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Long gold long term

|Includes: SPDR Gold Trust ETF (GLD)

What gold advocates claimed would be the sure deliverer of higher gold prices- intense inflation- has not arrived. Despite this gold remains long term bullish.

Although the dollar fell steadily from March 2009, and gold rose concurrently, traders were using gold more as a synthetic dollar short than a long in its own right. When the time came for institutions to de-leverage for year's end, they reverted their trades to dollar strength and risk asset weakness.

Yes, traders have treated gold as a risk asset. Most people want gold for its perceived low risk (or positive correlation with high risk environments), but its 2009 progress was mostly attributable to carry trade target vehicle status. This explains the December top and subsequent correction.

Inflation was not responsible for the run up in Q4 2009 (though it is still highly relevant long term, discussed later). Bank credit has not risen significantly. The Fed has to this point successfully retained more than $1.1 trillion in excess reserves. No one is lending this money, nothing is being done immediately to significantly increase dollars in circulation. The Fed and Treasury offer risk-free arbitrage opportunities for banks where they can pledge their worthless MBSs as discount window collateral, and then 'invest' in Treasury securities, or collect interest on their excess reserves. This, along with the Fed's open and disguised monetization, is in fact how the deficit was funded in 2009, and is one reason why commercial credit remains constrained.

So the imminent inflation many commentators predicted has not been responsible for gold's progress in 2009. The liquidity crisis has only meant de-leveraging and deflation.

I only see further deflation in 2010. Mortgage delinquencies continue to grow, and any rise on the long end of the Treasury yield curve means another slew of losses. Write downs will keep asset values low, reducing the leverage of any lending banks feel inclined to.

What, then, will drive gold prices higher?

Inflation forecasters have taken gold out of context this year. Before the liquidity crisis they accurately predicted an increase in circulated currency year after year. The debate may be inflation vs. deflation in the short term, but the long term trend remains inflation. Just because deflation has been the name of the game since 2007 doesn't mean inflationists are suddenly wrong. They may not have realized the intensification of widely circulated liquidity they predicted, but their long term case is stronger than ever.

This is consistent with rising commodities and equities since March. It is not inflation causing this, but monetization of risk and leveraged bets on synthetic dollar shorts, the fruit of ZIRP.

Gold has been, and will continue to be, a long term hedge against inflation and uncertainty. It became a popular trade this year, but the December correction has shaken off carry traders and weak investors.

Gold emerged from a very strong continuation head-and-shoulders pattern in September 2009, which should provide much more upwards momentum before another long term consolidation period is necessary. I don't mean to overstate the correction either- gold is still up 25% for 2009.

It has already made a tentative recovery of the 50dma (yet to be confirmed), with strong support from the 1080 level.

And the liquidity crisis has hastened many fundamental changes in gold's favor. Although central banks have only recently reverted to net buyers of gold, rather than net sellers, they provide genuine support for the market. China and other large US creditors want to hedge their dollar exposure as much as possible, which they are achieving by diversifying into gold (and by reducing demand for Treasuries, ensuring the Fed will continue to resort to monetization, and indirectly ramp up gold prices). Official demand for gold quickly drives prices higher in what is a relatively small market, and central banks are by no means done with gold acquisitions.

Further, spot market prices are no longer reflecting the true cost of immediately delivered physical gold. Demand has outstripped supply. COMEX futures' warehouses are unable to deliver gold contracts within a reasonable time frame, and it has become clear that there is not enough stored gold to settle all outstanding contracts. This moderate pullback will not resolve these severe shortages. Another price surge could result from investors discovering their paper gold assets are not adequately backed by physical metal.

Mining companies have withdrawn most of their price hedges as gold marches higher, removing short pressure at key levels, and demonstrating the industry's confidence in further progress. The Fed's efforts to suppress gold prices by supporting notorious hedgers are becoming fruitless, and these institutions have been left scrambling for physical gold to meet the contract obligations of failed shorts.

In summary, gold investors should focus on the long term success of gold, instead of viewing the liquidity crisis as the only relevant catalyst. Gold was relevant well before 2008, and will become even more so in the next decade.

Disclosure: I am waiting for further price and volume support to re-enter varied gold positions.