The Shine Comes off the Gold Market

ANALYSIS

The shine has come off the gold market.

The price of gold logged its biggest one-day decline in more than 30 years Monday, tumbling $140.30, or nine percent, to $1,361. While gold has been gradually falling since hitting a peak of $1,900 in August 2011, the sell-off didn’t become spectacular until now.

Before Monday’s big sell-off, gold had climbed every year since 2001, as investors bought the metal both as protection against inflation and as a so-called safe haven. The precious metal peaked as lawmakers wrangled over raising the debt ceiling in the summer of 2011 and threatened to push the U.S. into default.

But a slowdown in inflation, combined with speculation that the Federal Reserve is considering winding down its stimulus program, prompted investors to sell Friday. Reports that Cyprus may sell some of its gold reserves to pay off its debts, following its bailout, also rattled the market. The selling then intensified Monday as speculators dumped their holdings.

Here’s why gold is falling and what the decline says about the economy:

Inflation Remains Low

Investors bought gold because they were afraid that inflation would rise too fast as a result of the Fed’s stimulus. The higher cost of goods would erode the purchasing power of dollars. So far, though, inflation is under control, even as the economy has improved. In fact, the value of the currency has risen. That makes gold a less attractive investment.

The Fear Factor

Investors also buy gold as a safe haven, a kind of financial insurance, when they are worried about the possibility of some kind of financial collapse. While there has been a lot to worry about over the last six years — the financial crisis, the threat of a U.S. default, meltdown in Europe — none of those events have led to financial Armageddon.

That fear factor has dissipated after central bankers around the world have bailed out one economy after the other.

“Gold is an insurance asset for when things go very wrong,” says Nicholas Brooks, head of research and investment strategy at ETF Securities. “It’s just that people don’t feel the need for insurance right now.”

Stocks Are Rising

Stocks have surged this year on optimism that the U.S. economy is poised to decisively pull out of its slump following the Great Recession. That’s pushed the Dow Jones Industrial Average and the Standard & Poor’s 500 index to record levels.

The Dow is up 11 percent this year. Before the big sell-off, gold was down almost seven percent.

“In this world of hot money — ‘what have you done for me lately’ — people have lost patience. Especially when the Dow started making new highs, they started thinking, ‘Why am I in gold? I’m missing all the action,'” says Peter Schiff, CEO of Euro Pacific Capital.

Interest Rates Could Rise

The Fed has started contemplating ratcheting back its economic stimulus. If the economy continues to improve, the Fed may even raise interest rates to keep the economy from overheating and pushing up the cost of goods too much.

Holding gold makes sense when interest rates are close to zero, as they are now. That’s because your money isn’t earning anything in your bank account. If your money is earning a return on deposit, the attraction of gold fades.