The real reason for gold’s drop

Market Pulse: Jan. 31, 2011

The real reason for gold’s drop

We noted several weeks ago that gold may be setting up for a medium-term top. Since then, gold has fallen about $55 and has posted a new four-month low. As the chart below shows, gold has been falling even though the dollar has been weakening, which is an unusual situation that suggests underlying weakness in gold. In addition, physical gold assets are declining in gold ETF funds, which means some investors are cashing in their chips. (See chart below fundamentals.)

The current gold sell-off is being caused mainly by reduced financial crisis fears, as evidenced by the twin sell-off in the dollar and gold on reduced safe-haven demand. The U.S. economy has picked up significantly in the past several months and slowly is growing its way out of the 2008-09 financial crisis. China’s economy has been slowing, but not by nearly enough to cause a serious risk of a hard landing. Germany is growing strongly, giving a lift to Europe as a whole. Eurozone officials finally are drawing up more serious plans to address the European debt crisis. Adding to the negative mix for gold, ECB President Trichet has started talking tough about inflation, which increases the chances that he will start to drain reserves later this year. The Fed likely will start draining reserves by early-2012 at the latest.

Gold has an ephemeral value. Gold’s perceived value is driven more by technicals and market psychology than by the true supply and demand factors seen in most commodity markets. Analysts and traders like to talk about “fiat currencies,” and the reality is that gold is a “fiat metal” — it only has value because human beings decided it does. In any case, with the current easing of crisis pressures, gold’s value is downshifting and we see that process continuing over the near-term as the stock market rallies and the European crisis ebbs.

If given a choice of which metal to be long on a five-year trade, we would rather be long copper than gold. Copper’s strong demand picture is much more identifiable than for gold, and copper benefits from the long-term global development theme. Gold’s demand, on the other hand, is driven by the dollar and by crisis levels, which are much shakier demand variables.

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