What do you get when you mix negative real interest rates with stimulative money supply efforts by global central banks?

An exceptionally potent formula for higher gold prices that could send gold to the unimaginable level of $10,000 an ounce. Negative real interest rates and strong money supply growth are two key factors of what I refer to as the Fear Trade.

Negative real interest rates occur when the inflationary rate, or CPI, is greater than the current interest rate. A quick account of the G-7 and E-7 countries shows that the majority have negative real interest rates.

Across the developed G-7 countries, British citizens are the worst off with real interest rates in the U.K. sitting at negative 4.5 percent. U.S investors aren’t doing much better with rates at negative 3.25 percent and the Fed has all but guaranteed rates will remain there. Only Japan has a positive real interest rate among the G-7 and that rate is barely above zero.

Conversely, the most populous nations making up the E-7 have mostly positive real interest rates. However, the grouping’s grandest economic powerhouses, China and India, have negative real interest rates sitting around negative 2 percent.

Simply put, investors in those countries who have parked their savings in cash and low-yielding investments, such as Treasury bills and money market accounts in the U.S., are actually losing money due to inflation.

That can be tough for any investor, but when you’re the central bank of a country with millions of dollars in reserves, it can be catastrophic. This is why central banks around the globe have sought protection by diversifying their foreign-exchange reserves into gold bullion this year.

VTB Capital’s Andrey Kryuchenkov told The Wall Street Journal this week that, “Central banks are diversifying, and it has intensified to a rate that nobody had expected.” Latest estimates predict global central banks will purchase between 475-500 tons of gold in 2011.

This amount of capital flowing into gold has the potential to push prices up a level in 2012. John Mendelson from ISI Group sees gold prices reaching $2,200 an ounce during the first six months of 2012.

While real interest rates look to remain in the red for the foreseeable future, many of these same countries are printing record amounts of “green” with accommodative monetary policies.

U.S. Global’s director of research John Derrick says central banks around the world have focused their attention on stimulating growth. Beginning with Brazil’s interest rate cut in late August through the European Central Banks (ECB) cut early December, there have been 40 easing moves by global central banks, according to ISI Group.

John says this also means we will likely see more quantitative easing in 2012. The Bank of England has already started its quantitative easing, and many experts believe the ECB and the Federal Reserve will follow in its footsteps.

Bloomberg reports that global money supply (M2) is “set to increase the most on record in 2011.” The chart below shows the year-over-year change of global money supply has been gradually moving higher and higher since mid-2010.

The reason global central banks have shifted the printing presses into overdrive is simple: they need the money. My long-time friend Frank Giustra reminded us of this new reality in an op-ed piece for the Vancouver Sun last week. Frank writes:

The bottom line is that the money needed to bail out Europe and to fund America’s spiraling debt and future unfunded obligations is in the ten of trillions. IT DOES NOT EXIST. It has to be created by printing money in massive quantities, and despite all the rhetoric you will hear against such policies, in the end it’s the path of least resistance. Printing money is an invisible tax on savings, much easier to initiate, than, say, raising taxes or cutting back on services and entitlements.

As central banks print money and increase supply, currencies become devalued. Whereas in the recent past, one currency may be reduced in value compared with other currencies, this time there is global competitive devaluation as excess liquidity is put into the system. Historically, this excess liquidity has made its way to riskier assets, i.e. stocks and commodities.

Gold is generally a benefactor of this flight to riskier assets as many investors see it as a store of value. This chart illustrates the interconnectivity of gold and global money supply growth.

However, this image doesn’t tell the whole story. While the price of gold has followed the same upward path as money supply over the past 14 years, it hasn’t been able to keep pace with M2 growth, says the Bloomberg Precious Metal Mining Team.

In fact, if the global money supply were backed by gold, gold prices would be much higher, according to Bloomberg. The yellow line below shows how gold would be greater than $5,000 per troy ounce if just half of global money supply were backed by gold. If all of the money supply in the world were to be backed by gold, the price of one troy ounce would need to rise above $10,000.

It’s unlikely, of course, that this will happen, but it serves as a useful illustration for the disappearing value of the world’s fiat currencies.

Frank reminded readers that we have been down this path before. Frank says, “When great nations mature and over-extend themselves, they revert to the paths of least resistance: borrow and/or print money. They all did it and they all failed; this time will be no different.”

The beneficiary of this type of event has historically been gold.

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M1 Money Supply includes funds that are readily accessible for spending. M2 Money Supply is a broad measure of money supply that includes M1 in addition to all time-related deposits, savings deposits, and non-institutional money-market funds.

