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Gold Smashed!

Gold
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Gold

It's been a brutal week for gold.

The September contract fell 10 percent this week. According to the Wall Street Journal's Mark Gongloff, that's the biggest weekly dollar decline since January 1980 and its worst weekly percentage loss since 1983.

It's always dangerous to try to discern rationales behind market movements. But I think the story behind gold's decline is very different from the one I'm hearing from others, so I'm going to take the risk here.

The rise in the price of gold is often attributed to fears of inflation. Gold can be used to hedge against monetary debasement, the theory goes. Indeed, it seems that is the inspiration for some investors to buy gold.

I don't think fears about inflation in the U.S. played as large a role in the rising price of gold as many people seem to think. For one thing, the TIPS market tells us there are no inflation fears. The Federal Reserve Bank of Cleveland reports its latest estimate of 10-year expected inflation is 1.37 percent. In other words, the public currently expects the inflation rate to be less than 2 percent, on average, over the next decade.

Rather, I suspect the biggest source of inflation fears has been Chinese investors. The regime there has been on a treadmill to Hell, needing to create millions of jobs each year to avoid having its populace revolt. To create those jobs it has to keep its exports cheap, which requires it keep its currency artificially low. It does this by printing money, quite literally. Anyone holding lots of Chinese currency would understandably want to hedge against inflation.

But China has been putting the brakes on inflation. It is allowing its manufacturing sector to slow down — we've now had three consecutive months of contraction in Chinese manufacturing. The government is quite audibly fighting inflation. So perhaps the demand for gold from Chinese investors is retreating now that the economy appears to be slowing.

Back here in the U.S., I suspect the realization the economy is sputtering has damped even further the demand for gold as a hedge against inflation. The Fed's words this week sounded pretty dire.

There's really not much chance prices are going to shoot up very soon. When the October inflation numbers come out, I expect the Cleveland Fed will discover inflation expectations have dropped even further.

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