Some market watchers have attributed the gold rally merely to investors seeking a short-term inflation hedge or a perceived “safe-haven” investment in the face of a slowing global economy, ongoing global sovereign debt problems and Friday’s downgrade of US debt. Gold prices, however, have been on the rise for a decade and I believe there are a few key reasons why.

First, high gold prices can’t be blamed on fears of near-term inflation. While investors have historically paid a higher premium for gold when inflation expectations are high, inflation expectations have receded since a spring spike. In addition, the last decade has been characterized by low inflation in most developed countries.

But the rally in gold can be partly explained by longer-term inflation fears tied to deficit-related spending that would increase the money supply. When deficits are high, investors rationally worry about whether the government will ultimately deal with large deficits by creating a surge in the money supply. Today, this appears to be a growing concern among investors and as the US fiscal situation remains precarious, this may support gold prices, even in the absence of any near-term signs of inflationary pressures.

Rising gold prices are also explained by another sort of inflation — inflation as the erosion of the purchasing power of the dollar. Historically, the deterioration of the dollar has been a more important determinant of the performance of gold than traditional inflation. Gold tends to do best when the dollar’s value is eroding and we have seen a significant pullback in the value of the dollar versus other currencies over the past 2 ½ years.

Part of the relationship between gold and the dollar is mechanical. As gold is valued in dollars, a declining dollar by definition will lead to higher gold prices. However, the relationship between gold and the dollar also reflects a second dynamic. In those periods when investors are uncomfortable with any fiat currency, including the dollar, gold is the natural beneficiary — and increasingly these days, so is the Swiss Franc.

Now onto the final reason behind gold’s rise. One of the key drivers of gold and other commodities is the level of real interest rates, which are the nominal rates minus the inflation rate (or more accurately, inflation expectations). Over the last decade, we’ve been in an environment where real rates have been at historically low levels. Low real rates mean the opportunity cost of owning gold is low.

In other words, when real rates are high, you can get a return from owning paper assets like stocks and bonds. And there’s an opportunity cost to holding a commodity like gold that produces no income. When rates are low, however, that opportunity cost is very low, another explanation for why commodities are doing well in today’s environment.

So ironically, if we continue to be in an environment where the Fed helps keep real interest rates low, we’re likely to see an environment that continues to be supportive of gold and other commodities.

Past performance does not guarantee future results.

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