Gold has been on an uptrend since 2001 and has experienced a fivefold increase since then. In 2010, the price of gold broke one record after another. But do rising US real yields pose a danger to it?

The gold price has been mostly driven by investment demand in recent months, mainly reflected in the increasing quantities of gold held by exchange-traded funds (ETFs), which physically hold the yellow metal. Since 2003, these ETFs have recorded steady inflows of investors' money and almost no outflows, suggesting that it is mainly longer-term investors who are investing in the gold market. A gradual increase in ETF gold holdings is expected in 2011 as well.

Low real yields, in particular, play a key role. Due to expansive monetary policies that are preeminent in the industrialized countries, real yields should remain at a very low level for a long period, or perhaps even turn negative. Real yields are the opportunity costs of holding real goods. Provided interest rates remain low, investors who hold gold won't miss out on anything. Falling real yields have thus lifted the gold price. As real yields still remain low, despite the last and in our opinion only temporary increase, gold investments should remain attractive.

In addition, unconventional measures employed by global central banks could inflame the inflation expectations of some investors in the medium to longer term. Also, the current debate about a potential currency war is fanning concerns about the value of paper currencies. Both of these factors stimulate investment demand further because investors are looking to gold to protect them against a depreciation of paper currencies.

In the end, concerns about the European sovereign debt problem, or the slowdown in global economic growth, could lead to a rising level of risk aversion towards mid-2011. In this event, a growing number of investors would probably seek refuge in "safe havens" again, which would also benefit gold. Overall, strong investment demand is expected to persist, which should support the gold price in the coming months.

Central bank purchases are another positive factor for the gold market. Central bank gold reserves have continued their upward trend over the last one and a half years. In particular China, India and Russia acted as buyers on the market. Moreover, central banks in the industrialized countries have stopped selling gold. It looks as if the central banks have rediscovered gold's diversification role.

It is also worth mentioning that the International Monetary Fund has already completed the lion's share of its announced gold sales of 403 metric tons and, as a consequence, will not be a seller on the market for much longer.

Although investment demand plays an ever greater role in the gold market, demand for jewelery remains a key factor. Jewelery demand in recent years has suffered under volatile and rising prices and remains at a relatively low level. But despite higher prices, jewelery demand in the third quarter of 2010 improved by 8 percent year-on-year to 529.8 metric tons, according to the World Gold Council. Demand from the key markets of India, China, Russia and Turkey has picked up, in particular.

The idea that jewelery is a good investment probably plays a role in jewelery purchases in these countries. Especially in India, the world's largest gold consumer, gold jewelery is often purchased as a financial investment. Demand for gold in the country rose by about 36 percent in the third quarter of 2010. Jewelery demand in Western countries, on the other hand, has lost ground. This might suggest that jewelery in these markets is seen less as an investment and more as a luxury item. For 2011, a powerful recovery in global jewelery demand is unlikely because the price of gold is likely to remain expensive and global economic growth should weaken slightly.

Rising supply can't stop the price uptrend though. Gold supply has risen over the past two years in response to rising prices. Mining output was able to be increased, above all in China. Furthermore, producers have wound up the majority of their earlier hedging transactions.

The negative impact of dehedging activities should thus have a smaller impact on gold supply in the future. In addition to the improved mining supply (a rise of 3 percent in the third quarter of 2010 compared with the corresponding period in 2009), the supply of scrap gold has also shot up on the back of the attractive prices.

Overall, scrap supply rose by 121 metric tons year-on-year in the third quarter of 2010, or by 41 percent, according to the World Gold Council. A slight uptick in supply is expected in 2011 due to high prices, although this is unlikely to halt the upward trend in the gold price for the time being.

Further upside potential in gold price is intact but the risks are on the rise. Whereas brisk investment demand should continue to support the gold price, the risks are also increasing. On the one hand, the real price of gold is expensive by historical comparisons. Furthermore, investment demand has become a driving force on the market. But since it is rather volatile, it can also be quickly withdrawn. If global economic growth accelerates, risk appetite on the financial markets revives and real yields rise, several investors are likely to wind up their gold positions and reinvest this money in more promising assets.

But since jewelery demand is relatively weak and gold supply is rising, the gold price is likely to suffer greatly under a loss of investment demand. This could already be the case by 2012. Therefore, investors are advised not to undertake any more long-term gold investments, but to be prepared to wind up their gold positions when real yields start to climb noticeably over a long period of time. Another alternative would be to hedge the downside risks on existing gold positions.

The author is a commodity strategist at Sarasin Group, an international financial service provider. The opinions expressed here are entirely her own.

(HK Edition 01/14/2011 page2)