Watch the Dollar for Gold's Cues

Market analysis requires a combination of detective work, an understanding of numerous economic and financial rules and relationships, and perhaps most importantly, the ability to throw everything aside when all of your past training and experience fail. For example, take the relationship between bonds and crude oil prices over the past three months: On many days, both markets rose together on the notion that higher oil prices would slow the economy sufficiently to keep a lid on interest rates.

Even for one who has argued for more than two decades that this was the proper relationship, the irony of seeing the old shibboleth turned on its head was a little disconcerting. Even when I believed the market had the relationship wrong, I chose to go with the stampede in the interests of self-preservation. Besides, who would hear all my tut-tutting over the hoofbeats? The gold market is another situation where the wrong relationships are emphasized. But a review of commonly consulted indicators shows that a surprising proxy works best, and points to the need for a new way of thinking about factors that affect this commodity.

Where Does Gold Belong?

Over the years, gold has entered and left analysis a schizophrenic. On one hand, it should be one of the simplest and most rational markets going: Its currency-adjusted price should be the product of the difference between expected inflation and the expected short-term interest rate cost of carry and nothing more. On the other hand, it is a market imbued with mysticism. Keynes called it "a barbarous relic," and it is a favorite of those who believe the creation of paper money has been the root of all evil. I recognize gold's various symbolic values and let it go at that. Let's turn our attention to something we can measure, a set of indicators listed here in February.

The first is the annualized inflation gauge, which I abbreviate as AIG despite its confusion with the insurer of the same name. I have simplified the calculation of this measure to the difference between a constant maturity 10-year note and a constant maturity 10-year TIPS; this also allows for an earlier start, February 1997, to the series' history.

Source: Howard Simons