Watch the Dollar for Gold's Cues

The AIG, both in its nominal measure and expressed as a percentage of the 10-year note's yield, is a little higher than it was in late January. Both expressions have retreated from recent highs, but neither measure indicates that inflationary pressures are disappearing. On the surface, we have to regard the AIG by itself as supportive of higher gold prices.

But that is the sound of one hand clapping. No matter how high the AIG goes, it will not be positive for gold unless it exceeds the short-term interest rate cost of carry. The spread between the AIG and the three-month repo rate peaked in late May, and while still positive, it is back at its January 2003 level. The Federal Reserve has communicated its rate-raising intentions well, and unless the economy weakens to the point where the market no longer believes higher rates are in order, this declining spread is not all that encouraging for higher gold prices.

Source: Howard Simons

Signing a Lease

The actual supply/demand balance for gold is always difficult to ascertain. Suffice to say that many of the organizations that publish data are not disinterested. One datum that is market-based is the gold lease rate, the difference between LIBOR and the gold swap rate. When demand to borrow the metal is high, price spikes frequently follow. The ratio of the lease rate to LIBOR has been declining steadily for almost three years, a situation that speaks to both little interest in shorting the metal and a low level of future demand to buy it back in a short-covering trade.

Some gold bugs suggest the low lease rate is evidence that central banks are dumping gold bullion into the swap market in an attempt to cap gold's price. I prefer the simpler explanation. On balance, the low and declining lease rate should be a damper on gold's price, but gold has rallied for three years in defiance thereof. Let's call this one neutral.

Source: Howard Simons

Gold and Oil

Let's take a brief detour into the relationship between gold and crude oil, or, as noted last May, the non-relationship, despite the efforts of various twits to create one. Crude oil has been setting price records on a daily basis of late, while gold barely has budged. In fact, gold is no higher in price today than when crude oil was 30% lower in price than it is today. Bottom line: If you looking for a clue as to gold's future, look elsewhere.

Source: Howard Simons

More Bang With the Buck

The place you should look is the dollar. When all is said and done, which won't be anytime soon, gold has been a proxy for the dollar, and vice-versa, for the past three years. The dollar's value, as discussed a few weeks ago and previously, is a function of relative inflationary expectations between the U.S. and the rest of the world. If the market senses that the Federal Reserve will back away from rate hikes, the dollar will weaken, and gold will rise in nominal dollar terms.

Source: Howard Simons

Of course, the opposite will hold true as well. Rate cuts elsewhere or more rapid rate hikes in the U.S. will strengthen the dollar and dampen gold. While a number of factors favor a weaker dollar, we must be cognizant that Asian central banks may repeat their performance of last winter and support the dollar in order to keep their own currencies from moving higher. Barring that scenario, which we will have to revisit at another time, I regard the dollar as the decisive factor that could lead to higher gold prices.

A Note on Stocks

A final note to those who like to play commodities via commodity-linked equities. I pointed out in February how the Philadelphia Gold and Silver index had underperformed the increase in bullion prices. Several readers asked me to look at the Amex Gold Bugs index, which includes only those firms that have not sold their production forward past two and a half years. Fair enough; please find the comparison below.

Source: Howard Simons

The story remains the same one we have seen time and again: If you want to play the commodity, play the commodity. Or in the case of gold, if you do not want to play the commodity, play the dollar instead by either trading the currency, using a non-dollar bank account such as offered by everbank.com or using a diversified foreign bond funds.

In any case, cast off the mind-set that growth causes inflation, which should support gold. The fashion in this market will be that weak economic news will stifle the Federal Reserve, which will weaken the dollar and support gold.