LONDON Fear of inflation has always been one of the prime reasons for investing in gold, yet in an era of nail-biting uncertainty, investors are buying the shiny stuff to ward against price swings in either direction.
This was to be the year when the world economy flourished after suffering recession in 2009, corporate profits would bloom and central banks would remove their policy safety nets.
Investors would be ready to assume more risk, leaving their well-worn security blankets like gold to gather dust.
Things could not be more different. The Federal Reserve is widely expected to keep U.S. monetary policy loose as the economy struggles, global stocks are still a good 30 percent off pre-crisis highs and analysts are likely to trim their 2011 earnings forecasts, at least in Europe.
Market gauges of inflation expectations show little more than a muted rise in price pressures, but the more wary investors are taking no chances, and their hunt for safety has driven gold to new record highs this week above $1,270 an ounce.
"Forgetting the present, generically speaking, gold is a hedge against inflation. In normal times, it would not be a hedge against deflation ... but because this time the association with deflation is panic, then that flight to quality and liquidity is worth something," said Charlie Morris, head of the HSBC Asset Management Absolute Return Fund.
"Given value credentials of gold, it would survive the current era of inflation and win mandates on the quality angle as opposed to anything else."
THEORY AND PRACTICE
Theory dictates the value of gold rises as other prices rise, unlike the value of a currency, which is eroded by inflation, leaving long-term investments such as government bonds at the mercy of the swings in consumer price indexes.
In nominal terms, the price of gold has more than tripled in the last 20 years, to around $1,270 an ounce, from roughly $400 an ounce in 1990. Adjusted for inflation however, the price has risen by some 70 percent in that time, so in 1990's money, today's gold price is only worth about $700.
Europe's sovereign debt crisis has unleashed austerity policies across the region that could quash consumer spending, while growth in the United States remains stubbornly anemic and even China's economy is showing signs of moderating.
Policymakers are bombarding the markets with cash to keep credit flowing to the interbank lending mechanism, which has not fully recovered from the shock of the 2007 credit crunch.
"In a deflationary environment where asset prices are plunging, then by holding its value, gold will outperform. It is a bit of a chameleon and that's what attracts people to it," said RBS head of commodity research Nick Moore.
That said, Moore added he only places a 10 percent weighting in his gold price expectations on the inflation argument itself. He believes gold's safe-haven appeal will ultimately be what spurs it to outperform other asset classes.
Japan is the most widely used example of a developed nation caught in a deflationary spiral, in which prices have essentially declined for more than a decade.
This has not been the case in the United States. The core PCE, the Fed's preferred measure of inflation, has fallen since late 2008, when the credit crunch unfolded, but is still within the bank's target band of 1 to 2 percent.
In the last two decades, the U.S. consumer price index has risen by 65 percent, while gold has risen by 250 percent.
Looking at the most common market measures of U.S. inflation expectations, the five-year breakeven inflation rate -- derived from subtracting the yield of the benchmark inflation-linked bond from that of the nominal bond -- shows fixed income investors anticipate an inflation rate of around 1.35 percent.
Further out, investors are less sanguine. The 10-year breakeven rate is around 1.80 percent, which although low by historical standards, is up from around 1.5 percent in August.
"This is important for precious metals, not necessarily because we expect inflation to run rampant and push precious metal prices higher, but it signals a move away from deflation fears. A world where debt is an issue, falling prices will only amplify the problem," said Standard Bank analyst Walter de Wet.
Former Fed Chairman Alan Greenspan himself said more than 10 years ago that gold was "the ultimate means of payment."
"There are definitely going to be a group of investors holding gold for financial reasons and that will be inflation/deflation. There will be others who hold it as a safe-haven play," RBS' Moore said.
"It's been a great performer over the last ten years and now it's properly valued and accepted and part of society. Gold before was a bit of a pariah, one of these barbaric relics that no one understood and no one needed and that's now changed."
(Editing by Sue Thomas)