Gold Slips Amid Inflation's Revival

With the specter of inflation suddenly making headlines, investors might presume gold would be flourishing. Instead, the yellow metal has been floundering lately -- hitting a five-week low Thursday before rebounding Friday to end the week at $401.60 per ounce. But gold's recent retreat doesn't necessarily mean that the multiyear bull market in precious metals and related shares is over.

The dollar's revival, prior to Friday, has clearly weighed on gold and other commodities priced in greenbacks such as silver. The inverse relationship between the dollar and gold is well known: When the dollar rises, gold usually falls and vice versa. So it should come as no surprise that gold has sold off as the dollar has risen in recent weeks in conjunction with a string of mainly strong economic data; the greenback has done particularly well vs. the euro, which was at $1.1992 late Thursday vs. over $1.28 in mid-February.

Additionally, Jes Black, currency analyst at MG Financial Group, believes many sophisticated investors have used the recent media focus on inflation as an opportunity to exit gold -- at least for now.

"What I find fascinating about watching gold and the markets is that gold is a leading indicator for inflation," Black wrote. "Gold told us for the past year that the Fed's reflation trade would push inflation into the pipeline. The smart money bought gold and is now selling, but the general public is just now hearing about inflation and knows about gold as an inflation hedge, so they want to buy. But they are too late. The trade is crowded and now unwinding."

Reflecting on that unwinding, Black noted there were recently record levels of long gold positions in futures trading among speculators, or small traders. "The subsequent failure for gold to rally to sustain new 16-year highs beyond $430 per ounce earlier this month caused speculators to unwind their long positions resulting in a dramatic $20 plunge in two days," he wrote.

Black now believes that an intermediate-term retreat by gold will continue, with a target of around $350 per ounce. Longer term, however, he thinks gold will reassert itself. "The dollar is in a long-term secular bear market" because the U.S. government will eventually have to continue to increase the supply of greenbacks to "monetize its future liabilities."

More importantly, he said, "commodities are in a long-term bull market because of the emerging demand/supply imbalance."

From both technical and fundamental perspectives, others agreed with that assessment.

"We think gold likely continues in pullback mode," Rick Bensignor, chief technical analyst at Morgan Stanley, wrote in a note Thursday. "It seems very plausible that we could see a decline over the next several months to test down to more substantial medium-term support" at $374 per ounce.

However, the "cyclical and secular bull modes" will continue for precious metals, Bensignor predicted. Although the Amex Gold Bugs Index is down about 12.5% year-to-date, gold and related stocks have outperformed major equity averages for the past one-, two- and five-year periods.

No Faith in the Fed

"Gold will eventually rally against other major currencies," concurred Jean-Marie Eveillard, manager of the $6 billion ( SGENX) First Eagle Global fund and $600 million ( SGGDX) First Eagle Gold fund.

To bet on a sustained strong dollar from here is to bet that the Federal Reserve engineered monetary policy well during the recession, Eveillard suggested. "On the surface it seems the authorities handled things very well," he said. "It seems to me, though, that below the surface things don't look too good."

Eveillard expressed concern about the burgeoning U.S. current account deficit, and the expansion of U.S. consumer debt thanks mainly to artificially low interest rates. "What Greenspan did was flood the market with liquidity," he said. "We look at gold as insurance" against the possibility that the Fed got things wrong.

Frank Holmes, chairman and CEO of U.S. Global Advisors, a San Antonio, Texas-based money manager with about $1.7 billion in assets, offered a blunter assessment. "The biggest thing going for gold is that is has an inverse correlation vs. the dollar," he said. "I don't think the rally in the dollar is sustainable."

Holmes' stance is that gold's upward trajectory will ultimately resume but his firm has been investing in bi-metallic names -- companies that produce copper, nickel, and/or zinc in addition to gold -- in order to diversify its risk. Examples include Placer Dome ( PDG), Wheaton River Minerals ( WHT), and smaller-caps such as Northgate Exploration ( NXG). (Placer and Wheaton are among the top-five holdings of the ( USERX) U.S. Global Gold Shares fund, according to Morningstar.)

Holmes has also been investing in Latin America for the past several months, but his firm's position is that China is key to not just gold but to all commodity plays. As long as China's economy remains strong, he believes that all commodity prices will remain strong. He'd grow wary if China cools down but thinks the booming economy there has a ways to go, buttressing his long-term bullish view on gold.

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