2 Potential Scenarios for a Spike in Gold Prices

Gold can work both as a fear and inflation trade.

Jan 8, 2014 at 10:27AM

Gold, often played through the SPDR Gold Trust ETF (NYSEMKT:GLD), has its ardent followers that tout the precious metal's qualities during times of inflation and/or fear. No matter which school you follow (I personally subscribe more to the fear side), there are still potential scenarios where gold could reverse course and move higher. Here are two, one inflation based and one fear based, that I see as the most likely.

Rising gold prices are often linked to inflation. Inflation has many roots, one of which being increases in the money supply. Therefore it's been puzzling to many why inflation remains subdued in spite of the Fed's liquidity injection plan. I believe the answer lies in a little-discussed metric known as the "velocity of money." That's economist speak for how fast a dollar is turned over from one party to the next. As economic uncertainty grows more people tend to save and spend less slowing the velocity. As times get better people feel better about spending, thus reducing saving and increasing consumption, resulting in increased velocity.

So why is this important? In short, economists believe increases in money supply and velocity have an impact on price and output (represented by Y) in and economy. This is represented by MV=PY.

The reduction in velocity could be offsetting the increases in money supply, thus keeping inflation subdued. Looking at graphical depictions lends credence to this theory.

St Louis Fed V Of M
Courtesy of: Federal Reserve Bank of St Louis

Confidence declined drastically in 2008/09 and fear inspired people to save and/or spend less, causing velocity to plummet to record levels from which they have yet to recover.

St Louis Fed M
Courtesy of: Federal Reserve Bank of St. Louis

Meanwhile, record amounts have been added to the money stock as of late, and this therefore begs the question: What happens when velocity inevitably returns to the economy?

When velocity does return inflation most likely won't be far behind. Two dependent factors are how accurately the Fed can unwind and how quickly the velocity is increasing.

The miners
Knowing what metrics to watch can give you the edge when buying into the beaten down gold miners, represented best through the Market Vectors Gold Miners ETF (NYSEMKT:GDX). I cited miners specifically due to the fact that a rise in gold prices would have a greater percentage increase in terms of the miners' profits than the same increase in the overall metal itself. See my recent article explaining this more in depth.

In my opinion, one of the greatest economic quotes of all time is when FDR famously stated, "The only thing we have to fear is fear itself." Confidence in an economy breeds stability and paves the way for success. However, a lack of confidence does the opposite. One effect of widespread fear is that the tacit value for money is questioned and hard currency is often favored. This of course benefits gold.

Recently the Volatility S&P 500 Index, otherwise know as the VIX, has been trading around 5-year lows, meaning confidence in the economy remains high. Other volatility indexes such as iPath S&P 500 VIX Short Term Futures (NYSEMKT:VXX) and the iPath S&P 500 VIX Mid Term Futures (NYSEMKT:VXZ) trading near 5-year lows are confirming this confidence. Numerous reasons have been given by bears as to why this condition should change. The scenario I see most likely causing this change is a downturn in the market, which triggers an initial wave of selling. Compounding that selling would be the record high amounts invested on margin. Margin calls would force even more sales, further exacerbating the problem, as we saw in 2008, which also saw record amounts on margin at that time. Once on this path we would be destined to continue until unsustainable levels of margin are removed from the system.

Foolish conclusion
Nobody can predict the future. But likely scenarios can be studied and plans made in case they materialize. These two scenarios are what I believe would be the most likely to impact the price of gold in the coming years. Therefore, if you are interested in trying to call a bottom in gold it would be beneficial to maintain a watch on both fear and the velocity of money.

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James Catlin has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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