By Ben Baden

Fear and inflation play a role, but the low rate environment is the most important factor

Gold has been one of 2011's hottest investments. Over the past six months, the spot price of the precious metal is up about 30 percent. Gold is benefiting from a range of economic and psychological factors, including sovereign debt concerns in Europe and the United States as well as fears that the global economy could be slipping back into recession. And when investors become fearful, they tend to take refuge in the shiny yellow metal because of its inherent value. In addition, controversial bond-buying programs like the Federal Reserve's latest round of quantitative easing, "QE2," have chipped away at the value of the dollar, critics say, and added to inflationary concerns. That's beneficial for gold because it's often viewed as an alternative currency when other fiat currencies like the dollar and the euro look weak.

Russ Koesterich, chief investment strategist at iShares, agrees that concerns about higher inflation and fears of a downturn have helped boost gold's price, but he says the biggest contributor has been historically low real interest rates. U.S. News recently spoke with Koesterich about why the price of gold has the potential to move even higher. Excerpts:

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What's the most important factor to consider when looking at the price of gold?

The key thing is the real interest-rate environment, so the level of interest rates versus the level of inflation. If you look at that, it's been a much more important determinant of the performance of gold over the last 50 years, but much more importantly over the last 20 years, than anything else.

So you're saying commodities, specifically gold, can continue to prosper even in a slow-growing economy with muted inflation?

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The argument is very straightforward. The thing with commodities, which is so unique relative to stocks, bonds, or real estate, is they produce no cash flow. So if you're going to give up that cash flow, there's an opportunity cost. When the cash flow is high relative to inflation, there's a big opportunity cost. Today, take a simple example. The yield on the 10-year [treasury] note is about 2 percent. Inflation is running about 3.6 percent. So, as of today, if you have a 10-year treasury note, you're getting a negative real return. One of the things that's supporting gold is, unlike normal times, there is no opportunity cost to holding a lump of the metal, because the real rate of return you get on many assets, particularly many bonds right now, is low or negative. ... Basically, the rule of thumb is the lower real rates, the better commodities tend to do, particularly gold.

The Federal Reserve has said it plans on leaving rates at near zero until the middle of 2013. Is this why you think gold prices will continue to rise?

It is, but there is also the assumption is that inflation [in the U.S.] is relatively stable and doesn't slip back into Japanese-style deflation. We don't expect that to happen. So the conclusion is fairly simple. You know that interest rates are going to be pretty low for the foreseeable future. Unless you believe that inflation is going to fall dramatically, you're going to be an environment of low or negative real rates. That has historically been supportive of commodities, particularly gold.

How does gold fit into a typical investor's portfolio?

In small portions, it's a diversifier. In other words, it basically helps dampen the volatility of your portfolio. The biggest challenge you always have when you talk to people about their portfolio is that they tend to think of things in isolation. It's like cooking. It depends on how the ingredients play together. So ideally, you want to find assets that don't move at the same time, they do different things. One of the attractive aspects of gold is that it tends to behave different than other investments. So it's diversifying. In that way, it helps dampen the volatility from your stocks and bonds and more traditional investments.


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