MUMBAI (Commodity Online): By 2011, crude oil could break the $100/bbl mark while gold will break the $1500 barrier in 18 months, EURO-US Dollar will trade at 1.28 by end of 2010, according to an analysis by Bank of America-Merrill Lynch (BofAML).

The analysis pointed out that the targets may be achieved in a shorter span if central banks in emerging markets rush into gold sooner rather than later. But more critically, whether this change in correlations breaks the relationship between the EUR, commodities and risk appetite could well depend on the speed of the adjustment.

Traditionally, a weak US dollar against a basket of G10 and emerging market currencies could contribute to higher commodity prices. Since Ocobter, a vicious cycle of rising capital inflows into EMs, continued G10 and EM FX currency appreciation, and higher EM commodity demand has triggered a significant depreciation of the tradeweighted USD, pushing oil above $80/bbl. In turn, low elasticity of both demand and supply in the petroleum markets and a constant recycling of petrodollars into EUR kept oil prices and the trade-weighted USD trading in sync. This dynamic has also extended to other commodity markets.

Central banks in emerging markets (EMs) now realise that now realise “beggar-thy-neighbour” policies pursued by some G10 nations in order to get out of recession have natural limits. Political and central bank discomfort over USD weakness is mounting within G10. Few, if any, G10 nations are willing to embrace further currency appreciation given the current valuation levels. Now EM central banks have found out that adding more EURO, Great Britain Pound, Japanese Yen to portfolios is not that appealing while buying gold is. With G-10 fiat currencies suffering from a credibility problem, a move towards gold assets is likely, BofAML analysis said. As gold prices go up,commodities will follow.

There is a clear case to be made for stronger gold and oil prices and for a weaker EURO, but our view is not without risk. The negaive view on Euro-US Dollar could come under pressure if EM central banks decide to sell down their existing stock of fiat currency assets for gold. A move to diversify away from all G-10 currencies at the same time would hurt the US Dollar most given the higher USD weight in FX reserves. Meanwhile, a more aggressive shift out of fresh USD inflows into both EUR and gold by central banks could bring about the dynamic observed. In recent months, but the valuation and performance of the EUR during the crisis argues against this, BofAML observed in its analysis.



The sequence of events this week in commodity and FX markets suggests that it is possible to reconcile a weaker EUR with stronger oil and gold prices. As a result.Political and central bank discomfort over US Dollar weakness is mounting within G10. Few, if any, G10 nations are willing to embrace further currency appreciation given the current valuation levels. The problem is that every country with a floating currency is in the same situation, creating a vicious cycle, where a USD competitive depreciation leads to a GBP competitive depreciation, which in turn leads to a EUR competitive depreciation and so on.

Because the public finances of the US, Japan, Britain and the Eurozone are in such dire straits, it is hard to envision how these countries will return to trend economic growth without robust foreign demand.

Euro is too strong relative to other major currencies while cyclical and reserve diversification pressures will keep oil and gold on an upward trajectory. There are two channels that reconcile a weaker Euro with rising gold and oil prices. First, more flexibility in EM currencies (in effect a Chinese Yuan revaluation) will ultimately reduce reserve accumulation and flow diversification1 demand for EUR out of USD. At the same time, stronger emerging forex effectively will contribute to boost EM commodity
purchasing power. In turn, emerging market forex appreciation will likely reflect the strength of emerging economies and therefore be associated with strong commodity demand

Precisely because monetary policy is contagious, any given emerging market central banks can not hedge against further US Dollar weakness by buying EUR or GBP. This is because there is a significant probability that the ECB and the Bank of England will have to follow any monetary policy moves by the Fed, as it became apparent during the financial crisis. Then again, if emerging market central banks come to the conclusion that gold is better value than EURO, the problem of reserve diversification becomes one of game theory.

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