Here's the real reason why gold prices are soaring

It’s hard to find a group of investors more passionate about their trade than diehard ‘gold bugs’. They absolutely love their investment and have any number of fanciful Armageddon theories to account for why gold prices will keep going up.

Equally, the gold bugs are vociferous in silencing the dissenters: anyone who has a contrarian opinion about gold or suggests that gold prices are in bubble territory gets hectored and shouted down, with the choicest epithets being hurled at them.

The fact that gold prices have rocketed in recent months and years may appear to validate the gold bugs’ claims and hypotheses. But in fact, while gold bugs have been right about the surge in gold prices, they’ve been completely wrong about the reasons for gold’s golden run.

For instance, in just the past three years, when gold prices have shot up exponentially, gold bugs have come up many alarmist theories to explain the price appreciation and to reason that the trend will continue even going forward.

They have, for instance, argued that the “endless money printing” in the US will trigger hyperinflation , leading to complete and utter loss of faith in the US dollar. That loss of faith in the dollar is, in their estimation, will ensure that gold prices will keep going up, since, they claim, gold is the only hedge against inflation.

No less an investor than Marc Faber had warned dramatically that US inflation would reach the levels seen only in Zimbabwe.

“I am 100 percent sure that the U.S. will go into hyperinflation,” Faber said. “The problem with government debt growing so much is that when the time will come and the Fed should increase interest rates, they will be very reluctant to do so and so inflation will start to accelerate.”

Prices in the US, he warned, would rise at “close to” those seen in Zimbabwe - where the rate of price growth in July 2009 reached an astounding 231 million percent.

Jim Rogers too has been warning that “hyperinflation will consume the US”. He too is a bullion bull, whose call on commodities thus far has proved right on the money.

Other gold bulls have similarly exaggerated the theories about the coming collapse of the dollar to talk up their gold portfolio.

But in fact, the US today, although in rotten economic shape, is struggling with deflation, not inflation.

As Cullen Roach points out on his blog Pragmatic Capitalism, while there did exist a correlation between inflation in the US and gold prices, that relationship has been broken in recent years. Gold prices and inflation trends in the US are actually divergent - going in opposite directions.

Nomura Securities analyst Anthony Morris and Swati Aggarwal too reason that US inflation is not relevant to most gold buyers.

So, if it isn’t inflation that’s driving up gold prices, what is?

Standard Chartered’s head of metals research Dan Smith reasons that in fact, to understand why gold prices have shot up thus, we must look at what’s happening in China and India.

China and India today account for more than 50 percent of global demand, and charting rising incomes and gold prices (at left), he sees a strong relationship between the two. That is, gold prices have pretty much appreciated in line with rising incomes in China and India. Over the past 10 years, from 2000 onwards, the two lines are virtually marching in step.

“China and India are helping to drive a gold supercycle,” says Smith. And although in his estimation it’s risky to make projections about the future, he sees gold prices reaching up to more than $4,800 by 2020 in a “superbull scenario”

Morris and Aggarwal reckon that that if you expect nominal incomes in China and India to rise, that’s reason enough to buy gold.

“Gold is a beneficiary of the rising nominal incomes of the private sector in India and China. If one believes that rising nominal incomes (and low/negative real rates) are here to stay in these countries, then gold can be a way to participate in this growth.”

But what about the risks of a slowdown in Asia? Would that be bearish for gold? Perhaps, but analysts don’t expect to see a slowdown so sharp that it impacts trendlines in nominal income growth.

“If Chinese or Indian monetary authorities were to impose high real interest rates to tame inflation, this would be negative for gold demand volumes. But such substantial tightening is difficult to imagine, particularly from non-independent central banks,” reason Morris and Aggarwal. Then again, while such tightening would hurt demand in the two countries, it would also trigger an appreciation of the Indian rupee and the Chinese yuan (against the US dollar), which would still push up gold prices in US dollar terms.

In other words, gold prices will still go up, but not for the alarmist reasons that bullion bulls and dollar bears cite. The reasons for gold’s continued rise may lie closer to home - in India and China.