Earlier we presented one view on why gold is about to plunge. While that perspective was somewhat truncated, a report recently issued by Bank Of America's commodities team presents the case for gold at $1,500/ounce. As BACMLCFC observes, and agrees with other observations presented on Zero Hedge by both SocGen and by Jim Grant, "[d]uring the last decade we found that three variables alone could explain the fluctuations in the price of gold: risk, currency and commodity prices. In a nutshell, our analysis showed that gold is sometimes a currency, sometimes a commodity and sometimes a store of value. Of course, the elusive question will always be figuring out which market gold will track next." In essence, a detailed if longwinded report (get a cup of coffee now) to confirm that Paulson and Ackman will soon be much richer.
Gold Prices Continue To Move Towards $1,500/oz
The three stages of gold price appreciation
Departing from this analytic framework, we argued back in October 2008 that gold prices would move up to $1500/oz in three steps. The outburst of the credit crisis in August 2007 marked the start of the first stage where gold started to reflect the rising risk premia, rising from $650/oz to about $950/oz. The second stage of gold price appreciation, we argued well over a year ago, would primarily be about USD weakness and lack of confidence in fiat currencies. We argued that gold could break through $1200/oz in this second stage and strengthen against all currency crosses. The third and final stage will be driven, in our view, by a strong cyclical recovery in energy and commodity prices.
A weak dollar is now driving investors into gold
Our analysis shows that the recent rally in gold prices that started in April this year has mainly been about currency weakness, matching the second stage described in our October 2008 piece. Of course, many observers will argue that investor and central bank demand has been the main driver of gold prices for
some time (Chart 2). But this is the old traders' truism: prices go up because there are more buyers than sellers. The more critical question to understand whether a trend is sustainable is what drives that investor demand. In that sense, gold prices have rallied this year on the back of a weaker trade-weighted
USD (Chart 3).
The 2nd stage of higher gold prices is about USD weakness
Why are investors piling into gold? First and foremost, money is flowing into gold as investors seek to protect themselves from USD currency risk. Looking at daily gold spot returns and decomposing them into factors, we find that USD depreciation and currency risk have been important contributors to higher gold
prices (Table 4). Secondly, our analysis also suggests that changes in gold prices have been leading indicators of changes in 5Y breakeven inflation rates and in the USD yield curve slope (10Y-2Y) since April, suggesting that gold is really moving ahead of inflation expectations.
Decomposing the FX driven gold rally of 2009
In the most recent rally, some currencies have shown high correlation and high beta relative to gold prices since April (Chart 4). More specifically, EUR and CAD have shown the highest beta and correlation to gold, while KRW and JPY show some of the lowest in the last 8 months.
