Gold fever. Will its price fall?

For the last year Gold has attracted much of attention. There are numbers spoken in the range of 1500 to 5-7000 and rumors of bets in those areas. The notion is that if this is spoken of, it might happen. So everybody rushes in and tries to get a share in the profits. It's like people expect and believe the market is just and it is its duty to give them what they need. The sad truth is, to paraphrase what Mark Twain once said, that the market owes you nothing because it was here first.

Gold price might continue to rise. If the demand exceeds the supply this would be normal. Even if the trading never gets to deliver real bullion the price would still be a question of demand and supply. The only difference would be the leverage that is possible to be used when trading not in real bullion. The amount of that leverage however could vastly increase the available amount of money that could be poured into Gold and effectively to create a pump&dump structure similar to the credit bubble and the housing ones. These however, are only assumptions and possible future scenarios. Nothing is sure in markets.

Let's take a look at the historical movement of Gold compared to the movement of Euro/Dollar pair. As these are past numbers we could use them to make some notes or even conclusions.

Table 1. Changes in price of Gold and the value of US Dollar against the Euro

	1995-2001	2001-2008	2008-2008.10	2008.11-2009.11	2009.11-2010.05
Gold	- 39%	284%	- 41%	73%	5%
EUR/USD	- 39%	80%	- 29%	22%	- 20%

This comparison draws some interesting ideas.

The first one is that in general for the last 15 years Gold and Dollar were negatively correlated and the Euro and Gold were positively correlated. This means that whenever the Dollar rose in value against the Euro the price of Gold fell. This happens to be true till the last period which starts around the end of last year (November 2009) and continues till now. During this last period at first there is a slight fall of the Gold price in accordance with the rising value of the US Dollar but shortly after the Gold continues to rise and now Gold and Dollar seem to have broken its previous type of correlation as the value of Gold was increased by 5% for the period accompanied by a 20% rising of the Dollar.

In the light of the last market turmoil this could mean a lot more people could be using Gold as a hedge against a possible economic downturn. Or at least these people (or orders) entered the market in the last several months and were enough to break the previous type of negative correlation that was in place.

A second thing of note on the table above is the value of the correlation. Before 2001 the table shows the value was pure -1 which means there is a great possibility that the value of Gold was calculated in the "buying power" of the US Dollar. Thus every drop in the US Dollar drove the Gold price higher in the same proportion and vice versa. After year 2001 this doesn't seem to be the case.

During the later periods the negative correlation was still in place but it's power was changing. The proportion of movements (or say it Beta if you'd like) changed from pure -1 to more distorted values. For the next period the price of Gold rose 3.55 more that the value of the Dollar fell. With all other conditions equal this could mean there was a 3.55 times more demand for Gold than in the previous period. Such an increase in real demand looks a bit striking but having in mind the construction and debt bubbles all over the world in that period makes it not so impossible. The next periods just continue to distort the strong negative connection between the Dollar value and the Gold price. Thus we come to the last period in which the Gold price and the Dollar started to move in the same direction in contrast to all the previous periods in the table.

An interesting thing about the beginning of the century is that in the years of 1990-2001 the electronic means of trading became widely available. And then after year 2001 there came the CFDs to their fullest. This marked the era of the easy access to the market and eliminated the need to really own the shares (or commodities!) you trade in on leverage. With CFDs the leverage could go up to 1/100 or even 1/500. So a person with $1000 could have a buying power of $100000. This increased amount of available money could explain the bigger proportions between the movements of Gold and US Dollar during the period after year 2001. As the CFDs are not available to US investors this could mean that the world outside the US could be the reason for the changing the proportion.

Generally the price of Gold was affected by the value of the Dollar which happened to be lower in times of economic strength and growth and higher in troubled times. The higher value of Dollar when there are troubles in stock markets is possibly because the Dollar is perceived as a save-haven currency. I believe there is a chance the next recovery will be also accompanied by a weaker Dollar as this will help the US economy. So if the current newly found state of positive correlation between Gold and Dollar prices is preserved, this would mean the Gold could fall accordingly.

The last upside in the Gold price despite the rising Dollar and in the light of Europe's debt problems speaks that it could be mostly used as a hedge instrument now. Apart from the fact that using as a hedge something you own only on paper and not "holding in your hands" devalues the idea of hedge itself, using Gold as a hedging means that when there is no need to hedge a imminent danger, there would be no need to hold Gold.

All the above thoughts lead me to a conclusion that when times get calmer and the horizons look brighter the Gold price could fall. Even just in order to compensate the change in the correlation that appeared during the current crisis. There are technical signs that such a move could not be so much ahead in time but this would be a topic of another article.