Back in August, we discussed the precarious proclamation that Venezuelan President Hugo Chavez was shipping his country’s gold reserves home for safekeeping. On Friday, we learned Chavez’s chosen transportation method for “Operation Gold” was through the air after the first shipments arrived to much fanfare in Venezuela. Reuters* described the scene:

Excited crowds lined the roadside waving big Venezuelan flags chanting ‘It’s returned! It’s returned’ as a convoy of soldiers and armored cars carried the [gold] ingots from Maiquetia airport to the central bank in Caracas. …

… Drums and sirens sounded out across the square as many in the crowd sang ‘Forward comandante!’ in support of the president. Some waved homemade signs that said ‘The gold has returned thanks to Chavez!’ and ‘Long live our sovereignty.

This was just the first shipment in a plan that calls for all of Venezuela’s gold held in foreign countries—roughly 160 tons worth some $11 billion—to be returned home. A government official stated the gold shipments would be wrapped up by the end of the year, but would not offer any details on the shipments’ country of origin, says Reuters.

The convoy of 500 armed soldiers, tanks and aircraft was led by Nelson Merentes, president of Venezuela’s central bank, who played the role of grand marshall for the gold parade. A Financial Times* story quoted Merentes as saying, “We are bringing the gold back because unfortunately capital markets and the world economy are in turmoil, and for that reason it is preferable to seek protection.”

No doubt these comments were intended to soothe suspicions that the gold repatriation is motivated by the sanctions suffered by Chavez’s friend and former ally Moammar Gaddafi during his country’s fall into civil war.

Venezuela’s gold had originally been sent to Europe in the 1980s and 1990s to guarantee the country’s loans from the International Monetary Fund (IMF). Now, it’s been theorized the gold is being shipped back to serve a similar role for the country’s growing debt to China. Over the past five years, China has loaned the Latin American country $32 billion, including a $4 billion loan just a few weeks ago.

A move of this magnitude can significantly affect the gold market regardless of whether Chavez’s motivations are nefarious or patriotic. Banks often keep only a portion of their bullion deposits on hand, reselling or lending out the rest—similar to how cash deposits are treated in your own personal bank account.

Venezuela’s gold repatriation could serve as a de facto run on the bank—driving up gold prices in the process. Some believe Chavez’s announcement of “Operation Gold” was a catalyst for the August run up in gold prices, but there is no way to be sure. However, the impact could be significant if other countries employ a similar strategy.

Read Ocean’s 2011: Venezuelan Gold Now

*By clicking the links above, you will be directed to third-party websites. U.S. Global Investors does not endorse all information supplied by these websites and is not responsible for their content. All opinions expressed and data provided are subject to change without notice. Some of these opinions may not be appropriate to every investor.

Resurgent investment lifted global gold demand 6 percent from the previous year to just over 1,000 tons during the third quarter of 2011, according to the latest Gold Demand Trends Report from the World Gold Council (WGC). The potent cocktail of inflationary pressures in the emerging world and the European sovereign debt fiasco left investors searching for a safe haven—they looked for it in gold.

In an uncertain era where many asset values are declining, gold has thrived. Gold prices averaged $1,700 an ounce during the third quarter of 2011, 39 percent higher than the same time last year and 13 percent above the previous quarter, according to the WGC.

In total, investment demand increased 33 percent on a year-over-year basis to reach the third-highest quarter of investment demand on record, says the WGC. The increase was broad in scope. Investment in gold bars and coins jumped 29 percent year-over-year while holdings in gold ETFs reached an all-time high.

All global markets other than India, Japan and the U.S. experienced gains in investment demand; many of them (except Thailand and Saudi Arabia) saw double-digit increases.

While investment demand thrived during the third quarter, jewelry demand fell victim to the quarter’s economic fragility and price volatility—falling 10 percent on a year-over-year basis. Only four markets—China, Hong Kong, Japan and Russia—saw jewelry demand increase.

The WGC says a shift toward high-growth economies is “undeniably conspicuous in the gold market.” Nowhere in the world is this more evident than in China, where consumer thirst for gold appears unquenchable. China’s total demand, around 612 tons year-to-date, has already eclipsed that of 2010. In addition to domestically consuming every speck of gold mined in China, it’s estimated that the country’s gold imports could reach 400 tons in 2011. That’s roughly equal to the combined tonnage of gold demand for the Middle East, Turkey and Indonesia in 2010—and that’s just imports.

Consumer demand for gold in China increased 13 percent (year-over-year) during the third quarter as the country continues to close the gap on India. Chinese jewelry demand, also up 13 percent, eclipsed India for only the fourth time since January 2003. Combined, the two Asian giants account for over 50 percent of global jewelry demand.

The WGC says, “China’s increase in demand is being fueled by rising income levels, a by-product of China’s rapid economic growth.” This growth has given birth to more than 100 million gold bugs in China’s rural areas. China’s smaller third- and fourth-tier cities were responsible for the bulk of the increase in jewelry demand, the WGC says. In addition, the Gold Accumulation Plan (GAP), a joint effort from the Industrial & Commercial Bank of China (ICBC) and the WGC which allows investors to purchase gold in small increments, reached 2 million accounts in September. The WGC says GAP sales have already exceeded 19 tons so far this year.

