Just recently, on November 8, 2010, gold reached its non-inflation adjusted high of $1,400 per ounce. As shown in this chart by Kitco, gold has been increasing at a very rapid pace in the past year. This has prompted many investors to say that gold could potentially be the next “bubble,” or a security that has a huge increase in price only to suddenly “pop” and decrease rapidly in price. However, there is evidence to contradict these fears, especially in the U.S. bond markets.

Gold has historically had a direct relationship with inflation; that is when inflation goes up; gold prices go up as well. Since the world tends to trade with and is based on U.S. dollars, the main currency to watch when speculating gold prices is the U.S. dollar. With today’s 10 and 30 year U.S. bonds trading near record highs in interest yields (a sign that the market feels the U.S. dollar will be weaker in those time spans), there are signs in the market that investors are scared of inflation in the U.S. dollar. What are some of the implications for this in not only gold prices but in the global economy as well?

The last great example of major inflation in the U.S. dollar was in the 1970s. In that time, oil experienced a dramatic supply shock because the Middle East stopped exports to western nations. This caused the price of nearly all goods to increase rapidly and (combined with an increase in the U.S. money supply) resulted in inflation rates of around 7-13%. Gold reached an inflation adjusted high of $2,250 in this time. All of these historical factors seem to show that there is evidence for great inflation in the U.S. dollar to come in the next several years. This is especially important because the U.S. dollar has been used as the basis for the global economy and the G20 finance ministers will meet this weekend in Seoul to discuss global fiscal policy. You can be sure that much of the discussion will center around the U.S. dollar and potential inflation (just as it has in the days leading to the summit), but why?

The primary reason that the world is so concerned with U.S. inflation is that U.S. demand drives the world economy. When the U.S. dollar is worth less due to inflation, it makes other currencies worth more. When you factor in that the U.S. dollar is considered the basis of the global economy, the implications are even larger. With their currencies worth relatively more than others, foreign exports are less attractive. This can have a dramatic result in GDP for exporting countries such as Germany, China, and Brazil. Because of the United States’ position as the world’s largest economy and the currency basis for the global market, the effects of what happen there have huge ripple effects that will be felt around the world. It will be interesting to see what the G20 finance ministers propose this weekend. Some (most notably World Bank Chief Robert Zoellick) argue that the world must revert back to a gold standard; arguing that the markets have essentially already selected gold as the monetary standard in times of recession. Whatever solution comes out of Seoul this weekend, the world’s capital markets are likely in for a large change. What do our globalEDGE viewers think would be the best proposal for economic stability?

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