Why the Fed-Fueled Gold Rush Won’t Last

Why the Fed-Fueled Gold Rush Won’t Last

Toru Hanai / Reuters

John Paulson must be seething.

The hedge fund billionaire opted to slash his exposure to gold during the second quarter, according to SEC filings, meaning that in the wake of the taper-that-wasn’t – the Federal Reserve’s decision to leave untouched its $85 billion monthly bond buying program – he has lost out on some very, very hefty gains.

The logic behind gold’s 4.1 percent rise on Wednesday and 4.6 percent jump on Thursday – the largest one-day gain since 2009 – is fairly straightforward. As long as the Federal Reserve keeps pumping money into the financial system via this form of quantitative easing, the thinking goes, there’s a greater risk of inflation, or at least a weaker dollar. Either might make gold a great investment.

If you’re skeptical about the odds of inflation taking hold in an economy so sluggish that Fed Chairman Ben Bernanke doesn’t want to risk drawing down support for the long-term fixed income market, there’s another argument to throw into the mix: the ultra-low interest rates made possible by the quantitative easing make gold, which doesn’t generate any kind of a yield and in fact costs money to own, a more appealing investment.

On top of that, there’s the uncertainty argument: At times when the political or economic outlook is unpredictable, gold is still seen as a safe haven. Look around. The Fed certainly has been sending some muddled signals with respect to its intentions; the economy can’t seem to decide whether it’s growing at a muted but sustainable way or on the verge of slowing down again; and as for Congress, well, the less said the better. Uncertainty seems to be an understatement.

Not enough reasons to own gold? There’s the granddaddy of them all to consider, a factor that had already helped propel gold higher in the days and weeks leading up the Fed’s announcement of its non-action. That is the possibility of the conflict in Syria broadening thanks to allegations that the Assad government used chemical weapons in its battle against rebel forces. The last-minute U.S.-Russia deal in which Syria agreed to destroy its existing chemical weapons may have averted a real crisis for now, but I, for one, wouldn’t be against a resurgence in geopolitical tensions for one reason or another between now and the end of the year.

That said, I wouldn’t bet on gold’s rally taking it back to record levels any time soon, either. And it’s hard to recommend chasing gold prices higher when a combination of short-covering and speculation in response to an unexpected turn of events is what’s caused the buying. But the odds are that unless Bernanke is drastically misreading the state of the U.S. economy, and that it is in a far more dire state than even he believes, gold prices may linger in their current range for a few months, and perhaps have a few more big leaps as the wrangling over the debt ceiling intensifies in Congress.

To be a long-term gold bull – or a dedicated gold bug, one of that breed that is convinced that the only possible answer to any investment question is, “buy gold!” – you’d need to feel certain that the economy is likely to slip back into a recession, that we’re on the verge of another financial crisis, or that the political and geopolitical crises will become more severe. That’s a minority position.

Of course, as this week’s speculation surrounding the Fed’s likely course of action shows, sometimes the minority view turns out to be the right one. But in this case, a lot would have to happen for gold to embark on another multi-year bull run, and the risk you’d be taking might outweigh your possible return. After all, Bernanke and his fellow policymakers didn’t rule out tapering; they simply postponed their decision until the data was more supportive.

Awaiting that day, gold is likely to prove a volatile investment. The move up in the 24 hours following the Fed’s announcement was dramatic, but that was, in part, because the news was so unexpected. Absent more high profile drama, look for gold prices to generally drift lower and spike higher only on specific headlines that will make investors feel like dashing for shelter.

Above all, you may want to steer clear of gold mining stocks. While the precious metal was glittering, many spent heavily to expand their output, only to find that, as prices turned south after peaking in 2011, they can’t earn enough from their production to cover their expenses. In the much longer term, this may represent an investment opportunity, to the extent that the decision by the likes of Rio Tinto (NYSE: RIO) to cut back on exploration activities today may lead to a supply shortage down the road. If that happens, it is likely to be years away.