Inter-Market Gold Analysis

At time of writing gold (Feb. contract) has traded as high as 355.70 and is last at 350.00. This puts gold at its highest level since early 1997 and, we suspect, is worthy of a special IMRA issue.

We have often wondered whether Alan Greenspan's tenure as Chair-man of the Federal Reserve had anything to do with or perhaps every-thing to do with the behavior of gold relative to the broad commodities markets. From early 1987 through to the present day the gold/DJ AIG Commodity Index ratio has moved downward within a precisely defined channel. With the DJCI closing around 110 yesterday that put the upper limit for gold on a closing basis around 360.

At top right we show the gold/commodities ratio and contrast it with the price trend for U.S. T-Bill futures. As T-Bill prices rise short-term interest rates fall... and vice versa.

The Fed controls the very short end of the yield curve so its policies have a direct impact on T-Bill prices. Notice that each time the ratio has moved to the top of the channel T-Bill prices have begun to fall. In other words, one might argue that gold prices can rise but only to this extent before the Fed or 'the market' begins to tighten things up once again by pushing interest rates upward.

However... is this time different? In past issues of the IMRA we have pointed out that short-term U.S. interest rates have stopped tracking commodity prices and are now moving with indices like the Nasdaq Comp. and Nasdaq 100 Index. This puts the powers-that-be into a corner since it is rapidly becoming apparent that the effort to prop up the tech sector is giving gold its first chance in a decade and a half to stage a jail break to the upside.

Gold trades inversely to the U.S. dollar (dollar up, gold down) but the best market to view a currency relationship in our opinion is the Swiss franc. At bottom right we show the franc futures and gold futures from the start of 1994 through to the end of trading on Wednesday.

Both gold and the franc have escaped from their downward sloping trading channels and seem intent on pushing higher. As drawn the chart projection for gold is to just above 400 while the franc is headed up to 0.82.

The virtuous circle consists of the Fed holding short-term rates downward in an attempt, it seems, to put downward pressure on the dollar and support the equity markets but in so doing it is succeeding in adding upward pressure to the one market- gold- that it may least want to have rise at this time.

At right we show the ratio of gold to crude oil futures. In Thursday's regular IMRA issue we made a tentative case for crude oil prices moving as high as 60. That may seem somewhat extreme but at least it will help with our conviction as crude pushes into the high 30's.

If we look at the general trading range for the gold/crude oil ratio we get a sense that if crude oil is not yet 'too high' then gold is a whole lot closer to 'too low'- even at current levels. If we were to arbitrarily pick a ratio number from the middle of the chart (17:1) and use 30 for crude... we would come up with a number for gold in excess of 500.

From time to time we make a mistake and listen to other analysts' views. We try not to but some times things slip through before we can flip to the sports section or hit the mute button on the remote control. In a business that is determined to make things as complicated as possible we would suggest that the easiest way to look at the trend for gold is through the combination of bond and commodity prices.

Gold is a fascinating commodity and market because it is both money and a basic commodity used in the production or manufacture of an end product (typically jewelry). It is affected directly by interest rates (the price of money) and by commodity price trends so the combination of the U.S. 30-year T-Bond futures and the Dow Jones AIG Commodity Index is one way that we look at the underlying trend for the price of gold.

We show this chart at right and note that the basic trend for gold is not only positive but has been positive since late 1999. Perhaps we should thank the Bank of England for initiating sales of its bullion holdings and marking the end of a very long bear market for gold.

However... when we are asked how high gold can go or, perhaps more specifically, what constitutes 'high' for gold, we usually answer that we have no idea but we are fairly certain that we will know when it gets there.

At bottom right we show gold futures and the ratio (scaled upside down) of gold to the Philadelphia Gold and Silver Index (XAU). The last two major peaks for gold- 1987 and 1996- had one important thing in common: the ratio between gold and the XAU dropped to slightly less than 3:1. In our view any cyclical peak for the price of gold simply has to have followed a period of speculative activity in the gold mining shares. Put another way, the rise in the price of gold mining shares reflects the market's interest in funneling capital towards this sector. The higher the stock prices move the more the market is saying, in effect, there is a supply/demand imbalance in gold so take a pile of capital and go out and explore and develop additional gold reserves so that supply and demand can once again come back into balance. Until the gold mining shares move up to a point where capital can be raised and spent- a level that is usually associated with a gold/XAU ratio of about 3:1- it is hard to say that gold is 'high' no matter what price is settles out at.

So... if you do the math you get a sense of how much upside is still available in the shares. The XAU would have to push well above 115 if gold is in the vicinity of 350... and it closed Wednesday at 77.10.

A Daily Review of Global Capital Market Trends
Kevin Klombies Editor/Publisher
Email: krk@krk-imra.com
Phone: 1-403-241-2722
Fax: 1-403-241-5764
www.krk-imra.com