Long Term Perspective

Gold is a special metal. It has long been considered a hedge against inflation even though it has not always kept up with inflation. Gold is also considered a safe-haven investment in times of uncertainty such as war, economic, financial and political turmoil. Yet, over the past several years, more than one central bank announced its intention to sell some of its gold reserves. Could gold be losing some of its luster?

Despite all its attributes, some Fed officials still consider this a primary indicator of inflationary pressures. However, if gold prices rise because of political turmoil, this doesn’t mean that inflation is around the corner. Thus, it is very important to consider all factors that can cause gold prices to fluctuate. In the past ten years, one can make the case that gold prices fluctuated with the dollar exchange rate. Indeed, notice that gold prices fell when the trade weighted dollar increased, and conversely gold prices rose when the trade weighted dollar fell.

Actually, a declining dollar can indeed be inflationary because prices of foreign-produced goods become more expense to U.S. consumers and businesses. By looking at gold prices in combination with other key indicators one can more readily interpret the reason behind the gold price fluctuations.

Many economists believe that the dollar will be under downward pressure in 2007 due to rate increases abroad and a possible Fed cut in U.S. rates late in 2007. While interest rates are higher here than many foreign countries, and our economic growth is stronger than in many foreign countries, we still are facing record trade deficits.

Short Term Perspective

Gold prices have sharply recently over concerns over the declining value of the dollar, a jump in oil prices, and due to being seen as a safe haven relative to some financial securities tied to real estate assets. On November 26, gold set a cyclical high as of that date, closing at $826.50 an ounce. Gold could be closing in on the historical high of $850 an ounce set on January 21, 1980.

The foreign exchange value of the dollar has declined in recent months in tandem with expectations of Fed no longer tightening and likely easing while central banks overseas have been lifting rates and signaling further increases. Against the Euro, the dollar continued to hit new lows during October as traders anticipated that the Fed would be easing at the end of the month and also later in the year. When investors believe that the Fed will raise rates or overseas central banks will cut rates, the dollar appreciates. When investors believe that the Fed is done raising rates or foreign central banks will raise rates, the dollar declines in the FX market.