19 June 2006

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Since the beginning of this year till the 12th of May, the spot price of gold zoomed like a vertical parabola from $517 per troy ounce to $730 per troy ounce. Thereafter, it appears someone bear-hugged the gold bull and it fell off a cliff in an almost vertical descent to an intraday low of $530 per troy ounce in just over a month before rebounding to finish last week at $575. Most analysts - fundamental and technical - seem to be sure that this is just a bull market correction and that gold is now very cheap from a medium to long term perspective. Some very long-sighted analysts seem to think that sky is the limit for gold and that by the end of this decade, gold will or may skyrocket to $5000 per troy ounce! But then as George Soros has said, "Every long run investor is a failed speculator!" And, in the words of the great economist and stock market trader, John Maynard Keynes said, "In the long run we are all dead."

For a moment, assume that this is, indeed, just a bull market correction and gold is headed upwards to surpass at least the January 1980 all-time high of $850 per troy ounce. Would you rush to buy gold at the current price if you think or rather fear that it may first slide further to say $450 or lower in the next few months? Is there any proof that gold will fall to $450? Of course not, just as there is none that it will reach $5000 by 2010 or $850 in a year or even exceed last month's high of $730.

So what's the case for a resumption of the bull run? The factors cited are demand exceeding and continuing to exceed supply and that on an inflation-adjusted basis, the 1980 high of $850 corresponds to a price of around $2200 today or going backwards, last month's high of $730 corresponds to a price of just 282 in terms of 1980 dollars! As to the so-called demand, quite a lot of it appears to have been speculative due to the erstwhile easy monetary policy of the Fed to prevent deflation and the erstwhile quantitative easing policy of the Bank of Japan to fight deflation. Now the Fed has already hiked the Fed funds rate from 1% to 5% and doesn't seem reluctant to hike further. And, as you know, monetary tightening (or easing) takes effect with a lag. As such the full effect of the recent hikes will be felt in the months to come. The European Central Bank, whose only mandate is to fight inflation, began to hike rates last December shortly after the price of gold, capped under about €350 per troy ounce for quite a while, began to accelerate upwards. As far as Bank of Japan is concerned, for the first time in five years, Japanese short term Libor rates have begun to inch away from zero percent, with the Bank of Japan draining 26 trillion yen out of the Tokyo money markets. The BOJ has been expected to hike its overnight loan rate above zero percent in July, for the first time in almost six years. This may, however, get delayed if BoJ Governor is 'unduly influenced' by the Japanese government because of his investment in the scandal ridden Murakami fund. In any case, if the BoJ hikes rates this year, it would also be the first time since 2000 that the big-3 central banks have tightened liquidity in tandem.

Last month's peak in global commodity markets interestingly happened just a few days after
Jean-Claude Trichet, the ECB chief and spokesman for the G-10 group of central bankers warned on May 8th, "It is not the time for complacency if we want this global growth to be sustainable. We have to be careful to see that this period of global growth does not end up in inflation. Global economic growth remains strong and steady. There are elements there that call for very special attention, especially in terms of inflationary risks. We all concluded what was very important to prevent the second round effects because once they are there, it is too late." Thus, as long as the Fed and the ECB aim to keep a tight lid on inflation and the BoJ keeps on draining liquidity to pave the way for an eventual rate hike, there seems little reason for a resumption of the bull run in gold. Gold's run-up to $850 in January 1980 was preceded by double digit US inflation in the late 70s. This is far from the case now. If the Fed wants interest rates to be as low as is practicable, it will have to convince the market that it is intent on keeping a tight lid on current inflation as well as expectations of future inflation. That's what the Fed Chairman Bernanke and his colleagues seem to be doing now very clearly after some initial hesitation and 'hiccups'.

Another indication of the likely outlook for gold is the trend of the US Dollar Index. This index is a geometric weighted average of the change in six foreign currency exchange rates against the US Dollar relative to March 1973. Those six currencies are the Euro, the Japanese Yen, the British Pound, the Canadian Dollar, the Swedish Krona and the Swiss Franc with the Euro having the maximum weight of 57.6%.

Following the collapse of the Bretton Woods system of fixed exchange rates, the USD index has found strong support in the 80 to 83 region on no less than 5 occasions i.e. in 1978, 1990, 1992, 1995 and 2004 except that in 1992, the index fell briefly below 80. This year, the index fell as low as the mid 83s on May 12 and again June 5 but has since rebounded to about 86. This is the 6th assault on the multi-decade support zone and may, perhaps, have failed though it may be too early to jump to such a conclusion right away. The dollar index recovery has also seen gold (and silver) enter major corrections. In broad terms, when the dollar goes down, gold goes up. So if the dollar index support at 80 is not breached even on the next attempt, if at all such an attempt occurs in the next few months, we may have to say goodbye to the gold bull for quite a while.

