Will gold hold onto its gains?

Chris Laird
www.PrudentSquirrel.com
Nov 7, 2007

With gold ratcheting up to new highs in the $800s, we may easily see $850 and even $900 very soon. Oil is going out of sight, but there are some good fundamental reasons - like Yemeni pipelines blowing up, North Sea shutdowns, the ever present new manifestation of Mid East turmoil - and a Pakistani political crisis as they impose state of emergency measures. Of course with all this profit in the gold complex right now, some profit taking and consolidation is quite possible before $900.

Nevertheless, our question here is - is gold carving out new high prices that are going to stay with us into 08, or even longer, and maybe find its prices in staying over $1000 in 08? We surmise this is likely, as the USD carves out a permanent new low range well below 80 on the US dollar index, its former low.

USD driving gold

The real driver of gold is the ongoing fall of the USD, which so far has not seen a bottom after it fell below 80 on the USDX. When the USD fell below 80 on the USDX recently and stayed there, that was a new low range, as 80 has been a low for many years. Formerly, whenever the USD dropped to 80, it was supported. Our trade partners' central banks would intervene. Even if it did drop below 80, it was a blip. Usually, when the USD hit that level, it signaled a short term USD bull, and the USD would get back up to 84, 85, or higher.

During those times, 700's was pretty much a high range for gold recently. But gold's new record highs (nominally, not inflation adjusted) reflect evidence that the USD is finally turning to a new low range on the USDX (basket of currencies heavily Euro weighted). Right now, it's a question of whether the USD will carve out a range in the mid 70's, or can it even break into the 60's?

Major central banks have recently stated they are moving their minimum USD exchange rate tolerance lower. Up to recently, the ECB stated 1.40 USD to the Euro would cause intervention. Now that has changed to 1.50, according to some of their comments. Up to now, the BOJ would intervene to support the USD if it threatened to hit 110 Yen to the USD. That might still happen, but they recently made comments that the new defense level could be 100 Yen.

Those are two major changes about USD exchange rate policy since recent years. Those statements, and China's noises about the USD losing its world reserve currency status, have made currency markets realize new lower ranges for the USD below 80 on the USDX are likely permanent. The only question just now is where is the new low range? The USD is presently at 75.31, gold at an amazing $840.

There are a lot of reasons for the USD to weaken and find a significantly new low range right now. Probably the most significant is that our trade partner central banks have apparently decided to let the USD find new lows, whereas previously they defended the USD at 80. Of course we all know there are many good reasons for the USD to weaken, like a weakening US economy, huge trade deficits and so on. But, up to now, our trade partners were willing to support the USD despite that.

If central banks have indeed decided to let the USD find a new low range, then gold will reflect that. In fact, gold will outrun the actual USD fall (increase disproportionately) because central banks new lower USD policy is a major change from recent years. And of course, when gold carves new highs like this, and the USD new lows, speculators are all over gold, and a weak dollar.

The question becomes, then, will gold's new highs, and the USD new lows remain with us, or will this merely be a recent spike, and a significant correction come about, and gold return to the low 700's for example?

Or are we now next looking at gold prices over $1000, and in two years you will kick yourself for having to spend thousands of dollars an ounce to get some? "Darn, I could have bought gold at $800 bucks last year, and now its $1600!" - etc.

A permanent new high range for gold?

So we discuss the question of permanency of new gold prices levels - and are we next looking at over $1000 gold by January, and will the $800s be a new floor?

First of all, if gold is to remain at these new high levels ($800 and more) there have to be good fundamental reasons that stay with us. The foremost of these would be that the USD is now permanently in a new low range. (below 80 on the USDX and going lower for years to come).

I remember Paul Van Eden [van Eeden] discussing gold and the USD several years ago, and he repeatedly stated something like 'it's all about the USD, as far as gold prices.'

I agree with that view. We hear lots of discussion about Mid East turmoil boosting gold (true), oil prices boosting gold (true), wars, and various reasons for flight to safety. But these cases are usually short term events, and when the chaos subsides, gold falls back to whatever major trend it began in. Gold's major trend has been grinding higher and higher since '02. The USD's grinding lower and lower, but it did have a floor at 80 on the USDX for many years due to trade partner intervention.

There is such a huge USD footprint on the world economy that any movement in the USD affects gold prices more than anything else.

So, since the USD appears now to have permanently broken below 80 on the USDX, we definitely have a major change in world currencies and gold. In fact, as other central banks continue to raise rates to fight inflation, or find it very hard to ease because of inflation, and then the US must ease rates to deal with our various economic problems, and a very serious credit crisis - it is easy to make a case the USD has indeed carved out a permanent new lower range below 80 on the USDX, now in the mid 70's and still falling.

All of this means a weakening US interest rate premium to other currencies, a lower USD, and probably a new high range for gold that will stay with us. These are the long term trends supporting gold.

Now, a comment on the weight of the USD to gold, and or, gold to other major currencies. Gold is a central bank reserve asset. Central banks also hold other currencies as reserve assets. They can then use these reserve assets to support the value of their currencies.

Since gold is a reserve asset, unlike other commodities, its value is primarily driven as a comparison of the total gold reserves outstanding to the total of any one currency outstanding. In other words, since the USD is so huge worldwide (so much out there, and a primary world reserve currency) gold's' price is primarily driven by what the USD does. Gold is not primarily driven by varying yearly jewelry demand in India or Asia for example.

Gold is not primarily driven by oil prices. Both Jewelry and oil do significantly affect gold, but they are not primary drivers. What is a primary driver is the very roughly 100,000 tons of gold held for bank reserves, or safety by the public as money, compared to what the currencies do.

A fluctuation of 400 or 500 tons in gold demand in a year is a drop in the bucket compared to 100,000 tons outstanding. (I know there are more than 100,000 tons but I'm just using that as an example). Additionally, a 500 ton increase in speculative gold demand in a year is quite significant, but that component of gold demand is here today and gone tomorrow, and mostly just adds volatility. Gold ETFs are growing tremendously this year in tonnage.

And, even in the case of that gold ETF growth, much of it is not just speculation, but is due to flight to safety - protecting money from inflation, and a falling USD for example.

Gold is in a long term bull market vs the USD, and is going to go much higher in coming years. The political chaos, high oil prices, and other gold bullish factors are merely adding fuel to the fire. So is renewed speculative interest and ETF growth, but that component is very flighty.

Of course, gold can correct significantly if there is a serious world stock sell off, as this has happened numerous times this year. Nevertheless, apart from a long term world market selloff that does not recover, I expect gold to get over $1000 in 2008, and probably hold onto those gains. The primary reason is a new lower USD range, yet to be determined, that will likely stay with us going into '08. It is key that central banks appear to have decided to let that happen.

We have been discussing these issues in our PrudentSquirrel newsletter recently. We have been able to anticipate the 4 major market sell offs this year by up to two days. Subscribers also get mid week email market alerts, and they say that feature is greatly appreciated. You might take a look at our alerts link on the main page to see what kind of topics they covered.

Stop by and have a look.

Chris Laird