On Wednesday, I wrote a short piece on the Fed’s announcement that it would buy longer-term government debt.  In the comments of that post, I received a question asking, “Can you provide some insight as to why this would have caused gold to lose value?”

I was going to defer this question until later in the week, but gold had a huge down day again on Friday, this time dropping about one hundred dollars in one day.  This was mild compared to silver in percentage terms, which has basically crashed this past week.

First, I should point out that in a somewhat free market, all prices are determined by buyers and sellers.  This is no different for gold and silver.  There were obviously more anxious sellers of gold this past week than there were buyers.

With that said, I can speculate on some of the reasons that gold had such a terrible week.

On Friday, there were stories about an increase in the margin requirements in the gold market.  Many believe that this caused the sell-off and there is probably something to that.  In addition, this happened after it had already had a fairly big sell-off during the week.

As to the drop in the price of gold on Wednesday, there was apparently something that did not please gold owners about the Fed’s statement.  I think one possibility is that the market expected more from the Fed.  Many investors were hoping, or at least expecting, that the Fed would announce some mild form of QE3.  But the Fed’s announcement to rearrange its portfolio does not add any base money.  For the longer-term government bonds that are bought, an equal number of short-term bonds will be sold (or retired).  We should not see any significant increase in the adjusted monetary base based on these actions.  In other words, gold investors were counting on more loose money from the Fed and they didn’t get it with that announcement.

Another possibility in contributing to the gold price decline this week is that the economic outlook is gloomy.  This was confirmed by the Fed’s statement.  If we enter into another recession (even though I’m not sure we ever left the first one), this may be very bad for gold in the short run.

For some reason, investors still flock to the U.S. dollar during recessions.  I’m not saying they should flock to the euro or some other fiat currency, but it is fairly obvious that the U.S. dollar is in a long-term decline.  But economics and investing is based on human action, and a lot of individuals still like to park their money in U.S. dollars during down times.

This means that the velocity of money may slow down even more.  There is a higher demand for dollars (more liquidity and perceived safety), so dollars are not changing hands quickly.  Banks are not loaning money like they used to and consumers are not spending money the way they were 5 or 10 years ago.  This puts a downward pressure on prices and this will include gold and silver.

Although the gold market suffered greatly this week, I am still bullish on the metal right now.  In the not-so-distant future, we will start to see days where the metal is also going up one hundred dollars or more in a day.  It won’t just be on the down days when we see these big moves.  That is when you will know that we are getting close to bubble territory.  But even when we get into a gold bubble, we can expect it to last for a while and see prices go to the moon.  There will be a time to sell some gold (not all) and take some dollar profits.

If this crazy week in the markets confirmed one thing for me, it is the wisdom of the permanent portfolio.  It showed us that it is better to put more in gold than silver.  It also showed us it is important to have some exposure to bonds, as that was the only thing (besides cash) that didn’t get hammered this week.