How will recession of US economy affect gold prices?

For us, residents of virtual worlds, many problems beyond monitors pass as unnoticed. And even economical structural crisis didn't have any direct influence on the Internet life and online business. But it seems so just at first glance. Indeed, processes in economics have directly influenced virtual economy. And the first alarm for Internet users will be change in gold prices which always fluctuate during unstability and economical crisis. Gold matters should not be ignored as all e-finances are based on DGC-industry and depend on real cost of yellow metal ounce in dollars. Hereinafter we offer to your attention an interesting analysis of forecast on gold prices made by specialists of Casey Research.

From 1990s until today, Americans have maintained their life style by borrowing. As the American consumer is about to find out, the bill for that life style is coming due.

So to where will it lead the U.S. economy? Simply stated, surveying the landscape of current events, many of them are nothing else but direct consequences of excessive debt and inevitable slowdown in consumer spending, we expect stagflation. Loosely defined, this term refers to a general economic slowdown – a recession – but coupled with rising prices triggered by massive infusions of liquidity into the market.

That liquidity can be originated by governments: witness billions and billions thrown by leading central banks into the fray ; or it can come, let's say, as a certain percentage of over $6- trillion in assets possessed by  foreigners who are coming home to roost. On that latter point, almost every day we have heart news about wealth funds of foreign corporations and sovereigns  unloading their greenbacks in exchange of shares of some America’s largest financial institutions. Doug Casey has correctly pointed out when the trade deficit starts to shrink, exactly what has recently happened, than you need to look for cover... because, among other things, it means the tide of U.S. dollars is beginning to wash back up on U.S. shores.

To our mind the stagflationary scenario is more likely to be supported by a steady stream of data. For instance, despite an obvious slowdown in 2007 holiday season shopping, the Bureau of Labor Statistics reports that in November producers' prices increased  in the most rapid way in 16 years.

Rising prices turned stagflationary environment to be posive for gold, if for no other reason than that investors reallocate depreciating paper-backed investments into tangibles with a demonstrated ability to float as the intangibles sink.

So, we believe  we are heading for a stagflation. But what if we are wrong?

What happens if the global economic crisis gets so bad that it trumps any and all inflationary influences and we enter a straight-up deflationary recession?

That is, surely, a main question evoked in the minds of many gold investors.

Some quick thoughts...

Gold in a Recession

Traditionally, gold has been a safety net against inflation. Inflation is good for gold, a case we don’t need to make again here.

But, in a typical recession, the demand for everything slows and , as a result, the prices drop. The knee-jerk reaction of most casual market observers, therefore, might be that if inflation is always good for gold, then the opposite is always bad.

However, from the historical perspective it isn't always the rule.  The chart below shows the price of gold overlaid against official periods of recession as defined by the National Bureau of Economic Research. As you can see, about half of the time gold actually raised its value within recession periods.




Simply, there is no historical precedent that would prove gold wouldl fall during a recession.

But could we have a general deflation, the one that might tip gold into one of the down cycles? Of course.

The developing recession, based, as it is, on a global contraction in credit, seems to be especially long and deep. Practically every day  we witness multi-billion-dollar debt defaults that are, in turn, trigger both a freeze-up in easy credit and a flight from risk.

In response, the government came up  with its predictable "fix-it" tools – stimulus and bailouts. The tools of government stimulus are lowering the Fed funds interest rate, and potential new large-scale bailouts like the Resolution Trust Corporation (RTC) that was put into action to straighten out the Savings and Loan crisis of the 1980s, to the tune of $200 billion. While the Europeans have just unleashed $500 billion into new liquidity,  U.S. Treasury Secretary Paulson and Fed Chairman Bernanke  have been surprisingly slow to act. They started with denial and have moved to inadequate band-aids.

In the absence of any concentrated and well-funded program – such as the RTC – to try and keep the wheels on (and, at this point, it is not clear that any imaginable measure will suffice), the deflationary pressures of the housing collapse are winning.

But there is an important, longer-cycle pressure that is not frequently revealed, although it is obvious to any American consumer: the dollars they're spending are buying less. They see gasoline and facilities  prices to rise, but they don’t think much about the dollar itself as the underlying source of price inflation.

This decline in the purchasing power of the dollar is extremely important for the price of gold. That’s because the pressures on the dollar seem overwhelming when aggregated: huge budget and trade deficits, wars and retirement demands of baby boomers, unprecedented foreign holdings of U.S. dollars. Watching the prices of internationally traded goods, including oil at $90 per barrel and wheat at a record $10 per bushel, it is hard to imagine emerging situation of serious deflation.

Looking for Alternatives


The flight to quality expressed by investors unable to trust packages of mortgage loans, or to anything that is not backed up by government, is unprecedented. The interest rate on government-issued two-year Treasuries dropped to 3%, reflecting the increasing demand for safety. Concurrently, other interest rates have risen in response to enlarging mistrust and uncertainty.

Gold, of course, provides a different form of safe harbor alternative – an asset that is not only readily liquid but, unlike government paper, positively correlated with inflation that will erode the purchasing power of paper assets.

Right now, gold is not on the front burner, but this is only to be expected because of the state of flux of global financial markets. Like observers of a war of Titans, the market is confounded by the sheer magnitude of all that is going on, from the devastation being wreaked on the world’s best-known and most established financial institutions, to the unleashing of billions and billions in experimental new liquidity measures by central banks.

As the fog of war begins to clear and it becomes obvious that economic growth would be severely curbed, and fiat money is going to be sacrificed in the fight, a certain percentage of funds is locked on the sidelines – most of it  in U.S. Treasuries – it will later convert into gold and other tangibles. In the face of limited gold supplies, this surge in demand should create strong upward pressure on the price of gold and, for leverage, gold shares.

And in conclusion, even though the relatively sluggish and inept responses from the U.S. government in the face of the current credit crisis could produce a severely slowing economy, creating periods of deflationary fears that  would stress out the prices of gold, we continue to believe in massive inflationary bailouts  supporting a positive outlook for gold as the most probable scenario of "golden" case development .