Image: Gold © Comstock Images, Jupiterimages

Something curious is happening in the precious metals market.

Fundamentally, there couldn't be a better time to own gold and silver. But technically, the shiny stuff has just been hammered, inexplicably suffering a 1987-style plunge last month. Did a hedge fund blow up? Are policymakers pushing on prices to keep inflation expectations down? Are computer trading algorithms causing problems? We just don't know.

Now the question for investors is: Has the best buying opportunity we've seen in decades arrived even as most of the market focuses solely on stocks, or is gold a lost cause?

In fact, if the crash continues, gold's role as an important market signal points to two economic possibilities that would take many people by surprise.

Here's where I see gold headed and why.

The basics favor gold

The core bullish argument in favor of nibbling on gold and silver at today's low prices lies in their value as an alternative store of purchasing power, given that currencies are being diluted at an unprecedented rate, financial markets are frothy and real-estate and farmland prices aren't exactly at rock-bottom levels.

The four largest central banks are abusing their currencies as fast as they can, with Japan going for broke with the "cheap money will save us" meme while the European Central Bank cut rates earlier this month for the first time since the middle of 2012. And in just the past month, smaller central banks have begun joining in with gusto. Australia cut rates to record lows. Denmark cut rates. India cut. Turkey cut. South Korea cut. Israel cut. Kenya, Belarus, Poland, Georgia and Sri Lanka also cut.  

When the world is being flooded with cheap money, Economics 101 tells you the prices of all tangible assets -- including gold and silver -- will eventually increase. And that's why this could be a great buying opportunity.

But where's the inflation?

To understand why gold and silver are down, we need to understand why they went up.

Fear of inflation was the primary driver of the rush into precious metals back in 2011 that pushed gold prices skyward toward $2,000 an ounce, compared with $1,425 now. But this fear hasn't mattered much lately because inflation hasn't been a problem.

Thanks to some recent strength in the U.S. dollar and a deteriorating economic outlook, deflationary pressures have been more acute. The annual inflation rate as measured by the Consumer Price Index fell below 2% in early 2012, and it has pretty much stayed there since.

Central bankers are using this to justify their increasingly aggressive (I'd say desperate) cheap-money policies.

I think it's a sign that cheap money is losing its effectiveness. But they think it's a sign that they aren't trying hard enough -- despite the rising risks of negative consequences, including pushing older investors into inappropriately risky investments, creating asset price bubbles (just look at junk bond yields dipping below 5% for the first time), encouraging Washington, D.C., to continue its spendthrift ways and possibly -- as suggested by Stanford economist John Taylor -- holding back the recovery by interfering with the availability of credit.

While the prices of energy and food are relatively benign right now (except for natural gas, which is creeping higher), the two deeper structural drivers of inflation -- wages and housing costs -- are starting to edge higher. Wages are set to rise in response to falling labor productivity, increasing numbers of job openings and declines in the quality of applicants. And the housing recovery, which so far is being driven by investors looking to be landlords, will add further upward pressure to measures of housing costs. Rents are already rising, as the chart below shows.

Consumer Price Index

Add it all up and inflation has to be the result. That's bad for everyone in a lot of ways, but it's good for gold.

Now we hate gold?

Also weighing against precious metals has been an absolute collapse in sentiment and a fervent withdrawal of cash from the sector.

Net asset value in SPDR Gold Trust

The chart above shows just how quickly gold has lost favor among investors as funds have poured out of the SPDR Gold Trust (GLD) exchange-traded fund at a parabolic rate. Current asset levels in GLD have returned to late 2009 levels, a time when the Fed's monetary base was around $1.7 trillion instead of the $3 trillion-plus it has swollen to now.

Separately, according to the folks at SentimenTrader, small speculative traders in the futures market have gone net short, meaning that they are actively betting on further gold price declines, for the first time since the early 1990s. That's right. People haven't been this out of love with gold since George Bush the First was in the White House, Paula Abdul was on the radio, and "Terminator 2" was blowing up movie theaters.

 What's gold telling us?

I want to make one final point that's illustrated, somewhat cryptically, in the chart below. I'll explain.

Gold Fixing Price

The blue line is the Federal Reserve's short-term policy interest rate minus the year-over-year change in the Consumer Price Index. When this measure is negative, as it is now and as it was back in the 1970s, it signals an extremely inflationary condition, since real or inflation-adjusted interest rates are in negative territory.

In other words, after accounting for inflation, money isn't just free right now; people are paying you to borrow it (as long as you're a big bank borrowing from another big bank).

The red line is the annual price change for gold.

Image: Anthony Mirhaydari - MSN Money

Anthony Mirhaydari

The pattern has been that when the blue line goes negative, gold tends to perform very, very well as investors worry about erosion of the dollar's purchasing power. The worry ran deep in the late 1970s. That changed in the early 1980s, when gold prices collapsed as former Federal Reserve Chairman Paul Volcker jacked up interest rates to more than 20% -- well above the CPI rate -- to kill inflation.

The odd thing right now is that gold prices have collapsed to about the same extent in dollar terms, even though interest rates and inflation haven't really changed.

This could suggest that the market is expecting either a dramatic increase in interest rates from the Fed or a deflationary collapse in the economy. Both would be bad news. But both possibilities seem very unlikely at this point.

And that means that the sell-off in gold could be severely overdone, possibly caused by some kind of market dislocation, and prone to a rebound at least to its 50-day moving average -- which would be a 15% move up from here.

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This means that, with gold and silver prices stabilizing over the last month, it may be worth nibbling on precious metals down at these levels. Whether you're buying for long-term diversification or inflation protection, the prices look tempting.

More aggressive buying would be warranted if GLD or iShares Silver Trust (SLV) breaks through its upper Bollinger band, a technical sign that marks the start of an uptrend. Both are about 5% below this technical threshold right now.

At the time of publication, Anthony Mirhaydari did not own or control shares of any equity mentioned in this column in his personal portfolio. He has recommended both GLD and SLV to clients.

Be sure to check out Anthony's new money management service, Mirhaydari Capital Management, and his investment newsletter, the Edge. A free, two-week trial subscription to the newsletter has been extended to MSN Money readers. Click here to sign up. Mirhaydari can be contacted at anthony@edgeletter.com and followed on Twitter at @EdgeLetter. You can view his current stock picks here. Feel free to comment below.