Gold breaches above its 7-week high of $847 per ounce, further approaching its 30-year high of $850 per ounce, amid a combination of broad dollar weakness and increased asset allocation shifts into the metal. We stated in our 2008 preview last week that we expect prolonged gold gains this year to be as high as $930 after an initial pullback towards $780, despite an anticipated rebound in the U.S. dollar. So far we expect the dollar to gain into Q1 and begin to consolidate towards Q2 before a prolonged decline in Q3 and Q4. The reasons for this assessment are:
Central bank liquidity injections will boost gold
As the Federal Reserve, Bank of England and Bank of Canada blitzed the money markets with over $600 billion in liquidity injections in the last two weeks of 2007, market interest rates headed lower while inflation continued to push upwards. Persistent liquefying operations from the Fed and the ECB are likely to highlight the luster of the precious metal relative to paper currencies, especially as the real cost of money is dragged down by high inflation and lower interest rates. The inflationary consequences of these expansionist monetary practices coupled with persistent robustness in commodity prices are expected to offset any downward pressures on inflation resulting from cooling economic activity. While the relationship between strong commodities and cooling economic growth may prove untenable, agriculture, energy and metals are likely to remain supported by supply constraints rather than demand factors.
Low real global interest rates are good for gold
Although the Federal Reserve has distinguished its monetary policy maneuverings between liquidity injection operations (aimed at relieving funding shortages in the money market) and interest rate-cutting moves (aimed at shoring up the economy), we do not expect these liquidity measures to stave off the risk of further slowing. Anticipated deterioration on the macro economic front (rising unemployment rate, higher jobless claims, soft post-holiday consumer demand and slowing prices/construction activity on the commercial property front) will maintain the Federal Reserve’s policy bias towards the downside, as per its December FOMC statement and November forecasts for lower term inflation and higher unemployment for 2008 and 2009.
Global real interest rates are low and will head lower. The inverse relationship between interest rates and gold prices is driven by the notion of yield substitution. But as real interest rates fall, investors are hit by a double whammy of rising inflation and falling nominal yields, two reasons prompting the shift to higher yielding gold. Real interest rates in the United States have fallen to 2.20%, while those in Japan , Eurozone , the UK and Canada are at -0.1%, 1.0%, 3.50% and 2.40% respectively. With UK rates widely expected to fall by at least 75-bps this year (we expect 100 bps), the expected decline should further boost gold. High nominal rates in Australia and New Zealand are the main reason for our bullish outlook for these currencies, with the main source of downside risks seen from prolonged declines in U.S. and global equities.
So why expect a dollar recovery?
Despite our expectations for further Fed cuts (75-bps to 3.50%), these rate cuts will not occur in a global vacuum, but will be accompanied by easing from the Bank of England, European Central Bank and Bank of Canada. Yet even if the ECB ends up holding rates unchanged at 4.00% for the rest of the year, market speculation and expectation alone could do the job of sending the euro lower. There is also speculation that this year’s entry of Cyprus and Malta to the Eurozone may tip the balance of power inside the ECB Governing Council towards a more growth-oriented policy away from a German style inflation policy. Most of all, the expected dislocation of economic activity in the UK and resulting market turmoil from prolonged declines in housing prices and consumer spending power is expected to force the Bank of England into cutting rates by 100 bps to 4.50%. Prolonged selling in equities is expected to trigger renewed declines in AUD, CAD and NZD against the dollar during Q1, as investors further unwind their carry traders away from high yielding currencies.
The 2 pm release of the FOMC minutes from the controversial December decision of cutting rates by 25-bps will shed light on the extent of the agreement and bias regarding the need to cut rates further. Recall that the FOMC balance of vote shifted towards one dissenter calling for a 50-bp cut (Rosengren), away from October’s decision when one dissenter called for no change against a 25-bp rate cut. Nonetheless, tomorrow’s ADP report on private employment and Friday’s payrolls should provide more substantive guidance for the markets than the FOMC minutes.
Euro gains capped at 1.4740
Today’s release of the Eurozone December manufacturing PMI showed a decline to 52.6 from 52.8 points, but this morning’s ISM may stabilize the foundation for the pair. Chances that the ISM will drop below 50 are greater than 70%, in which case will likely drive the pair above the $1.47 mark. Yet, we anticipate selling to emerge at 1.4720. Key resistance stands at 1.4740. Any unexpected gains in the ISM, such as renewed strength in the new orders index and prices paid index is likely to call up 1.4640 support, followed by 1.4560.
USD/JPY eyes 110.80
Downward bias emerges on a combination of weak U.S. data from the past seven days and the onset of further equity market sell-off. Fresh reports placing Citigroup’s Q4 writedowns at $13 billion aren’t likely to improve the situation in the broad indices. Support emerges at 111, followed by 110.80. Upside capped at previous support of 111.60, followed by the 200-day MA of 112.00.
GBP least attractive of dollar-selling alternatives
We extend our GBP bearishness from 2007 into 2008 as the currency remains the least attractive currency to buy against the USD during U.S. weakness. We continue to deem periodic gains in cable as selling opportunities for a currency that faces a dismal outlook for housing, consumers, banking and the greatest downside potential for interest rates in the G7.
Cable eyes support at $1.9760, followed by $1.9740. Upside capped at 1.9850, followed by 1.9880.
Ashraf Laidi Chief FX Analyst CMC Markets US