Central banks to take bullion by the horns

The leap to record highs in the price of gold bullion has been fuelled by the fear factor stemming from unrest in parts of the Mena region.

But once calm is restored, the precious metal's battle with the world's central banks begins.

In the six weeks since tanks rolled into the centre of Cairo to quell protests that deposed Hosni Mubarak, the Egyptian president, gold has risen by almost 10 per cent to hit a record $1,436.40 an ounce on Wednesday as investors weigh up the likelihood of an oil price shock to the global economy.

Prior to the civil unrest in parts of the Mena region that propelled oil above $110 a barrel to 2-year peaks, there was a strong argument bubbling earlier this year that the global recovery was gaining traction and inflation was accelerating to warrant the developed world's central banks raising interest rates.

Now, investors are a lot less certain about the outcome of the protests, which have eclipsed the prospect of gold-denting rate rises.

"Essentially, moving into gold, or silver at this moment is more about a play that events in the Middle East are going to deteriorate rather than get better," said Nick Moore, an RBS global commodities strategist.

"Prior to this event, gold was already richly priced … but because every day seems to bring fresh horrors in Libya, one can't rule out that there won't be some maniacal event that drives gold higher," he said.

Investors often buy gold to protect their portfolios from the ravages of inflation. But when price pressures build enough to trigger a response from a central bank, gold can quickly switch from being a blessing to a non-yield bearing curse.

There is no doubt that record food prices and soaring energy costs are whittling away consumer purchasing power and investor returns, driving real interest rates - a benchmark rate minus inflation - deeper into negative territory.

The lower the rate of interest, the greater the support to gold, which bears no yield of its own and therefore gets sidelined for stocks, high-yielding currencies and bonds when rates rise and returns improve.

BlackRock, a major investor in gold and gold equities, said last month the key threat to the bullion market was "an increase in real interest rates. When these begin to rise, the opportunity cost of holding gold will encourage investors to sell the metal".

Real interest rates in the Group of Seven economies are now all negative except in Japan, compared with five nations this time last year, as inflation has picked up.

In the rest of the Group of 20 leading and emerging economies, which include Brazil, China, India and Russia, real interest rates are negative in six of the 13 nations, compared with five this time last year.

So the heat is on the central banks not to lag in the fight against inflation, particularly in the emerging world, home to the biggest gold buyers India and China - which has already raised rates three times since October.

"There is lots of capital in China, they've got the same fears that any other investor would have and with inflation picking up, by holding [yuan] you get negative real returns," said Daniel Brebner, a Deutsche Bank analyst.

"That doesn't make much sense and you have to look to hedge against that risk," he said. "This is something we've been seeing and it will continue."

Meanwhile, the gold/oil ratio - the number of barrels of oil needed to buy one ounce of gold - has fallen to its lowest since late 2008, the nadir of the global financial crisis, indicating oil's outperformance relative to that of gold.

But the effect of the turmoil in parts of the Mena region on both assets has made this particular market gauge less representative of investor risk appetite or confidence in global growth.

"Both are inflation indicators but they can also be safe-havens sometimes, so there is some credibility behind this ratio, but don't read too much into it," said Eugen Weinberg, a Commerzbank analyst. "On the consumption side, those two commodities are not competing with each other." Market-based inflation expectations have also picked up sharply from where they were six months ago.

The US Federal Reserve and the European Central Bank are widely expected to withdraw emergency cash measures put in place during the financial crisis, while many emerging economies such as China are tightening policy to combat inflation and "hot-money" inflows from yield-starved investors.

For now, even if gold loses its "peace dividend" from tensions subsiding in the Mena region, it is still a long way off buckling under the weight of the central banks collectively allowing for higher inflation and stronger growth.

After all, aside from gold, no other major asset class has rallied for 10 years in a row, defying global boom and bust, inflation, deflation, oversupply or shrinking consumer demand.

* Reuters