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December 16, 2008 / 9:37 PM / in 9 years

Gold retains allure as cenbanks battle deflation

By Frank Tang - Analysis

NEW YORK (Reuters) - Even as fears of deflation prompted the U.S. Federal Reserve on Tuesday to slash interest rates to the bone, gold retained its allure as an inflation hedge among investors watching central banks flood financial markets with money.

The conventional wisdom is that the price of bullion, seen as a safe haven that retains value in times of inflation, will drop on the threat of deflation, a devastating economic state in which overall prices decline.

But fund managers said they expect gold to stay well bid as central banks expand money supply to bolster the economy at the expense of fighting inflation.

“Gold does not benefit from deflation, but rather it benefits from the cure of the deflation,” said Axel Merk, manager of the Merk Hard and Asian Currency Funds, with $300 million of assets.

With U.S. rates and Treasury yields at rock bottom, Merk said, the dollar will weaken.

The Fed cut its target for overnight interest rates to a record low zero to 0.25 percent. The central bank said it would employ “all available tools” to dispel a year-long recession.

Brian Hicks, co-manager of the $500 million Global Resources Fund at U.S. Global Investors, said he expected gold to revisit $1,000 some time next year, driven by negative real interest rates and the massive amount of money to be injected into the system by central banks.

“At some point, the market is going to transition from an environment of concerns over deflation to an environment of concerns over inflation, and that’s the real inflection point for gold,” said Hicks.

On Tuesday, U.S. February gold futures and spot gold both rose above $850 an ounce. Gold remains nearly 20 percent below the all-time high of $1,030.80 it hit on March 17. It fell amid a wave of “deleveraging” in which investors sold bullion for cash to cover margin calls amid losses in other assets.

GOLD AS A MONETARY VEHICLE

However, fund managers said a major obstacle to gold’s rise would be removed as the market has already seen most investment liquidation and as fund redemption eased after the U.S. stock market plummeted to an 11-year low.

“There aren’t many assets that are desirable now, and gold is showing its true color as a financial asset,” while other industrial metals such as copper were falling in sympathy of a weakening economy, said Bill O‘Neill, managing partner of LOGIC Advisors.

O‘Neill said gold has still attracted strong demand in the physical market, with unprecedented buying in gold coins and bullion bars in the last several months even as most asset prices dropped.

Caesar Bryan, portfolio manager of GAMCO Gold Fund, said bullion could rally against most currencies as major industrial countries fight recession using policies that should depreciate their currencies.

“When confidence falters in paper currencies and other investment assets, then interest rises in gold. I think that is where we are,” said Bryan, who manages $360 fund assets.

Bryan said that a U.S. rate cut to zero would lower the opportunity cost of buying gold compared to fixed income investments, and that should also discouraged central banks to sell gold.

“As we get out of this period of deleveraging and risk aversion, we think that the clear winner of commodities to investors will be gold,” said Hicks of U.S. Global Investors.

Reporting by Frank Tang; Editing by David Gregorio

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