By Gnanasekar Thiagarajan
The price of gold can reflect many macro variables at once. We believe three variables alone go a long way in explaining the fluctuations in the price of gold: risk, currency and commodity prices. Gold is sometimes a currency, sometimes a commodity and sometimes a store of value.

With the outburst of the credit crisis last August, we entered into the first step where gold started to reflect the rising risk premium. While comparing the fall of commodity prices due to the credit crisis, we see that only gold held on so well, mainly due to the risk premium.

Flight to safety:

Despite the recent coordinated measures across the world to calm the markets, the global liquidity crisis is nowhere near its end. Moreover, with higher gold lease rates, gold is even trading in parity with money-market rates and increasing its appeal relative to holding cash. This all suggests that flight-to-safety will still be the main driver of gold prices for some months to come and gold could revert back to $1000/oz in the process.

Gold is expected to develop a stronger trading link to the currency world as risk premia on money stabilize. Then, as the United States fiscal and trade deficits gets un-manageable, the weaker dollar could then help gold break through $1200/oz.

Inflation returning…

There is a good chance, that the monetary easing we are seeing now will be overdone. Consequently, the world may be facing serious inflationary pressures later if the current policies are successful in avoiding deflation. The current global bank bailout is inflationary, and will likely result in more money chasing the commodities.

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In turn, the combination of higher cost of money and higher input cost inflation could force oil back up to $100/bbl. As we expect gold to maintain its long-run relationship with other commodities, gold prices could well push higher to $1200/oz.

The lack of investment in supply infrastructure has been the major force behind the current commodity super-cycle. As Emerging Market economies go back to their long-term growth trends, they will do so in an environment with severe supply bottlenecks.

In fact, even considering the recent sell-off in commodities, gold prices are still cheap relative to oil prices. In our view, gold prices could appreciate strongly in order to keep their long-run historical relationship to other commodity prices.

What can possibly go wrong to the bullish view?

Should the financial stress turn out to be more severe in other countries, the dollar could fail to depreciate in the medium term and in-turn limit the upside on gold. The situation therefore reflects a shortage of USD as market participants reduce risk and push money into the safety of US Treasury bonds.

Similarly, should a deflationary spiral take over the global economy, the next big leg of commodity price inflation may simply not happen, again limiting the upside on gold.

Gnanasekar Thiagarajan is Director, Commtrendz Risk Management Services Pvt Ltd

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