The gold price continues its march higher as risk falls off

Kathleen Brooks
THE LAST two years have been good for gold. It’s been one of the only assets to march higher during the financial crisis, and is now getting a boost from the sovereign debt problems in Europe. Since Europe’s crisis, investors’ reactions have been to ditch risky assets in favour of perceived safe havens – gold and the US dollar. Since reaching a high of just above $1,200 per oz at the end of last year, gold still remains elevated and yesterday was trading above $1,170 per oz.

So what is supporting the price of the precious metal? Low interest rates and a risk premium caused by the financial crisis and now compounded by the sovereign debt problems in Europe, explains Adrian Ash, head of research at “There is now a genuine panic about the sovereign risk in the Eurozone, which means that gold will continue to find a strong bid.”

And technical signs suggest that gold will continue to appreciate as long as Europe remains in crisis. Since 2000 gold and the euro-dollar exchange rate had a positive correlation of 0.52 – this meant that when the gold price appreciated so did the euro versus the US dollar. That is no longer the case and gold now has a negative correlation with the euro-dollar rate, -0.44, so when the gold price rises the euro tends to fall. The significance of this reversal in the relationship is that gold is being used as a safe haven asset, since unlike government debt, gold is virtually impossible to default on.

Adding to upward pressure on the gold price is that the problems in Athens should limit the flexibility of the major central banks to raise interest rates anytime soon. Fears about contagion and the high levels of debt in some developed economies mean that central bankers will not want to spook the markets, which only adds to gold’s strength: “When you don’t earn anything on cash (when interest rates are at 0 per cent or very low) that is when people buy gold. I don’t think any of the major central banks will think about raising interest rates any time soon,” says Ash.

And it’s never been easier for retail investors to trade in physical gold. ETF Securities offers a dedicated physical gold exchange-traded fund (ETF) and db x-trackers has a commodity index ETF that tracks the DBLCI Optimum Yield (OY) Balanced Index, which includes gold. These products are also highly liquid. According to data provided by iShares, the ETF provider, in the first quarter of 2010 nearly $1bn of assets flowed into European precious metals ETF funds.

But is it too late to jump on the gold bandwagon? Although the Eurozone crisis could drag on for a while, some analysts, including Michael Crook at Barclays Wealth in New York, says that once things settle down in Europe the gold price could tumble to as low as $800 per oz.

“One of the main drivers of the gold price is crisis. In times of crisis the gold price can be driven up by 20-40 per cent,” says Crook. “However, once everything calms down we almost always see crisis premiums come out of the market.”

Crook says that the gold price could fall even more than normal because he believes that even at 0 per cent interest rates in the US are still too restrictive. Usually the gold price falls when interest rates are too high, and then rises when rates are too low. Crook believes that US interest rates are far from restrictive: “We think that with unemployment this high, interest rates should be negative, but of course the Fed can’t lower rates from here.”

But what will cause the price of gold to fall? “When it becomes evident that the global macro picture has become stable, as long as inflation is not an issue, as it doesn’t appear to be, then this should send gold lower,” says Crook.

Of course retail investors who had the foresight to go long gold five years ago have clocked up big profits, but for those that waited on the sidelines there could be more upside to come. Just be sure to reverse your position once there are signs of a return to economic normality.