared by Axel Merk, president and founder of Merk Investments. He remains very concerned that recent policy actions will spur high inflation that the government won't be able to tame.

"The amount of the stimulus is going to be much more than people predict. I don't think the government has an exit strategy and there's been way too little effort to look ahead. They're trying everything just to prop up a broken system," Merk said, adding that in the hard currency fund he manages, they have a 14.4% allocation to gold, which is higher than usual.

With gold acting as an effective hedge against uncertainty, deflation, and inflation, why bother investing in anything else?

A big downfall to investing in gold is that the precious metal doesn't offer the same return potential that equities do --particularly in a recovery environment as the current market is eagerly awaiting.

"When the economy begins growing and if the Fed shows that it's on top of the inflation curve, then there's no reason to invest in gold because equity markets will offer much better returns," said Pawlicki. The Fed has been selling government-backed bonds to help swallow excess liquidity. If economic stimulus measures successfully return confidence to the market and banks loosen their grip on lending, the stock market is likely to heat up, leaving gold in the cold.

Current gold prices seem to suggest that government actions are having their intended effect.

"As fiscal and monetary stimuli kick in, the slowdown in the global economy is easing," said Francisco Blanch, a commodity strategist at Banc of America Securities-Merrill Lynch Research, in a recent note. "Risk perceptions are clearly on decline with the VIX having fallen 33.0% from levels above 50.0% just a couple of months ago. Equities have risen for six successive weeks, with the S&P 500 up more than 28.0% from its low in March." Blanch also noted that as a result, gold prices are showing less volatility.

According to Pawlicki's estimates, gold prices will hold in the mid-US$950 to US$1000 range in the near-term. Once the economy begins showing signs of recovery and investors' risk appetite improves, however, he sees prices dipping to between US$750 and US$800.