What's Next for Gold and the Dollar?

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 |  Includes: DGL, GLD, IAU, UDN, UUP
by: Daniel Zurbrügg

In our May issue of our newsletter we looked into the changing importance of and outlined our investment case for gold. At that time, we made the following forecasts:

  • Trading within narrow range (USD 860-950) for Q2, 2009
  • Move towards and eventually breach the USD 1,’000 mark in Q3/Q4, 2009
  • Increased supply/demand shortfall
  • Increased demand as inflation hedge

Now, about six months later, these forecasts have become reality

Half a year after we made these forecasts, we can tell that they were pretty accurate. As we are writing this report here in early October, Gold has not only broken the psychologically important USD 1,000 mark but has actually moved upwards to USD 1,050 already and continues to follow a strong upwards trend. In our previous reports we have mentioned several times that gold, although it is a non-interest bearing investment, is a very compelling investment case since its relative importance is increasing quickly. The main reasons for this are investors demand for an inflation hedge and as protection against another very severe crisis.

Also, in an attempt to diversify investment holdings, Asian investors and central banks are buying large quantities of the yellow metal. Considering the almost chronic supply shortage, we think there are several factors at play which should continue to drive the gold price towards USD 1,500 in coming months.

It goes without saying that part of the gold price advances were also caused by further weakness of the U.S. dollar. Is the greenback now finally finding some support at current levels? We have our doubts and continue to be bearish on the U.S. dollar for several reasons. Although we think that the risk for strong inflationary pressures have fallen somewhat, it is clear that the U.S. does not have too much interest in a strong currency. With the amount of government debt now at record levels, the last thing the U.S. wants is a strong currency.

Also, the U.S. dollar’s role as the world’s sole leading currency is coming to an end, and, although it will remain an important currency, its share of world currency reserves is going to fall further from here.The recent rumors that the greenback will be replaced as the “oil currency” gives clear evidence that the relative importance of the U.S. dollar is falling.

Although the current amount of government debt is almost mind blowing, we don’t think that it is a hopeless situation. Compared to the size of the U.S. economy it is still manageable but in our view drastic measures to correct the unpleasant situation need to be taken. These measures must include spending cuts and increased spending discipline as well as steps to promote real economic growth since it is unrealistic to hope that inflation and spending cuts alone will rebalance the deficit. Unfortunately the measures taken so far are targeted at either redistributing wealth, increase spending or at protecting the domestic economy.

Although probably relatively popular politically, these measures are counterproductive and will not help to improve the situation. We remain bearish on the U.S. dollar and expect another 5-10% decline in the next six months before it is possibly finding a new equilibrium price around 1.60 against the Euro.