What's Driving the Golden Spike?

The key factors behind the dramatic rise in gold prices and a peek at what might be next.

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No matter where you looked during the second half of 2007, investing was a wild ride. Mortgage woes, a credit crisis, oil near $100 a barrel, volatile stocks, a slumping dollar—it's enough to send investors running for the hills. And, as in troubled times past, those hills have been filled with gold.

By the fall, investor demand pushed the per-ounce price of gold past the $800 mark, nearing levels not seen for 27 years. It was boosted at first by surging global demand, but gold's role as an investment, just like stocks, bonds, or options, has supercharged its latest ascent.

Here's a look at what's sent the price of an ounce skyward in 2007 and some bets on where it's headed next:

The dropping dollar. There's a reason currency desks also trade gold. When the dollar, the world's reserve currency, starts to lose value, all sorts of investments not tied to the greenbacks start to look more attractive. Gold is one of them, as it tends to hold value in uncertain times and could rise if inflation pressures appear as prices for foreign goods also rise for U.S. shoppers.

Fear. If you really expect that the U.S. housing debacle will drag the country—and possibly the world—into a severe recession, gold looks mighty attractive. Geopolitical threats, like the possibility of the war in Iraq ballooning into wider conflicts in Turkey or Iran or political upheaval in nuclear-armed Pakistan, bring out gold bugs, too. Those are just the latest bits of turmoil, following the tech bust in 2001 and the 9/11 attacks, that got investors thinking more defensively about protecting their assets with gold. "You had investors looking around for ways to diversify their portfolios and ways to hedge themselves against adverse market activity. Gold has sort of been reborn as an alternative investment class," says Joe Foster, a portfolio manager at the Van Eck International Gold Fund.

New investors, big and small. New ways to invest in gold have attracted both individual and institutional interest. The research firm CPM Group estimates that gold holdings by exchange-traded funds in November shot up more than 25 percent from just a year earlier. At the same time, analysts also say volatility in the gold market has surged, in part because of hedge funds jumping in and out of the market and thus sparking larger-than-average price swings. Back at the start of the year, daily gold prices mostly fluctuated in a $5-to-$10 range. Now, $30 swings aren't uncommon in a day.

Soaring oil. When oil prices move up, gold often follows suit as investors consider how high energy costs will boost inflation. In November, when oil neared $100 a barrel, gold broke new ground as well. While crude has pulled back to around $88 today, the gold market still clearly sees some risk of rising price pressures due to higher energy costs.

The Fed. With the Federal Reserve and other central banks cutting interest rates, gold's rise might seem a bit odd. After all, it's traditionally a hedge against inflation, something the Fed currently doesn't seem to view as its biggest problem. But the Fed's reasons for cutting rates—namely, slowing U.S. growth and uncertainty surrounding housing, the financial industry, and consumer spending—have sparked extra interest among investors looking for a bit of shiny insurance against either surprise inflation that the Fed won't be able to fight or a severe downturn in the economy (or, most worrying, both at the same time). Consider this: The last time prices topped $800 an ounce was back in 1980 (in today's dollars, the price was more than twice that), when core inflation was running well above 10 percent and when the economy dipped into back-to-back recessions.

Basic supply and demand. While all those factors are behind the headline-grabbing surge in gold, the floor for a pullback in prices has been creeping up, too. Mining costs are now running at around $400 an ounce vs. $250 in 2001, as big scores of easy ore become tougher to find. At the same time, demand for jewelry among India's growing middle class and from industrial users in China has soared along with those booming economies—though it's unclear whether they'll pull back now that prices are so high. Still, gold bulls like Credit Suisse predict demand will rule the day in the long term, noting that lower mine output could finally lead to a net deficit in the gold market starting as early as 2009 to 2010.