After a recent tarnishing, gold was shining again Thursday. The precious metal was taking its cue from the Bank of Japan's decision to start unraveling an ultra-easy monetary policy that has pumped liquidity into global financial markets for the past five years. The move is a prelude toward the central bank's ultimate goal of lifting interest rates, which remain near zero in Japan.

The link between the BOJ's announcement and gold's rally sounds counterintuitive. The precious metal has benefited from a massive surge in global liquidity, as have other commodities. Besides the BOJ, the world's other major central banks -- the Federal Reserve and the European Central Bank -- had also kept interest rates at historically low levels for the past few years.

This low-interest rate environment encouraged global borrowers to invest in higher-yielding assets at very low cost, boosting the price of everything from commodities to stocks and emerging-market bonds. This "asset inflation" has been a double benefit for gold, which not only rose as a commodity but also because it serves as a hedge against inflation.

But global central banks have now recognized inflation pressures and have entered a tightening mode, with the BOJ just now joining the bandwagon. On the face of it, this is all bearish for gold but much of this has already been discounted by the market.

Anticipation of the BOJ's move -- together with expectations of further rate hikes by the ECB and the Fed -- contributed to gold's recent correction from 25-year highs of $580 per ounce in late January to $540 this week.

Other commodities have also fallen sharply, with the CRB index dropping over 9% since late January. A link between rising rates and commodities has been made by Jeffrey Frankel, economics professor at Harvard's Kennedy School of Government, as reported here .

On Thursday, gold rose $3.30, or 0.6%, at $547.6 after trading as high as $550.90 intraday. Gold mining shares dropped as the metal came off its highs. The Amex Gold Bugs Index fell 1% led by weakness in Newmont Mining ( NEM), Rangold Resources ( GOLD) and Iamgold ( IAG).

The Philadelphia Stock Exchange Gold & Silver Index dropped 1.9% and the CBOE Gold Index fell 1.5%.

Stocks also fell on Thursday as crude oil turned higher to finish at $60.47 as Iran refused to suspend its uranium enrichment program just as the UN Security Council takes up the case.

The Dow Jones Industrial Average dropped 35.14 points, or 0.32%, to 10,970. The S&P 500 fell 0.4% to 1273 and the Nasdaq Composite fell 0.6% to 2254. Tech shares, particularly Google ( GOOG), were again leading the market's downside.

Dollar Dealings

The reason gold fell off its highs, was the same reason it moved higher on the day: The dollar. The greenback, which took a hit in morning trade after the BOJ announcement, found some strength later in the session on expectations of a strong February employment report on Friday.

Gold, which had lost its traditional inverse relationship with the U.S. currency last year, seems to be regaining it now.

As a dollar-denominated commodity, gold should normally benefit from a weaker greenback. As the dollar weakens, it takes more money to buy the same amount of gold. As the dollar strengthens, the price of gold drops. This, however, didn't work last year as gold rose even as the dollar strengthened.

That's because gold became an alternative to the U.S. dollar, which global investors consider less and less as the currency of choice, says Peter Grandich, editor of The Grandich Letter.

The gold-as-an-alternative-to-the-dollar scenario is becoming even more of an issue now that the Fed has signaled it may eventually stop lifting rates, having taken the fed funds rate from 1% to 4.50% currently, while both Europe and now Japan have just entered a tightening phase.

The dollar has remained supported by the Fed's 20-month tightening campaign. This tightening bias had kept the huge U.S. economic balances -- i.e. the trade and the budget deficits -- off of currency traders' radar screens.

Normally, these imbalances should be undone by a weakening dollar, which makes exports more attractive, and higher market rates (i.e. long bond yields), which make financing borrowing more attractive.

The U.S. bond market, it could be argued, has already started to adjust to the prospect of competitive pressures from rising global bond yields by selling off in recent weeks. On Thursday, the 10-year Treasury bond finished little changed ahead of the employment report, with its yield at 4.73%. That's 20 basis points higher than where it stood for most of February.

But the dollar remains supported by the prospect of more rate hikes. The dollar originally dipped Thursday after news that the U.S. trade deficit reached a new record high of $68.5 billion in January from $65.1 billion in December, way above economists' forecasts. But it rose ahead of the employment report, which is expected to keep the Fed tightening for a while longer.

Yet, that's not going to prevent gold from moving up. "People outside of the U.S. don't want to own dollars because of all the underlying economic problems but they can't see any dominating currency to replace it," Grandich says. The move towards gold is the best alternative to hedge against expected future dollar weakness for many large investors and funds in Asia, Europe and the Middle East, he says.

That's also the view of Julian Phillips, a gold analyst with GoldSeek.com. Among the biggest influences he sees for the gold market this year is China's efforts to diversify its assets away from the dollar.

China has kept the yuan artificially low, boosting its exports, and recycling export dollars by buying Treasuries. Still, these Treasury holdings, along with China's massive dollar reserves, are at risk if the dollar falls, Phillips says. China has already started buying up gold with the dollar and intends to double its gold reserves this year.

The challenge for China is to do this without provoking a big drop in the dollar or a spike in the price of gold, Phillips says. Either way, it looks like gold still has some bright days ahead, while the outlook for stocks and bonds get cloudier.
In keeping with TSC's editorial policy, Godt doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He appreciates your feedback; click here to send him an email.