<strong>JANE FOLEY<br />RESEARCH DIRECTOR, FOREX.COM</strong>THE market returned from its summer holidays last week with a hearty appetite for risk, undermining the US dollar so much that euro-dollar rallied into a new trading range and, unsurprisingly, boosting the price of oil and metals. What was surprising, however, was the surge in gold, which broke the $1,000/oz level for the first time in 18 months. <br />While dollar weakness will have provided some of the support for the yellow metal, the bulk of the 40 per cent rise in gold from last November&rsquo;s low clearly reflects more than a dollar move &ndash; the US dollar index is just 7 per cent below this year&rsquo;s average.<br />So what else may have added the extra shine to gold? Historically, the precious metal has been seen as a flight to quality and as a hedge against inflation. At the height of the financial crisis both of these fears were certainly valid supports for gold. <br /><br /><strong>AGGRESSIVE POLICY<br /></strong>But while the global economic recovery is certainly not out of the woods today, neither reason holds as much water as it did 12 or 18 months ago. <br />Risks still remain but the financial system has started to heal, albeit gradually. The improvement is evident in the continued reduction in money market rates, the rise in risk appetite and the improvement in economic data. Central banks have retained their very accommodative policies and hindsight is suggesting that the use of very aggressive monetary policy near the start of financial crisis was indeed the correct action. <br />The basis of this assessment is that the inflation outlook remains subdued despite continued QE. When the Fed, the Bank of England and others first introduced quantitative easing in the spring, the market&rsquo;s big fear was that inflation might be an unfortunate by-product two to three years down the line. <br />As yet, the aggressive increase in the money supply has not translated into a rise in the availability of cheap money to households and business since banks have not been lending freely and have tightened their assessments of risk in the wake of the credit crunch. <br />The fact that QE has not yet bred inflation has encouraged the view that without aggressive monetary policy the outlook for the global economy would almost certainly have been much worse. While exit policies will have to be carefully managed when the time comes, continued increases in joblessness in many countries will provide a natural dampening mechanism to inflation for some time yet. It thus seems increasingly likely that central banks&rsquo; inflation-fighting credentials will emerge from the financial crisis intact.&nbsp; <br /><strong><br /></strong><strong>CRISIS OF CONFIDENCE</strong><br />If inflation expectations remain low and well managed over the next couple of years, the attraction of gold relative to paper fixed income assets should recede. But what else then could have caused gold to be pushed back up to the $1,000/oz level? Apart from fear and inflation, the other factor that could drive gold significantly higher is a crisis of confidence in the US dollar. This too is highly unlikely. <br />The dollar may have been trending lower this year but as yet the move has been orderly. The pace of a currency shift is of huge relevance to policy makers and investors since if it is slow and progressive then policies can be altered and hedging strategies put in place. Thus, a slow and moderate depreciation in the value of the dollar may be more easily accommodated within the US Treasury&rsquo;s strong dollar policy. <br />A strong or sharp move, however, is likely to raise hackles within the US authorities and beyond.&nbsp; The dollar&rsquo;s credentials as the world&rsquo;s primary reserve currency may be in question but it still faces no competition for this status. <br />Furthermore, it is in the interest of China and all major foreign holders of US paper that the greenback does not enter freefall. They will maintain the pressure on the US to get its budget in order and to improve the fundamentals of the dollar, but in the meantime they will have to keep buying US paper and supporting the buck in order to protect the value of its existing holdings.&nbsp; <br />With the drop in the dollar thus limited, it would take an unexpected nosedive in the outlook for the global economy to send investors flocking back to safe havens. In which case, the further upticks in gold may prove to be good selling opportunities.&nbsp; <br />