Why gold isn't falling in deflationary environment?

Summer inflation worry was all gone.  Now everybody is worried about deflation, including Bernanke.  So why the gold, the hedge of inflation, isn't falling? (Source: WSJ)

Many corners of the market are fearing deflation. So why is it that gold isn't selling off sharply?

As the quintessential hard asset, one that traditionally hedges against rising consumer prices, gold's trajectory these days should be downward. After all, prices for just about every other commodity, from oil to nickel to cotton, have plunged as inflation risks have seemingly abated and as investors increasingly fear deflation.

Yet, gold has largely traded between $750 and $850 an ounce for the last few months, and is up about 8% since the Fed cut interest rates to between 0% and 0.25% last week.

It hasn't been an entirely smooth ride. Gold sank amid panic this fall as investors crowded into the U.S. dollar. And it remains well under its $1,002 close back in March. But the metal hasn't stumbled nearly to the degree many other commodities have. Clearly, deflation worries aren't tugging at gold.

Instead, other factors -- historically low U.S. interest rates, U.S. dollar weakness and the longer-term inflationary pressures of the Federal Reserve throwing trillions of dollars at the American economy -- "mean the environment is favorable for gold," says Tobias Merath, head of commodity research at Credit Suisse in Singapore.

The Fed's recent actions and words -- that it will pursue unconventional stimulus such as buying agency debt, mortgage-backed securities and, potentially, longer-term Treasurys -- have pushed Treasurys to unusually low yields.

That development neutralizes a key argument against gold: that gold imposes a holding cost since it generates no interest. Now, the U.S. dollar, measured by short-term T-bill returns, effectively offers no yield either.

And while inflation isn't apparent today, stimulus packages and bailouts mean much more money in the system. That is classically inflationary. Moreover, despite efforts to sop up this liquidity later, the effects of unintended consequences might mean some portion of the trillions added to the Fed's balance sheet are likely to "stick around" to fuel inflation, says Axel Merk, who recently increased gold exposure in his Merk Hard Asset Fund and personal portfolio.

Says Malcolm Southwood, commodities analyst at Goldman Sachs JBWere in Australia, "I'm telling clients that the environment over the next five years is extremely constructive because of the inflationary risks further out."

Near-term gold could still demonstrate some weakness as the last of the panic trade peters out. And if the European Union cuts interest rates, as some expect, that could boost the dollar's value, which could undermine gold. And U.S. and European Central banks could sell gold to raise cash to pay for bailouts, which would be bearish for gold prices. But Mr. Southwood suspects Asian central bankers looking to diversify reserves would grab that supply, seeing the sales as "an alarm signal about the dollar."

And what if deflation does hit? Even that doesn't necessarily spell doom for gold, as some think. During the deflationary Great Depression, "gold preserved its value," says Matt McLennan, a lead manager at First Eagle funds, which runs a gold fund. "It preserved its purchasing power."