It’s a harbinger.
It’s a hedge.
It’s been a helluva wild ride.
It may not over.
Last week, following a stronger than expected labor report, the U.S. dollar rose and gold fell nearly 4 percent, its greatest tumble in 14 months. The question many investors and speculators are asking is, whether gold’s 9-year bull run is over?
In concert with the steep drop in gold, the Japanese yen strengthened and the dollar rose to its highest level in a month against the euro as investors weighed whether the world economy is recovering fast enough to warrant higher central bank interest rates. Even with the U.S. currency moving higher, traders in the $3.2 trillion a day foreign exchange market are paying the highest prices in more than a year to protect against a sudden rebound in the dollar after its worst annual performance since 2003.
With the signs of the first marginal stabilization in the jobs market, investors and currency speculators are trying to stay ahead of the interest rate curve. To this point, the Federal Reserve and Chairman Ben Bernanke have held steady to their program of “quantitative easing” by keeping interest rates at historic lows.
Most analysts agree that unless and until the employment picture starts showing real improvement, the Fed will be little concerned about the threat of inflation. A future upswing in interest rates by the Fed will not only push the dollar higher, but make U.S. Treasuries more attractive. With even fractionally higher interest rates, Treasuries may become an appealing safe haven if investors remain skittish about risk.
Option Traders Are Skeptical
While the possibility may seem remote, a prolonged period of record low interest rates could foster a “systemic risk” by creating additional asset bubbles. Many analysts are acutely concerned about rising share prices that may be more closely linked to the availability of “cheap” money than to actual intrinsic value.
Despite the fastest growth in U.S. earnings in 15 years, option traders appear to be unconvinced that the Standard & Poor’s 500 Index will extend its biggest rally since the 1930s.
The cost of put options – bets by traders that share prices will move lower – to protect against declines in the stock market over the next year are 22 percent higher than one month contracts, the biggest gap since the end of 1999 just prior to the collapse of the tech bubble. In spite of the 63 percent advance in the stock market since March, this price gap on the options market shows that investors remain concerned that the projections for record earnings in 2011 may be exaggerated.
In this high stakes game, investors and speculators alike may take this opportunity to re-enter the precious metals market, especially after last week’s deep selloff.
The past year has seen a record accumulation in gold along with other commodities. For example, the SPDR Gold Trust, the biggest exchange-traded fund backed by bullion, has amassed more metal than Switzerland’s central bank. These acquisitions have been spurred by a plunging dollar and anxiety that the at least $12 trillion of government spending to lift economies out of the worst global recession since World War II will trigger a new round of inflation.
Huge Gold Rally
Last month, the U.S. Mint suspended production of some American Eagle coins made from precious metals because of depleted inventories. In response to the swelling global demand, the U.K.’s Royal Mint more than quadrupled production of gold coins in the third quarter. Even London’s legendary department store, Harrods Ltd., began selling gold bars and coins for the first time in October.
This demand frenzy contributed to a 30 percent rally in gold this year, beating the 25 percent gain in the S&P 500, with dividends reinvested, and a 2.4 percent drop in Treasuries. With the U.S. economy contracting 3.8 percent during the 12 months ending in June – the worst performance in seven decades – investors flocked to gold.
Gold prices continued to make new highs despite reports that the U.S. economy expanded at an annual rate of 2.8 percent during the third quarter. Although many observers believed that precious metals had become overpriced and were overdue for a correction, it took the brighter than anticipated jobs report to prompt a brisk round of profit-taking.
This latest slide in gold prices, from their all-time high of $1,226 to below $1,150, likely will not deter the pace at which gold continues to be acquired. In light of the debt bubble that has been created by the U.S. government’s multi-trillion dollar bail-out, central banks from China and Brazil to Russia and the United Arab Emirates are fretting about the disproportionate amount of their reserves that are still held in U.S. dollars. Even the IMF – International Monetary Fund – has expressed a tone of distress over the continued stability of the U.S. dollar.
Given these conditions, this pullback in gold prices may be temporary. If the dollar begins to soften and the stock market underperforms, gold demand and prices will be re-energized.
If this occurs, the previous record highs could be left in the dust.
John Cohn is a senior partner in the Globe West Financial Group based in West Los Angeles. He may be contacted at www.globewestfinancial.com
