By Dian L. Chu,  Eco­nomic Fore­casts & Opinions

The U.S. dol­lar rose, com­mod­ity prices dropped and stocks fell last Fri­day after the Fed­eral Reserve unex­pect­edly lifted an emer­gency lend­ing rate for the first time since the finan­cial crisis.

The dol­lar hit an eight-month high against a cur­rency bas­ket, while gold prices rose as investors bought the metal to hedge against paper cur­ren­cies and debt default risks in Europe. Gold futures ended on Fri­day with a weekly gain of 3.1% at $1,122.10 an ounce.

Gold’s Retreat

Gold had ral­lied to a record of $1,218.30 an ounce on Dec. 3, 2009, as near-zero U.S. inter­est rates and gov­ern­ment spend­ing weighed on the dol­lar and coun­tries includ­ing India and China boosted gold reserves.

How­ever, bul­lion in the spot mar­ket has declined more than 6% since Decem­ber, as the U.S. dol­lar ben­e­fited from the unfold­ing debt cri­sis in Dubai, Greece and the rest of south­ern Europe.

New Inverse Tango with Euro

Since gold is pri­mar­ily a hedge against the dol­lar and infla­tion, it typ­i­cally has the strongest inverse cor­re­la­tion with the US dol­lar. In the last month, how­ever, the trend has bro­ken with gold trend­ing inversely with the euro and pos­i­tively with the dol­lar (Fig. 1). The euro has now taken cen­ter stage in dic­tat­ing the price of gold as it per­tains to the fis­cal health of Greece and other euro­zone countries.

Fears over the out­look for the euro have been dri­ving investors out that cur­rency, and lifted both bul­lion and the dol­lar as alter­na­tive assets. The euro has declined, par­tic­u­larly against the dol­lar and gold, almost 5% against the dol­lar, and gold in euro terms is up 4.2%, so far in 2010.

Mari­achi — PIIGS & The Fed

The new trend between the euro, dol­lar and gold is expected to con­tinue amid fis­cal chal­lenges in the UK and Euro­zone, PIIGS (Por­tu­gal, Ice­land, Italy, Greece and Spain) in par­tic­u­lar. Uncer­tainty over the details of any finan­cial res­cue pack­age for Greece will likely keep the mood in the mar­kets ner­vous, and the cur­rency mar­kets volatile in the near term.

In addi­tion, the Fed's dis­count rate hike sig­nals that other cen­tral banks will likely fol­low suit in exit­ing from stim­u­lus mea­sures, while the euro­zone, UK and Japan will likely lag behind. This view has partly trig­gered sell­ing of the euro against the dol­lar, and some other cur­ren­cies to seek a pos­i­tive yield and per­ceived safety.

These two fac­tors will likely con­tinue to be the major forces dri­ving the euro’s direc­tion for the rest of Q1, and may spill over into Q2 depend­ing upon solu­tions to the Eur­poean Union`s debt prob­lems and dearth of future growth opportunities.

Tech­ni­cals — Short-term Mixed

Tech­ni­cally speak­ing, the short term indi­ca­tors of gold are mixed and still trend­ing bear­ish as gold prices remains in the lower part of its recent trad­ing range.

Tech­ni­cal ana­lysts have widely diverg­ing views as well. For instance, Char­tered Mar­ket projects gold to reach about $1,400 within 12 months as long as the $1,000 level holds; whereas Bar­clays Cap­i­tal con­sid­ers a “fair value” for gold around the $700 to $800 an ounce level.

Mean­while, Nouriel Roubini, eco­nom­ics pro­fes­sor at the Stern School of Busi­ness, New York Uni­ver­sity, says that there is a bub­ble in com­modi­ties, and that the price of gold should be no higher than $1,000 an ounce given the cur­rent mar­ket conditions.

Tech­in­cal lev­els of sig­nif­i­cance would be a break­out above the $1150 level, which would be bull­ish; and break­out below the $1050 level of sup­port, which would be bear­ish for the com­mod­ity.  (Fig. 2)

Vul­ner­a­ble to Rapid Unwind

Accord­ing to the Com­mod­ity Futures Trad­ing Com­mis­sion (CFTC), NYMEX gold futures open inter­est increased 3.2% in Jan­u­ary. Com­mer­cial traders increased their long posi­tions, while hold­ing net short posi­tions. Non-commercial spec­u­la­tors held net long posi­tions but increased their short posi­tions. Over­all, about 54% of the par­tic­i­pants held net long posi­tions in Jan­u­ary. (Fig. 3)

Gold has attrac­tions for those man­agers of pri­vate insti­tu­tional funds. Many investors from George Soros to John Paul­son have been buy­ing gold as lower inter­est rates and con­tin­ued money-printing could devalue the U.S. dol­lar in the long term.

Bil­lion­aire fund man­ager George Soros, for instance, told the finan­cial élite at Davos that gold rep­re­sented the "ulti­mate asset bub­ble”; how­ever, data from SEC fil­ing showed his fund more than dou­bled the stake in the SPDR Gold Trust (GLD) three months ear­lier. In fact, the gold trust is now his fund's biggest invest­ment, val­ued at $663 million.

The large num­ber of long spec­u­la­tors play­ing in the Gold mar­ket could leave the mar­ket vul­ner­a­ble to a rapid unwind­ing when sen­ti­ment changes – the crowded trade sce­nario. One can only spec­u­late that Mr. Soros could be seek­ing to exploit this mar­ket vul­ner­a­bil­ity with his seem­ingly unchar­ac­ter­is­tic and con­tra­dic­tory actions.

Other Mar­ket Factors

Fur­ther­more, the gold price direc­tion also hinges on sev­eral events about to unfold within the next few months:

1) Greece's bor­row­ing needs are cov­ered only until mid-March, and is set to launch a new bond offer­ing of $7 bil­lion in com­ing days – Eurozone/euro could stand or fall on the suc­cess or fail­ure of this bond sale.

2) Euro­pean finance min­is­ters gave Greece a one-month reprieve to show its deficit reduc­tion plan was being rolled out effectively.

3) Dubai World will present a pro­posal to cred­i­tors in March to restruc­ture about $22 bil­lion of debt.

4) The IMF’s phased open-market sales of the remain­ing 191.3 tons of gold it planned to sell last year as there are no more offi­cial buy­ers – Bear­ish for gold, unless another cen­tral bank steps up.

5) The Fed­eral Reserve will end a $1.25 tril­lion pro­gram of mortgage-debt pur­chases in March – Gold-bearish as it reduces liquidity.

As ever gold thrives on finan­cial, eco­nomic and mon­e­tary uncer­tainty, there is cer­tainly plenty of that in the world today.  Sov­er­eign risk will likely remain the main theme for 2010, and pos­si­bly 2011.  This all sets the stage for the next five years of mon­e­tary and fis­cal pol­icy deci­sions around the globe which will ulti­mately define the future for this pre­cious metal from an invest­ment standpoint.

Dis­clo­sure: No Positions

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