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The inverse relationship between gold and US dollar has been broken in recent months and other commodities followed the yellow metal.  The current gold rally is not based on fundamentals and is speculative whic..
12 Mar 2009
Commodity Online
MUMBAI: Traditionally, gold would have an inverse relationship with dollar. When US dollar rises gold falls and vice versa. However, in the past few months both the gold and US dollar are simultaneously rising.

Daniel Tenengauzer, Head of foreign exchange strategy at Merrill Lynch notes that the correlation between the US dollar and the price of gold has suddenly and inexplicably broken down. Merill Lynch points out that there are significant risk to the yellow metal in the near term but a small allocation for the longer-term oriented portfolios is advisable.

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Francisco Blanch, head of commodity strategy at Merrill Lynch, has pointed out that this odd combination of gold and the US dollar appreciating at the same time has made gold more attractive to non-US dollar investors.

The dramatic change in the correlations between gold and the US dollar does seem worrisome, especially when other commodities are not performing well. Traditionally, most real asset investments tend to outperform when the US dollar depreciates in value. For example, commodities performed exceptionally well through most of this decade in conjunction with the US dollar’s decline. However, commodities began to underperform as the dollar bottomed and began to appreciate.

Investors have to draw a distinction between momentum and speculative investments and those that are longer-term and fundamentally based. Merrill Lynch points out that fundamentals tend to provide better returns in the long run rather than momentum, speculative investments.

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However, recent gold rush in not based on fundamentals but on speculation. The stronger US dollar, the significant increase in the shares outstanding of the most popular gold-related Exchange-Traded Fund (ETF), and the recent significant repositioning into gold of hedge funds and long-only portfolio managers are just a few examplesGlobally, most popular gold-related ETF, SPDR Or GLD has seens its shares outstanding rise 33% since the beginning of this year. That figure is well above the historical trend increase in the shares outstanding and shows a record increase in demand for gold by investors. Importantly, this reflects financial demand or potential speculation, and not fundamental demand, Merrill Lynch notes in its report.

The small cap value mutual funds now hold more than 2% of their assets in the SPDR or GLD, up from virtually zero in 2008, Steven DeSanctic of Merrill Lynch said. It appears as though traditional long-only equity managers — who are supposed to
pick stocks based on company fundamentals — increasingly are making macroeconomic asset class investment decisions.

Mary Ann Bartels, chief market analyst at Merrill Lynch, has noted that hedge funds are very long gold. According to her work, large speculators now have about $16 billion long exposure to gold. Such levels have historically signaled a “crowded”
trade and near-term price risks. She also points out that large speculators’ exposure to gold is larger today than during the somewhat panicked period right after the fall of Bear Stearns.

Movements of the US dollar can explain 70-90% of the movement in the price of gold in the last 5-10 years. More recently, gold was a stellar performer during 2008, but the bulk of gold’s performance came in the first half of the year when the US dollar was weak. Gold’s returns dropped once the dollar stabilized and began to appreciate during the second half of the year.

Some, like Dave Rosenberg, chief North American economist at Merrill Lynch  have argued that this inconsistency can be explained by the increase in deflationary fears. Dave’s studies show that although gold is often thought of as an inflation hedge, historically it also has been a hedge against deflation. Inflation expectations are beginning to slide again and gold’s performance has begun to slow.

It will be interesting to see if gold’s performance can be maintained if inflation expectations continue to fall.

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