Tuesday, April 27, 2010

The Fear trade

Most pundits believe the USDollar and the price of gold (priced in dollars) have an inverse relationship. As the USDollar weakens, the price of gold rises--with the inference that it takes more dollars to buy that same ounce of gold. Likewise, as the USDollar gains strength, the price of gold should naturally decline. Hence, gold is an apt hedge against a weakening dollar--and rising price inflation. Gold keeps its monetary value even while paper currencies decline. We're seeing that in Europe and the United Kingdom, as the Euro is sinking faster than the USDollar, due to the spreading fiscal problems in Greece, Portugal, Spain, and other European countries. Priced in the sterling pound and the Euro, gold prices are at an all-time high (priced in USDollars, gold is currently 5% below it's all-time peak).

Generally, in normal times, this gold/USDollar inverse relationship is intact.

However, in periods of financial crisis, when trust in government finances is low, the relationship between gold and the USDollar can be linear. In other words, even though the USDollar can gain in strength (as measured by the USDollar Index), gold can also rise in tandem, as both may be considered safe harbors for scared capital.

However, the inverse relationship may return if fear in the USDollar returns, which would be even more bullish for gold. Markets remain nervous and tenuous, and currently, markets are betting on a worldwide economic recovery. Increasing risk exposure (and attempting to increase returns) is back in vogue. Hence, the carry trade (borrowing USDollars, investing the proceeds in higher-risk trades) will have a dampening effect on the dollar, which is bullish for precious metals.

But the next crisis-triggering event will cause a return flight to the dollar, which could temporarily put a damper on gold's rally. But once cooler heads prevail, gold will resume its rightful place as a hedge against not only inflation, but also against financial crisis and currency debasement. We saw this in late 2008, after the Lehman blow up, when gold and silver prices collapsed briefly, but have both resumed their decade-long rally ever since.

See disclaimers on sidebar.

Disclosure: long physical gold and silver, and long gold and silver mining shares.

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