Why gold won't stay down

Fundamentally, there couldn't be a better time to own precious metals, but technically, precious metals have taken a beating. Given that currencies are still being diluted, the core bullish argument for metals still remains. When the world is being flooded with cheap money, the prices of tangible assets will eventually increase.

By Anthony Mirhaydari
5/15/2013 5:45 PM ET
MSN Money

Something curious is happening in the precious metals market.

Fundamentally, there couldn't be a better time to own gold and silver. But technically, the shiny stuff has just been hammered, inexplicably suffering a 1987-style plunge last month. Did a hedge fund blow up? Are policymakers pushing on prices to keep inflation expectations down? Are computer trading algorithms causing problems? We just don't know.

Now the question for investors is: Has the best buying opportunity we've seen in decades arrived even as most of the market focuses solely on stocks, or is gold a lost cause?

In fact, if the crash continues, gold's role as an important market signal points to two economic possibilities that would take many people by surprise.

Here's where I see gold headed and why.

The basics favor gold

The core bullish argument in favor of nibbling on gold and silver at today's low prices lies in their value as an alternative store of purchasing power, given that currencies are being diluted at an unprecedented rate, financial markets are frothy and real-estate and farmland prices aren't exactly at rock-bottom levels.

The four largest central banks are abusing their currencies as fast as they can, with Japan going for broke with the "cheap money will save us" meme while the European Central Bank cut rates earlier this month for the first time since the middle of 2012. And in just the past month, smaller central banks have begun joining in with gusto. Australia cut rates to record lows. Denmark cut rates. India cut. Turkey cut. South Korea cut. Israel cut. Kenya, Belarus, Poland, Georgia and Sri Lanka also cut.

When the world is being flooded with cheap money, Economics 101 tells you the prices of all tangible assets -- including gold and silver -- will eventually increase. And that's why this could be a great buying opportunity.

But where's the inflation?

To understand why gold and silver are down, we need to understand why they went up.

Fear of inflation was the primary driver of the rush into precious metals back in 2011 that pushed gold prices skyward toward $2,000 an ounce, compared with $1,425 now. But this fear hasn't mattered much lately because inflation hasn't been a problem.

Thanks to some recent strength in the U.S. dollar and a deteriorating economic outlook, deflationary pressures have been more acute. The annual inflation rate as measured by the Consumer Price Index fell below 2% in early 2012, and it has pretty much stayed there since.

Central bankers are using this to justify their increasingly aggressive (I'd say desperate) cheap-money policies.

I think it's a sign that cheap money is losing its effectiveness. But they think it's a sign that they aren't trying hard enough -- despite the rising risks of negative consequences, including pushing older investors into inappropriately risky investments, creating asset price bubbles (just look at junk bond yields dipping below 5% for the first time), encouraging Washington, D.C., to continue its spendthrift ways and possibly -- as suggested by Stanford economist John Taylor -- holding back the recovery by interfering with the availability of credit.

While the prices of energy and food are relatively benign right now (except for natural gas, which is creeping higher), the two deeper structural drivers of inflation -- wages and housing costs -- are starting to edge higher. Wages are set to rise in response to falling labor productivity, increasing numbers of job openings and declines in the quality of applicants. And the housing recovery, which so far is being driven by investors looking to be landlords, will add further upward pressure to measures of housing costs. Rents are already rising, as the chart below shows.

CPI index

Add it all up and inflation has to be the result. That's bad for everyone in a lot of ways, but it's good for gold.

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