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Last Friday's spike in gold after the terrible U.S. jobs report has many wondering whether gold is ripe for a reversal. Here's the short and sweet answer.

Below is a brief gold forecast based on its true nature and relation to currency and other asset markets, with particular focus on gold's relationship with the EUR and USD, as well as likely policies related to them. It's part of an ongoing series of articles from The Sensible Guide To Forex, a site dedicated to showing mainstream investors how to achieve currency diversification for lower risk and better returns, either via conservative forex trading or currency diversified income investing.

Gold has been sliding since last summer. However, the global slowdown raises the risks of widespread policies that dilute the purchasing power of the most widely held currencies, and that favors a renewed gold uptrend. We may have had our first taste of the coming move with this past Friday's U.S. job reports disappointment and spike in gold.

After the initial panic of a Greek exit from the EUR and related default risk subsided, gold held support ~$1575. This past Friday's awful U.S. jobs reports sent gold soaring, because the bad jobs data caused markets to assume that QE3 (believed dilutive to the USD's value and a pro-risk move that pressures safe havens like the USD) was likely, and would both sink the USD and send gold on its next leg higher.

WHY YES?

1. NO EZ BAILOUTS OTHERWISE

Even if the coming Greek election brings a pro-bailout party, Greece is an ongoing default threat and likely requires ongoing money printing to fund its bailouts. No one is willing to pay, so the likely funding mechanism is money printing, with Germany once again backing down (for the last time, perhaps).

If / when contagion threat kicks in, either from a Greek default, or from Spanish or Italian 10 year bonds hitting 7% yields so that one of them needs a bailout, then the EU must choose: print or die. Given the risks of contagion spreading globally on a scale equal or greater to that of the Lehman collapse, the Fed and other leading central banks may well end up kicking in some cash, most likely freshly printed, given how their voters might respond to new taxes or spending cuts. Spain is the big concern, and is the 4th largest economy in Europe. It needs an estimated €400 bln in funding for the coming 3 years, far beyond the current actual means of eurozone bailout funds. Italy would present an even bigger funding dilemma.

2. TECHNICAL PICTURE: GOLD READY FOR OVERSOLD BOUNCE

As we noted in our recent article, even without considering the eventual money printing of the second most widely held currency, the EUR, markets appear convinced that last Friday's U.S. jobs reports means the Fed is about to do some serious USD printing via QE3. Yes-- technically it's not necessarily money printing, but markets have generally (and probably correctly) ignored the technical distinction, typically treating both gold and the USD as if the USD was now worth less (again, probably true in the end) and gold correspondingly worth more as the prime USD hedge. We discuss particulars of the technical picture in the above mentioned article.

3. GOLD IS NEITHER RISK NOR SAFE HAVEN ASSET – IT'S A CURRENCY HEDGE

This is they key to grasping how gold behaves.

There are those who somehow believe that because commodities are hard assets they should share a positive correlation. Wrong. Oil is an industrial commodity-- essential though it is, its demand does vary to a degree with economic activity. Oil is a classic risk asset, likely to decline during economic downturns. Gold is uniquely neither risk nor safe haven asset. It's a currency hedge. Therefore its value rises or falls with fear about the purchasing power of the most widely held currencies, the USD and EUR. Both are at risk of de facto devaluation from continued printing. That means ongoing fear of loss of purchasing power that favors higher gold prices. Only in time of panic, when need for liquidity overrides need to preserve wealth, does gold drop despite fears of money printing, inflation, or other threats to the USD, EUR, or at times other widely held currencies (gold prices can rise in local markets when the local currency's use as a store of value becomes doubtful, as may happen in India or other emerging markets).

Gold's correlation to other classic risk assets like the bellwether S&P 500 is tenuous at best, 11% and 17% respectively since the start of the current quarter. For more on our thoughts on gold: see here and here. Nor has gold correlated reliably to other safe haven assets.

Because gold is a currency hedge and neither risk nor safety asset, it can rise or fall in good or bad times. For example:

  • Gold can rise in good times if inflation is believed to be a threat to the purchasing power of cash. It can fall in times of optimism if there is no concern about fiat currencies losing value, or if it's believed that risk asset yields will outpace inflation.
  • Gold can fall in bad times because inflation is usually not a threat, or if fear is so high that demand for liquidity overrides demand for assets that preserve wealth. However, when plunging risk assets suggest rising risk of policies that dilute purchasing power (like money printing) that are seen as inflationary, gold rises.

We discuss gold's behavior in greater detail in our coming book, The Sensible Guide to Forex. See here for description, and here for advanced reviews.

WHY NOT?

1. GOLD TENDS TO MOVE IN THE OPPOSITE DIRECTION OF THE USD ABOUT 50% OF THE TIME

Thus, if the dollar continues to rise on safe haven flows, gold could suffer. However, a 50% correlation is by definition only right half the time. Moreover, by logic this correlation should be even less reliable if the USD is under threat of dilutive policies like QE3.

2. THE EU CRISIS COULD SPARK PANIC THAT GIVES PRIORITY TO LIQUIDITY OVER PRESERVATION OF PURCHASING POWER

If the EU crisis worsens and contagion threat spreads through the banking system and threatens another banking crisis like that seen after the Lehman crash or worse, liquidity demand will trump desire to preserve wealth. Indeed, Lehman was just one bank. The EU crisis threatens the entire EU banking system and those directly or indirectly tied to it (all banking systems to some degree).

3. LONG GOLD POSITIONS YIELD NO INCOME

Thus gold positions are more expensive to hold than other assets. Thus, if we get more panic from the EU, investors may sell it to fund losses elsewhere. When you need cash, you want to sell your most profitable assets, or get rid of the lowest yielders.

CONCLUSION

We remain bullish for the coming year on gold, if:

  • The threat of money printing, stimulus, and other programs that risk diluting the purchasing power of cash (especially the widely held EUR and USD) continues, be it from Eurobonds, emergency bailouts, QE 3, etc., (likely if both EU and US economies continue to slide).
  • Inflation remains a threat.
  • Markets avoid the level of panic that makes holding cash a priority over preserving wealth (typically short term conditions).

We believe the above conditions are more likely than not.

One of the biggest lessons of recent years is the need to protect yourself against the risk of crashing markets and currencies dragging you down with them. The best help I can offer can be found in the first forex book ever published, to show how both prudent active traders and long term investors with limited time and risk tolerance can tap forex markets to hedge currency risk and improve returns.

DISCLOSURE /DISCLAIMER: THE ABOVE IS FOR INFORMATIONAL PURPOSES ONLY, RESPONSIBILITY FOR ALL TRADING DECISIONS LIES SOLELY WITH THE READER. IF WE REALLY KNEW WHAT WOULD HAPPEN, WE WOULDN'T BE TELLING YOU FOR FREE, NOW WOULD WE?

Source: Has Gold's Next Move Higher Begun? 3 Reasons For And Against