Gold - Still a Barbaric Relic?

My name is gold. For many years, for a variety of reasons, the bears have despised me. I must ask why? I have many attributes. I am a hedge against the inherent inflation risks of holding fiat currencies. I have many industrial uses and I am very much in demand by the jewelry industry. Please don't hate me because I'm beautiful. Also, why is it that I am still referred to as "that barbaric metal?" It is true that I have been around since the beginning of time, but it is also true that I have had value for thousands of years. How many of the world's currencies that were in existence, even in the last century, are here today and how many of those have held their purchasing power?

Bullish Reaction to Bearish News

Gold has made a historic move to the $1,030.80 level, at a time when history has shown that many commodities, including gold, usually do not advance in price in times of economic weakness. Some analysts have argued that demand from hedge funds and exchange traded funds artificially and temporarily pushed gold futures to historical highs. There may be some truth to this line of thinking. In light of this possible reason for the recent strength in gold futures, the question must be asked; how come various commodities, such as coal and steel, which do not have as much speculative interest as other commodities, were able to advance to extreme high levels, as well? Why are many commodities going up in price at a time when near recession, or recession has historically resulted in weaker demand for commodities, as industrial and speculative demand often cools? The housing market is in a shambles, which is evident in all sectors of the industry. For example, the recent U.S. pending sales of existing homes in February fell to its lowest level since the index began. This suggests it may take longer than previously anticipated for a bottom to be made in the housing market; especially since credit conditions continue to tighten. Even Manhattan apartment sales fell to their lowest level in 18 years. The housing slump has also arrived at the Hampton's, as prices for new single-family homes have fallen over 19 percent in recent months. We are definitely in a period of economic weakness, which Federal Reserve Board Chairman Ben Bernanke recently acknowledged was a possibility. He also said the U.S. economy will not grow much, if at all, during the first half of this year and even "could contract slightly." He also said the growth outlook was weaker now than it was when the Federal Reserve released its last set of forecasts last January and the "uncertainty about the inflation outlook has increased." Inflation concerns are not only a domestic issue. Euro zone inflation has rocketed to its highest level in almost 16 years and is well above its target growth rate of around 2%. The Bank of England has an inflation target of 2% as well, but inflation in February was at 2.5%. China is also experiencing an inflation problem. With all of the increased levels of inflation that we are seeing in so many parts of the world, it appears as though the bullish inflation influence on gold is more than offsetting the bearish influence of prospects of international economic weakness. Another possible explanation for the strength in commodities, in general, including gold, may be due to the growth of the federal budget deficit in the U.S. Expenditures for the military continue to expand and there appears to be few on Capitol Hill that are calling for fiscal restraint. The worsening projections for the federal budget deficits and the national debt are not supportive for the long-term outlook for the U.S. dollar and therefore, remain bullish long-term influences for gold.

Real Interest Rates, Inflation and Demand

In addition, the real interest rate influence is turning more bullish for gold. Real interest rates are calculated by taking the nominal interest rates, such as the three-month Treasury bill rate, minus the inflation rate, either expected or actual. Currently, the real interest rate in the U.S. is less than zero, which is essentially “free money” and is highly inflationary down the road. All of this is long term bullish for the gold market. Another U.S. dollar bearish influence and bullish gold influence is the growing trend toward international business beginning to shun U.S. dollar denominated transactions. Currently, there are increasing numbers of Chinese exporters that are shying away from the U.S. dollar and attempting to conduct more of their business in Euros or British pounds. Also, some of the deals that the Chinese are making in U.S. dollars are subject to price adjustments prior to shipping. Lately, even some rock stars are demanding that their contracts specify that they be paid in Euros and not in U.S. dollars. While there are many major bullish influences on the gold market, as the U.S. dollar declines, there are a few offsetting short-term bearish influences, as well. For one, consumers in India, who buy about 25 % of the world's gold output, are beginning to slow their purchases. By some accounts, gold demand in India has dropped over 60% on a year-to-year basis. It looks as though the recent high prices for gold have started to adversely impact the demand for gold jewelry, not just in India, but on an international basis as well.

International Monetary Fund Gold Sales

Another short-term bearish influence is news that the International Monetary Fund has decided to sell about $11 billion in gold reserves, which is the equivalent of about 13 million ounces. This proposed sale represents about 12.5% of their total gold reserves. Although this planned gold sale cannot take place until it gets approval from the U.S. Congress, the psychological impact of this much gold likely to come into the market is having, at least, some negative impact. This remains a short-term bearish influence on gold even though International Monetary Fund officials said "gold sales would be conducted in a transparent manner with strong safeguards to ensure that they will not result in any market disruptions." Another short term bearish influence on gold is the fact that the implied yield curve, which is based on Eurodollar futures, is inverted until September of this year. The yield curve is inverted when short-term interest rates are higher than those of longer maturities of the same credit market instrument. The significance of an inverted yield curve is that it is one of the best indicators of an impending economic slowdown. Between now and September, we can expect bearish on balance economic news. This in turn, implies less demand for commodities, in general, including gold. Because the short-term fundamental influences are currently offsetting, gold futures are likely to remain in a trading range with breakouts not following through in either direction between now and early September. However, the outlook for gold futures changes dramatically in September, based on our fundamental and technical analysis. This is because that whenever the yield curve changes from inverted, which represents a slowing economy, to normal, which represents a growing economy, demand for commodities, including gold, normally increases. The vast majority of the time the yield curve is "normal." This is when short-term instruments carry lower yields than those of longer dated maturities. This is logical since investors demand a higher rate of return when holding longer-term debt obligations. This "normal" yield curve, which reasserts itself in the early fall period of this year, is consistent with a healthy economy that is likely to grow at anticipated rates. An anticipated better economy near the end of the year should increase demand for commodities, including gold. With real interest rates at less than zero, which is also highly inflationary, we will have the perfect storm for another major up leg in gold futures. While there may be little follow through in either direction in gold futures between now and early September, expect renewed inflation forces to emerge later this year. This in turn, will propel this "barbaric relic" to new historical highs that are likely to take place between late this year and the middle of 2009.

Trading Strategy

This is one of only a few markets that should only be traded from the long side. It is not just because the main trend is higher. This is because geopolitical incidents are not pre-announced and can be devastating for those who are caught short. Between now and September, trade from the long side, but be willing to take profits on rallies. However, when September arrives, be ready to establish long term long positions in this market. In order to calculate an upside price objective we have employed the measured move technique of determining price targets. The price objective that we have calculated is derived from the weekly June gold futures chart. When the price difference between the August 2007 low and the early March 2008 high is added to the late March 2008 low, we can calculate a price objective of 1245.20. This anticipated resumption of the bull market for gold is likely to be a multi-year event.

Alan Bush

Sr. Financial Futures Analyst
Archer Financial Services
1.800.243.2649 ext 7911

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