How to Explain the Current Gold Rush

After a sharp rise in the first quarter of 2011, gold prices in the second quarter reached a new record in excess of $1,670 an ounce, driven by worsening fears about EU sovereign debt and the prospect of a Quantitative Easing III (QE3) plan in the United States.

The cash injection which has been part of rescue plans in the EU and US can explain most of the recent rise in gold prices. In addition, a return to responsible fiscal policies may limit the tendency of investors to seek safe havens such as gold investments that offer an alternative to cash.

In Europe, as long as the EU efforts do not confront the long-term fiscal balance issues in countries such as Greece, Portugal and Ireland in order to postpone the prospect of a default, the market will continue to worry about sovereign risk and the threat of contagion to Spain and Italy will remain.

In the United States, the debate on the debt ceiling highlighted the wide gulf between the Republicans’ and Democrats’ political goals. As in Europe, painful truths must be accepted before remedies can be adopted by political institutions to confront years of overspending. Until now, the American political system seems firmly established in the denial of painful truths about deficit reduction. Thus, any delay in reducing the deficit, especially if accompanied by a third quantitative easing plan, will be considered a vote for further public spending – which will only further increase the deficit – and lead to high demand for precious metals in the short term.

Ultimately, we believe that common sense will prevail, both in Europe and the United States, which will lead to a long-term bearish view on gold. But, in the short term, precious metals could rise further if governments prefer cash injections to fiscal balance over time.

Governments must choose between overspending which will increase the demand for precious metals and fiscal balance.

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