Flight To Dollar An Ominous Sign That Could Be Very Bullish For Gold

May.15.12 | About: SPDR Gold (GLD)

By Amine Bouchentouf

While eurozone problems weigh heavily on gold prices now, a larger financial storm is brewing that would return the yellow metal’s safe-haven status.

Gold began 2012 on a very positive note, reaching the $1800/oz. range during several key trading sessions in the first quarter of the year. As we entered the month of May, gold has given up all of its returns, currently trading at $1560/ounce as of May 15.

Many investors are perplexed by gold’s recent decline and what we can expect for the remainder of 2012.

Troubles in the Eurozone

The biggest elephant in the global capital markets remains the European sovereign debt situation. As several key European economies begin to falter and stutter, many have already reached a grinding halt. For instance, youth unemployment in Spain is now more than 50 percent, and Greece’s GDP fell 6.2 percent in the first quarter alone.

As if this economic lethargy and paralysis weren’t enough, Europe is now being gripped by an equally alarming and dangerous political crisis. One of the ways that European governments attempted to stem this economic downturn was to introduce a program and package of austerity across many of the region’s ailing economies. The idea was that countries must adopt strict austerity measures to begin stimulating economic growth once again.

The problem is that the European citizenry has emphatically rejected these austerity measures, feeling these fiscal policies are being shoved down their throats by the Germans. (Germany’s economy is strong and it has been a leading voice in introducing austerity measures to its economically weaker neighbors.) France and Greece recently held elections, and both countries essentially fired governments that were intent on austerity.

In France, the citizens voted in Francois Hollande, a career socialist who has vowed to cut austerity programs; in fact, he has committed himself to spreading further social welfare programs in the country and around Europe. Furthermore, France’s new president appears to be on a collision course with his austerity-friendly German counterpart.

In Greece, the new government has also pledged an anti-austerity program. Even more alarming is that the country may be on the verge of actually breaking away from the European Union altogether. If that were to happen, the chaos that would be created in global financial markets would be incalculable and unpredictable.

The political turmoil in Europe is wreaking havoc in global markets, and investors are so alarmed they are bringing their risk assets to zero.

In this environment, not even gold is spared: It is being treated just like any other risk asset.

The World Outside Europe

Many believe the troubles in the eurozone may be contained, especially with growth in leading emerging economies. However, we are seeing signs of slowdowns across the world’s main economies.

Economic data from China isn’t as strong as expected: Retail sales are lower from the same period last year, industrial output showed a decrease relative to previous quarters, and the country’s real estate sales (a key indicator of economic growth) have slowed as well.

Even growth in India is slowing, perhaps even more so than in China. Industrial output in India dropped 3.5 percent compared with the same period last year. And investors aren’t comforted by Russia’s economic outlook, as Putin signed on for another term as president of the Russian Federation.

What we’re left with is a soft economic outlook for the global economy. In such an environment, investors tend to flock to the least risky asset in the world, which remains the U.S. dollar and U.S. Treasurys. Indeed, the greenback has shown exceptional strength relative to other currencies this year, and especially during the last month.

The U.S. dollar is being seen as a safe haven, and that’s also creating a lot of pressure on gold prices. The last time the greenback performed so well was right before the Lehman Bros. collapse in September 2008. Is the dollar strength indicating a global financial catastrophe on the horizon? It very well may be.

In such a case, you can expect gold to outperform most other assets in a period of crisis. Gold may initially sell off, such as we saw in September 2008, only to rally afterward as investors begin to flock to its safe-haven status.

What To Do

In this period of extreme volatility, it is advisable to avoid equities at the moment. You can pick and choose your positions, but be very careful, as the market can turn very violent. I believe gold will be trading between $1400/ounce and $1800/ounce over the next two quarters, but will eventually outperform most other assets in case of a financial crisis.

The most prudent way to invest in gold is to stick to physical bullion exposure via gold certificates, ETFs such as the SPDR Gold Shares ETF (NYSE Arca: GLD) or actual physical gold. I would avoid gold equities at the moment until we have more visibility on the global economy.

Disclosure: The author is long gold via a number of trading instruments.