The world equity markets are reeling under the sub-prime mortgage crisis in the US, but precious metal prices are set for a bull run. The Federal Reserve’s move to cut interest rates to avoid a liquidity crisis could spark off this gold rush.

In an article — Federal Reserve Could Start A Gold Rush — published in the August 20 edition of Forbes magazine, reporter Andrew Farrell wrote: “The Federal Reserve is mulling a federal funds interest rate cut; a move that would buff the lustre of gold miners.”

On Friday, August 17, the Federal Reserve reduced its discount rate — a secondary rate at which banks in the US borrow money directly from the Fed — by 0.50 percentage points to 5.75 per cent in a move to ease liquidity in the system.

This is being looked upon as a step towards a higher cut in the federal funds interest rate (the benchmark inter-bank borrowing rate).

According to RBC Capital Markets, the investment banking arm of the Royal Bank of Canada, in 60 per cent cases gold shares gained when the Fed slashed its key rates.

“If the Fed reduces its key lending rate by 0.50 percentage points to 4.75 per cent at its next policy meeting on September 18, the dollar will fall dramatically and gold will go through the roof.

Meanwhile, the London Bullion Market Association forecast an average price of gold at $665 per troy ounce (1 ounce = 28.35 grams) in 2007 compared with $444.50 for 2005 and $603.50 in 2006.

The peak price of gold has been projected to settle between $825 and $850, with a low of $605.

According to a Bloomberg survey, investors and analysts are in favour of buying gold because of “mounting losses from US sub-prime mortgages” and it represents “a haven from more risky financial assets”. Some 75 per cent of those surveyed advised buying gold.

Demand trends

In its report on gold demand trends, the World Gold Council forecast increased demand for gold in the first quarter of the current financial year in terms of both tonnage and dollars. Net retail investment was higher by 28 per cent in the April-June period compared with last year in tonnage terms. Consumer demand in China and India rose 31 per cent and 50 per cent, respectively, while gold supply fell 2 per cent.

The increased demand was attributed to several reasons. The central banks in emerging economies such as China and Russia are diversifying their holdings of foreign currencies into more tangible assets such as gold.

Second, the year of the golden pig in China prompted people to buy gold. Third, the strong economic growth in India created more wealth for the middle class, which in turn bought more gold.

The global demand for gold has more than doubled to $17.4 billion at the end of June this year compared with that in 2003, leading to a sustained upward trend in its price.

India’s demand for gold in 2007 is likely to exceed 1,000 tonnes for the first time, according to the World Gold Council. “The early indications are for a very, very strong year for India’s gold demand," Philip Olden, managing director and chief marketing officer of the World Gold Council, told Reuters. “If the price stays stable, you are probably looking at a demand which is at least 50 per cent higher than last year,” Olden said.

“But if prices rise, volumes may fall — though in value terms, gold demand may still jump by 50 per cent,” he added.

Last year, the demand for gold in the country was 715.5 tonnes. Latest figures from the council show the country’s gold demand in the first half of 2007 was 528.2 tonnes, including jewellery and net retail investment demand.

Supply side

On the supply side, overall mine supply rose only 5 per cent compared with April-June quarter last year and only the central banks of France, Spain and Indonesia (31 tonnes, 80 tonnes and 23 tonnes respectively) sold their gold reserves in the market.

This supply shortfall may increase next quarter as South Africa has reported a fall in gold output by 10.8 per cent in volume terms.

ETF option

Investing in exchange traded gold funds (ETFs) of mutual funds could be a better alternative to buying physical gold because gold ETFs closely track the price of physical gold in the market.

For the week ended August 14, the ETFs of UTI Mutual Fund, Kotak Mahindra Mutual Fund and Benchmark Mutual Fund fetched 0.46 per cent returns, the highest average returns across all categories of schemes.

India’s per capita gold consumption is 17 grams, half of the US and one third of the West Asian countries.

James Burton, CEO of the World Gold Council, said: "We are pleased to report a very strong second quarter with demand for gold reaching unprecedented levels in a number of markets…Several countries stand out. The figures from India this quarter are particularly pleasing and we will continue to encourage India's ongoing love affair with gold." At 317 tonnes, India's total demand for gold in the second quarter of 2007 was equivalent to half the global mine output for the quarter."

Bullion plunged to its lowest in seven weeks to $641.10 on August 16, when investors sold precious metals for cash to cover margin calls on losses triggered by a dip in the US sub-prime mortgage market.

With the global crude oil price hovering above $70 a barrel, the risk of inflation has not been fully abated. If inflation creeps up again, demand for gold will be more.

If you want to invest in gold, exchange traded gold funds of mutual funds could be a better alternative to invest in physical gold because gold ETFs closely track the price of physical gold in the market.

The returns of each of the three ETFs from UTI Mutual Fund, Kotak Mahindra Mutual Fund and Benchmark Mutual Fund posted 0.46 per cent returns, the highest average returns across all categories of schemes for the week ended August 14.