Things weren’t quite as rosy for demand in the world’s second-largest jewelry market. Indian jewelry demand took a 26 percent hit as volatility in the rupee shook investor confidence. The rupee decreased 9 percent against the U.S. dollar during the third quarter, more than double the currency’s average quarterly move over the past five years.

Historically, Indian jewelry demand bottoms in July-August, before picking up heading into the Shradh period of the Hindu calendar. That didn’t happen this year because Indian consumers were discouraged by high and volatile prices. The WGC says:

Consumer confidence in India has been knocked by the persistence of high domestic inflation rates. Inflation of almost 10 percent, as measured by the Wholesale Price Index (WPI), adversely affected jewelry demand, through its impact on both disposable income levels and general consumer sentiment.”

Currency Effect on Gold Prices

The weaknesses of the rupee against the U.S. dollar also negatively affected India’s demand. This chart illustrates the dramatic effect currency fluctuations can have on gold prices.

The gold price in Indian rupees has appreciated over 31 percent since June 30, more than three times the price appreciation denominated in Japanese yen. This means that a consumer looking to buy gold in Japan would have three times the purchasing power to buy gold at their local dealer than an Indian counterpart.

The gold price in yen terms has lagged due to the currency’s strong appreciation against other global currencies. It’s a similar story for the U.S. dollar and Chinese yuan (pegged to the U.S. dollar), which investors have favored since fleeing the euro.

Gold’s Volatility

Chaos in the currency markets amplified gold’s volatility to roughly twice historical levels during the third quarter, the WGC says. Our research also shows that gold’s recent roller-coaster ride is an anomaly. We sorted through 10 years of data to capture all of the 10 percent (plus or minus) moves selected assets have had over a one-month period. The results show gold experiences plus/minus 10 percent moves 7 percent of the time; about the same as the S&P 500 Index. In comparison, crude oil sees moves of this magnitude 30 percent of the time.

Gold equities have been more volatile than gold bullion. The NYSE Arca Gold Bugs Index (HUI) experienced these swings 33 percent of the time. In a market with gold prices trending upward, this beta provides a potential boost for miners. However, this can also have a negative effect during volatile markets as investors overreact to downside swings.

Gold Outlook

“Gold demand faces headwinds in the near term because of the strength of the U.S. dollar,” Marcus Grubb, Managing Director of Investment for the WGC said on a conference call Thursday. “I still think the macro situation is very favorable to gold because we still don’t have a lender of last resort in the eurozone.”

Speaking of the eurozone, Nigel Farage—leader of the United Kingdom’s Independence Party—spoke some much-needed harsh words to the European Council this week. Farage is one of the U.K.’s most powerful conservative officials and is an unabashed Eurosceptic, meaning he does not ideologically believe in the idea of the European Union. I originally saw the video posted on Zero Hedge but it has since gone viral.
Farage lambasted the group saying, “The Euro is a failure and who is actually responsible, who is in charge out of you lot? Well of course the answer is none of you because none of you have been elected. None of you actually have any democratic legitimacy for the roles that you currently hold with this crisis.” “You should all be held accountable for what you’ve done,” Farage continued later. “You should all be fired.”

Click here to watch the video.

I think Farage echoes the sentiments of many, who are exhausted, enraged and exasperated by the technocrat circus in Europe. Europe’s carousel of fiscal calamity will certainly keep spinning in the near term and will likely continue to be covered heavily by the media. This will continue to drive the Fear Trade, while China and the Far East power the Love Trade by feasting on gold.

Now that’s something all gold investors can be thankful for. I wish you and your family a very Happy Thanksgiving! If you happen to be in the San Francisco area November 27-28, come visit me at the Hard Assets Investment Conference where I’ll be speaking about market supercycles.

All opinions expressed and data provided are subject to change without notice. Some of these opinions may not be appropriate to every investor. Beta is a measure of the volatility, or systematic risk, of a security or a portfolio in comparison to the market as a whole. The following securities mentioned in the article were held by one or more of U.S. Global Investors Fund as of September 30, 2011:  Industrial & Commercial Bank of China.

The S&P 500 Stock Index is a widely recognized capitalization-weighted index of 500 common stock prices in U.S. companies. The MSCI Emerging Markets Index is a free float-adjusted market capitalization index that is designed to measure equity market performance in the global emerging markets.

The NYSE Arca Gold BUGS (Basket of Unhedged Gold Stocks) Index (HUI) is a modified equal dollar weighted index of companies involved in gold mining. The HUI Index was designed to provide significant exposure to near term movements in gold prices by including companies that do not hedge their gold production beyond 1.5 years.

By clicking the links above, you will be directed to third-party websites. U.S. Global Investors does not endorse all information supplied by these websites and is not responsible for their content.