Bull vs. Bear: Will gold hit $500?

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At $991.60 an ounce, gold is retreating from the approach it took a few weeks ago to its March 2008 record price of $1,032.70 an ounce. I posted earlier this week that the Fed's plan to take $1 trillion in cash from the financial system could be a sell signal.

This prompted a reader who holds all his wealth in gold to challenge my thinking in a series of e-mail exchanges. I concluded that in order to justify his asset allocation, this fellow must cling to a conspiracy theory the survival of which depends on ignoring inconvenient facts.

His case for gold is that the world will collapse unless the Fed keeps pumping limitless amounts of liquidity into the world financial system. He believes that the entire story of the Fed removing $1 trillion from the financial system was a "plant for consumption on the eve of the G-20 summit. So, they type up a nice little piece of fiction."

He believes that people who think the Fed will try to stop inflation are going to be unpleasantly surprised. He wrote, "Boy, are they in for a shock. The most recent example of a massive Fed liquidity drain and interest rate hike was under Volcker in the 70's. Volcker would privately tell you that the Fed could not possibly do that today. The leverage prohibits it. It would be Armageddon."

Moreover, he thinks that derivatives and money market funds laden with paper from bankrupt firms, like Lehman Brothers, will force the Fed to keep pumping more dollars into the system. As he emailed, "Am I the only one who recalls that last fall the government feared a run on all money market funds and had to backstop them?"

He continued, "[Do you] think that it was only Lehman paper that was the problem? It was much, much more. Lehman filed bankruptcy, which triggered defaults but there was and is much, much more OTC crap in money market funds than that, almost all at fictitious values."

My counter-argument is that the Fed changes its policies in response to where it thinks the economy is heading. A look at the history of Fed interest rate moves and gold prices suggests that interest rates do not remain low forever; nor do gold prices only go up.

What makes the Fed raise interest rates is expectations for rising inflation. And with the Fed beginning discussions with its primary dealers about selling $1 trillion in reverse repos -- which removes cash from the financial system -- coupled with the Fed's statement that the recession appears to be almost over, the Fed is signaling a change from loose to tighter money.

I challenged the fellow to provide statistics on the specific proportion of money market funds invested in defaulted paper and to offer concrete evidence that the story of the reverse repos was propaganda. In the meantime, the Treasury is ending its guarantee of money market funds -- suggesting it is no longer concerned that the public is skittish about them.

In general, I'd guess this fellow has made a nice profit in gold. Why wouldn't he want to preserve that profit by selling at least some of his gold and putting the proceeds in a different place?

Peter Cohan is amanagement consultant, Babson professor and author of eight books including, You Can't Order Change. Follow him on Twitter.

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