Gold shed $57/oz over two days in early February, falling to its lowest fix since October 2009 on 5 February, at $1,058/oz. The immediate cause was a stronger dollar, but although the US currency has appreciated significantly against the euro and other currencies so far in 2010, the extent of gold’s move on those two days was significantly larger than the change in the value of the dollar – the US currency gained 2.1% on its dollar index between 3-5 February, and 1.8% against the euro, but Gold lost 4.8%.

Gold was not the only asset to fall – other commodities fared worse, e.g. LME base metals (on their index) fell by 5%, the S&P GSCI commodity index lost 6%, and other ‘risky’ assets such as emerging-market equities suffered, with the MSCI Emerging Markets index falling 6%, and the HSBC Emerging Markets index down 7%.

The reason for the rout seems clear enough, and was the same reason that pushed up the dollar. An increase in ‘risk aversion’ caused by fears over the credit-worthiness of Greece and other European countries, plus signs that the Chinese authorities were taking actions to rein-in the country’s rampant growth, created a flight-to-safety, of which the US Treasury bonds and the dollar were the main beneficiaries.

Why didn’t this help gold, which after all is seen as a safe-haven? The answer seems to be “it depends”. On each of the 11 trading days since 2004 when the MSCI Emerging Markets index has fallen by more than 5%, gold has risen on six and fallen on 7; excluding the effect of the dollar, which tends to rise on such occasions, gold has risen on eight and fallen on five. But on three of those five it has fallen by a hefty 3-4%, similar to this time around.

These occasions seem to be when there has been a rein-in of carry trade positions (dollars borrowed in the US to fund more lucrative investments elsewhere). As investors liquidate assets to obtain dollars, the price of those assets fall, and gold is no exception.

The fall would make sense if gold investors fit into broadly two categories – those who hold gold for “safe-haven” reasons over the medium to longer-term, and those with a shorter-term outlook that are holding it merely because it is going up. If the latter sell when risk aversion rises, then the extent to which the gold price falls on such occasions will depend on what proportion they make up of the investment community; given gold’s tremendous run since September 2009 it was probably higher than normal before the most recent correction.

Yet there is another puzzle and problem – the lack of obvious investment flows into the ETF, either inflows or outflows. The market leading SPDR ETF by 8 February had seen an outflow on the week earlier of only 5t, and this was due to an outflow of 7t before the price crash on 4 February – after that there was an inflow of 2t. This perhaps suggests ETF holders are more long-term investors. Nevertheless, the lack of investment inflows is a problem for the Gold market – across all 17 gold ETFs we track, there was a net outflow of 21.4t in January, and about 7t so far in February.

Small as these are they are a problem. At this time last year, there were huge inflows, 105t in January 2009 and an enormous 221t in February 2009. Unless inflows pick up in the next few weeks that will be a gap of about 350t in two months alone – and one that needs filling elsewhere.

The big question now is – can gold fall further? Despite the stronger dollar, gold has held onto some of the gains it made in Q4 2009. Compare the gold price now ($1,060/oz) when the dollar index is just over 80.4, with what it was ($930/oz) when the dollar index was last over 80.4, in early July 2009. It’s evident how the gold price responds to the dollar; in 2H 2009 up to 2 November rising as the dollar fell in a pretty consistent way.

Then, although in November/early December the dollar fall slowed, the gold price increase accelerated. Now, after 4 December, the dollar has been gaining and the gold price falling, but gold is now at a consistently higher level.

Short-term outlook on gold

There are two risks for gold: further dollar gains, and/or a realignment of gold prices at every dollar level. The former is probably not too worrisome; currencies go up and down. The latter would be worse, if for example investors decide it’s time to take profits and run.

Certainly, there seems little inclination to add to positions. We think this scenario is unlikely while the debt/deficit situation is so severe and inflation one possible remedy. In the short-term then nervousness about the dollar’s recovery will dominate $1,020/oz-$1,120/oz.

Courtesy: Fortis Bank Nederland - The Metals Monthly February 2010

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