Food Inflation From Worldwide Drought Could Push Gold Above $1900 An Ounce By Year End

Gold prices are up 3% so far this year. However, commodities like corn and soybeans are up over 30% due to the severe drought-like conditions the farms have been experiencing. According to one expert, higher food prices could ultimately offer support for gold prices.

Christopher F. Davis
August 12, 2012
Seeking Alpha

Gold prices, which have traded in the $1,550 to $1,640 range since about late May, are up 3% on the year so far, but other commodities markets, such as crude oil, are up about 7% and have rebounded well off of their lows in May. Further, corn is up an astounding 33% and soybeans are up an impressive 39%, due primarily to the severe drought like conditions we have been experiencing. The ETFS that track corn and soy, such as CORN and SOYB, are up in tandem. After the U.S. Department of Agriculture slashed U.S. national crop yields for corn two months in a row because of the devastating drought, we are seeing corn prices near all-time record highs and soybean prices are also near all-time highs. On Friday, the U.S. Department of Agriculture also estimated that the U.S. corn crop is its lowest level since the 2006 growing season. I believe that the drought's effect on grain prices may possibly be spilling over into the gold markets, as there had been some quiet yet supporting commentary from experts very recently.

George Gero, vice president with RBC Capital Markets Global Futures and a precious metals strategist, has stated that gold traders "have been keeping an eye on grain prices lately, as they are primarily concerned about food inflation picking up". Further, higher food prices emanating from droughts in the U.S. Midwest and elsewhere ultimately could offer support for gold prices, according to HSBC holdings. HSBC noted that:

we believe that the relationship between oil and gold has been well-documented, but agricultural prices, especially those for grains, also impact gold.

Not only has "a large swathe of U.S. farmland has been deemed disaster areas by the U.S. Department of Agriculture due to the impact of drought," but according to the U.N.'s Food and Agricultural Organization, other big grain-exporting regions, including much of South America and Ukraine, are also in the midst of droughts. They believe this could "affect the soybean as all the major grains are being hit by drought", HSBC also stated.

The view about possible food inflation impacting gold markets is not shared by everyone. Daniel Pavilonis, senior commodities broker with RJO Futures, said while USDA lowered the size of the crop, it also cut use, such as for exports. "Those countries (who buy corn) will seek alternatives. I don't think the corn crop is a factor for gold," he said.

Next week the U.S. government will release its producer and consumer price index reports for July, which measure wholesale and retail inflation. The core producer price index and consumer price index are both expected to rise 0.2%. Some economists said the overall figure may be higher to account for rising food prices. Charlie Nedoss, senior market strategist with Kingsview Financial, said next week's inflation reports "may not yet register the surge in grain prices", but "higher food prices will work their way into the economy in the next six to 12 months".

I see possible food price inflation due to rising grain prices as yet another opportunity, and a reason, to own gold. Prior to this drought, deflation concerns had driven down the price of gold and the gold miners. Now, possible European stimulus, another likely round of QE3, and most notably, food price inflation are all significant tailwinds that will support the price of gold. In fact, gold closed above its 100 day MA and is forming a bullish engulfing chart pattern. I believe support relative to food cost inflation may be seen in the trading of December gold contracts at $1602 with possible topside resistance seen at $1645 and $1670 levels. A breakout above $1670 would be a massively bullish signal, and could take gold to $1900, as analysts at HSBC have predicted.

How to play it: My favorite way besides physical bullion is to pick up the SPDR Gold ETF (GLD), either outright or through long expiration, in the money call options. Another more speculative way to play the rise in gold prices would be to pick up one of the individual gold miners or mining ETFs, as they have sold off very hard this year. My favorite ETFs to track the gold miners are the GDX, GDXJ, and NUGT. My favorite individual gold miners are (EGO), (AEM) and (AU). Large cap miners are also an excellent way to play the rise in gold and the larger miners (GG), (ABX) or (NEM).

Bottom line: Gold is getting support and tailwinds from multiple areas of the economy, and this severe drought is another possibly under-appreciated tailwind that deserves recognition.

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