The gold put option

The European Central Bank (ECB) extended the cap on gold sales, only this time limiting sales to 400 metric tons, instead of the current limit of 500 tons.

http://www.bloomberg.com/apps/news?pid=20601068&sid=a5S1sSNJDGvc

This is bullish for the price of gold, as central banks cannot indiscriminately dump gold into the market, causing the price of gold to sink. By my own deduction, the first 5-year cap instituted 10 years ago catalyzed the impressive run up in the price of gold. In that time span, gold has almost quadrupled in price, while equities have languished in negative territory. Reality is setting in--central bankers can print currencies ad nauseum in an effort to stimulate their domestic economies, but they cannot print gold. Gold has to be mined, and it is only being added to existing world supplies by 0.5% per year. By contrast, central bankers are increasing the money supply by double digits.

This is a direct consequence of easy money policies enacted by central banks worldwide, including the Federal Reserve. With money supply increases come price inflation of real assets--including precious metals.

Using back-of-the-envelope calculations, we can establish a floor for the price of gold. Last year's panic selling of all liquid assets to honor hedge fund redemptions depressed pricing of all asset classes--including gold and gold ETF's, which are liquid. The 2008 bottom was $660/ounce. Factor in a 20% reduction in potential gold sales from ECB sales, and we arrive at an adjusted bottom of $825. Thus, that is an effective put option for the price of gold.

Should we experience another liquidity crisis when stock markets tank, and commodity prices also plummet, if the price of gold approaches $825 (gold currently hovers at $960), I would accumulate more gold-related assets. Gold is a prudent hedge against monetary inflation with no counter-party risk, as it has been accepted as a monetary store of value for centuries.

I don't believe gold will correct to that level--if anything, it will elevate its price, as the threat of selling pressure has largely been removed.

Another bullish indicator for gold is the increased interest in gold purchases by Chinese and Russian sovereign funds, as they diversify away from USDollar-denominated securities, mainly Treasuries. Monetary inflation debases the dollar, causing their holdings in reserve accounts to sink in value. Exporters no longer wish to be paid in devalued USDollars.

Despite rhetoric from Fed Chairman Bernanke and Treasury Secretary Geithner that the US advocates a strong dollar policy, their actions are contrary to their claims. Sovereign fund managers and foreign finance ministers already know that is a lie. Unfortunately, American consumers will be the last to figure it out, as their purchasing power and standard of living become progressively diminished.