So what should one do now? As the legendary Warren Buffett has said, "Be afraid when everyone is greedy and be greedy when everyone is afraid." You may say that right now while few seem to be greedy, most are hopeful and very, very few are worried. All those who bought gold near the recent top and are hoping for another rally to or above $730 would do well to remember the famous adage, "Bull markets climb a wall of worry and bear markets flow down a river of hope." If this is also of no avail, one final suggestion might help. Do whatever enables you to sleep well at night!.

Currency Market View - Rupee and Majors

USD/INR

Fortnightly movement: O-45.7800 H-46.1300 L-45.7700 C-45.84.
Sentiment: Range bound activity
Expected range for 1 Month: 45.25- 46.25
Expected range for 3 Months: 44.75- 46.25

The domestic unit witnessed a range bound movement this fortnight, as no major decision gave a breakout in either direction. However a bias towards appreciation was seen as rupee found difficult to fall below 46.13 levels despite dollar strength and falling stock markets. It was also seen that every rise in the stock markets favoured the domestic unit.

The forex reserve position remained without much change at $162.87bn. The 6-month benchmark forward premium, which stood around 0.65% last fortnight, closed at 1.0% this weekend.

We expect dollar to be stable at current levels, with an upward bias. A reversal of bearish trend in emerging markets will have positive effect on Rupee. Premiums are likely to stay high as participants are expecting another rate hike on July 25th domestic monetary policy review.

EUR

Fortnightly movement: O-1.2924 H- 1.2977 L-1.2529 C-1.2640
Sentiment - negative
Expected range for 1 Month: 1.2300 - 1.2750
Expected range for 3 Months: 1.2000 - 1.2750

The Euro rose to a new, marginal, multi-month high of 1.2977 on June 5 before slipping over the next few days to about 1.28 following hawkish comments from the Fed Chairman Bernanke as also other Fed officials. On June 8, the ECB hiked its repo rate by 25 bps to 2.75% as widely expected. However, the ECB President's failure to suggest further hikes saw the Euro slump rather sharply by over 1.5 cents. Last week, the Euro extended its losses to about 1.2530 on a larger than expected decline in the German ZEW economic sentiment index, a larger than expected rise in the US core PPI and a continued slide in gold prices below $600 a troy ounce. However, despite a stronger than expected rise in the US core CPI to 2.4% y/y and an unexpected improvement in the US consumer sentiment, the Euro recovered smartly on the news that net foreign capital flows into the US fell to a 25-month low of $46.7 bln in April compared to the trade deficit of $63.4 bln for the same month.

The rise in the US core CPI well above the Fed's comfort level as also expectations of a Fed rate hike on June 29 are, however, likely to cap the Euro's recovery to about 1.2750 before a renewed slide to about 1.23 and later to 1.20.

GBP

Fortnightly movement: O-1.8835 H- 1.8879 L-1.8314 C-1.8501
Sentiment: negative
Expected range for 1 Month: 1.8000 -1.8650
Expected range for 3 Months: 1.7650 -1.8650
Sterling tracked the Euro closely and finished last fortnight sharply lower against the dollar. It also ended slightly weaker against the Euro probably on the news that UK unemployment rose by 5800 in May rising to about 951K, its highest level since April 2002.
Sterling's recovery from the low 1.83s is likely to be capped under 1.8650 before fresh declines push it lower to 1.80 enroute to 1.7650.

JPY

Fortnightly movement: O-111.67 H- 115.43 L-111.41 C-115.17
Sentiment: negative (for yen)
Expected range for 1 Month: 113.00 - 118.00
Expected range for 3 Months: 113.00 - 118.00

Following hawkish comments from Fed officials as also dovish comments from the People's Bank of China Governor that Chinese interest rates would not be increased for the time being, the dollar rose sharply past the 113.50 resistance and touched 114.70 before finishing the week ended June 9 just under 114 yen.

The dollar found support over 113.50 and rose past the 115 yen level last Tuesday when the Japanese Nikkei equity index plunged over 4%. The dollar finished last week on a very firm tone over 115 yen.

While the Nikkei's 19% sharp sell-off from this year's highs could prove to be a deterrent to the hawks at the BoJ, the BoJ Governor's investment in the scandal ridden Murakami fund may erect additional barriers. Under the circumstances, the dollar seems more likely to rise towards 118 after a brief consolidation between 113 and 116. However, a direct rise over 118 seems unlikely amidst persistent expectations of a BoJ rate hike and Chinese yuan revaluation/widening of its trading band against the dollar.