Fundamental Forecast for Gold: Bearish

Gold prices finished the last trading day of 2010 perched just below their record high at $1431.25, completing the tenth consecutive year of gains. Looking ahead however, the metal will face formidable headwinds as the bulls attempt to continue the advance.

The price of gold has seemingly decoupled from the risk-on/risk-off dichotomy that has ruled financial markets in the aftermath of the 2008 global meltdown, proving attractive for bulls and bears alike. While the former sought protection from inflation as the global recovery gained momentum, the latter feared paper assets would enter freefall once again, making the yellow metal broadly appealing as an alternative store of value. However, as we’ve discussed elsewhere in detail, runaway price growth looks decidedly unlikely while recent economic data suggests the US economy – the world’s largest – is finally starting to pick up momentum, making another crisis of the magnitude witnessed three years ago unlikely (though growth will probably prove far from robust).

With that said, markets trade on expectations about the future rather than the reality witnessed in the present, so what will it take to finally undo the perception that a hedge against extreme outcomes is necessary? A global rise in borrowing costs seems the likely answer. The world’s governments are awash in debt having splurged on stimulus to ward off the global credit crunch and subsequent recession. As with individuals, governments that owe more must pay higher interest rates on future borrowing as a reflection of the added risk they pose to would-be lenders. We have already seen a dramatic run-up in European bond yields, and more of the same on a wider scale is likely on tap for some time yet. The slow recovery in economic activity encourages this process: as growth picks up, firms put capital to work toward expansion, reducing the supply of loanable funds and pressuring interest rates higher. For its part, gold pays no interest, making it increasingly unattractive to investors as yields rise elsewhere. While bubbles often defy the skeptics’ admonitions, continuing to inflate long after the fundamentals point toward a reversal and making the picking of a top a dangerous endeavor, the landscape seems fertile to produce a formidable snap-back in gold prices in 2011.