Gold Takes Center Stage

Stocks aren't the only assets on the rise these days. The metals -- yes, as in gold and silver -- have also been strutting their stuff, with the Philadelphia Gold & Silver Index (AMEX: XAU  ) up nearly 2.6% today and 24.8% year to date.

Today's rally in the metals has been led by gold, which topped $383/oz., marking a seven-year high. The world's largest gold miner, Newmont Mining (NYSE: NEM  ) , also reached a new multi-year high, surpassing $40 for the first time since early 1997. Bloomberg noted today that speculative gold holdings for the week ended September 2 reached 122,847 contracts, the highest number of contracts since February 1983.

What's driving this massive flow of capital to the metals?

In short, a weakening U.S. dollar. Today, the dollar is down vs. all 16 major currencies tracked by Bloomberg. And so far this year, the dollar has fallen 6.2% vs. the euro and 2% against the yen. The dynamics of the dollar's value are quite complex, but suffice it to say the dollar's downward trend appears likely to continue as our currency faces pressure from the "twin deficits" -- the federal budget deficit and the current account trade deficit.

As the dollar declines in value, the metals' value rises -- just like other non-dollar currencies. (For all practical purposes, gold and silver are alternative currencies to the dollar.) As a currency, the metals are unique in that their supplies are relatively fixed, with only limited additional supply each year from mining production. In contrast, the supply of dollars is rapidly expanding as the Federal Reserve attempts to stave off deflationary pressures by pumping up the money supply.

In sum, as the Fed increases the supply of dollars, their value declines vis-à-vis other currencies, including the metals. For an excellent and much more in-depth explanation of the factors behind gold's rise in value, see John Mauldin's excellent essay from more than one year ago explaining why he saw gold as an undervalued asset (free registration required).

At time of publication, Matt Richey was long Newmont Mining.


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