As we enter 2010 the weight of expectation for gold prices is greater than at any time in several decades. The hyperinflation camp and fiscal terrorists believe monetary and fiscal excesses is creating mountains of freshly printed money which will cause an uncontrollable acceleration in goods and services prices (not to mention asset prices) and drive investors into the relative security of a finite currency such as gold. Then there are the deflationists who believe years of profligate debt accumulation has necessitated a full unwinding of cross-border and domestic debt obligations at a personal, corporate and government level. The deflationist argument for gold looks back to multiple periods in our history where severe deflation caused runs on banks and on issuers of fiat currencies.

Last year it looked as though investors portfolio preferences had shifted rapidly towards gold in a relatively small space of time. In fact, investor buying, central bank buying and gold producer buying took place throughout 2009, totalling around 1500 tonnes. It seemed to accelerate in the second half (recall that gold was flat on the year by May) simply because the buying was being held in check in the first five months of 2009 by the biggest surge in scrap gold selling since the Asian Crisis in 1997-98.

Turning to 2010, the extreme outcomes being envisaged by markets (hyperinflation, default-ridden deflation or a central banks crisis) will have to come closer into view than they did in 2009 in order to have a dramatic impact on the price of gold. Much investment demand has been to insure against these events and the further we navigate 2010 without signs of monetary crisis the harder it will be for gold to enter the bubble phase many are hoping for, although gold certainly satisfies all the pre-conditions for a price spiral.

Whether 2010 will be gold’s breakout year remains to be seen. If the market decides that the Fed’s doubling of its balance sheet and extremely accommodative monetary policy stance was just a short term measure then gold prices could be vulnerable. The market may look back at the Fed’s balance sheet growth and argue that the actions post-Lehman should be understood as temporarily moving the wholesale money market onto its own balance sheet. Banks with surplus funds lent them to the Fed by holding excess reserve balances, and banks that needed funds borrowed them from the Fed through the discount window. Foreign banks that needed dollar funding got it through their own central bank, which got it from the Fed through the liquidity swap facility. Banks that were short of collateral eligible for discount borrowed directly through the new commercial paper facility. Shadow banks that could not deposit in the Fed instead bought Treasury bills, and the Treasury deposited the proceeds at the Fed.

Once we think about the Fed’s balance sheet expansion in this way, the doubling seems in fact rather small. After all, the wholesale money market is much larger than the mere trillion or so that Fed took on. In this context, the doubling of base money supply and the emotive term of printing money may not have a hyperinflation ending after all. Having said that I think there are at least two much cheaper ways of gaining exposure to protection against a monetary crisis and a potentially explosive move in gold prices than simply buying expensive and time-decay prone long-term call options. In fact, the skew toward long term call options versus equivalent puts has been at extremely unattractive levels.