As we write, the gold price is at $1,364 having bounced off support at $1,324. It is now consolidating, so we have to ask is it about to return to an upward movement longer-term? If it is just consolidating before another strong drop we need to know because it could mean that the long-term upward trend will be broken. For sure the gold market has moved into one of those high risk areas where one expects a sudden and a strong mover, either way. But if it is going to rise, then we are at the point where we should be entering or re-entering the market. The trader may well find himself taking a 'spreading' position and the medium or long-term investor must decide to go in or stay out. The Technical picture is not as conclusive to them as they would like, so they may only enter once they see a clear direction. What process should an investor go through when a market is in this condition?

Adjusted Mind-set

Before we continue, we would like to adjust the common perspective on the gold price. Prior to the de-linking of gold from the dollar in 1971, gold was thought of as the only real money. Currencies were measured against gold. The fact that President Richard Nixon and his Administration cut the dollar's link to gold and made it the sole global reserve currency did not change that. People's perception of money in the last 40 years has changed and today people's reference point for gold is the U.S. dollar price. With the sovereign debt crisis and quantitative easing influencing the value of currencies since 2007 most people now question the value of the dollar as a 'measure of value', while continuing to see it as a 'means of exchange'.

This takes us back to the need for a 'measure of value' and an adjustment in our perception of the future of gold. With the head of the World Bank highlighting the need for gold to be a value reference for currencies we have arrived back [in thought, if not in deed] at gold being real money. We want to go further than that so that we have a correct perspective of what is and will, happen to global currencies in the future. We would suggest that one should not see the gold market as going up or down, but currencies that are going up or down against gold. Once we have that perspective in mind a clear picture of gold emerges in the currency world and exchange rates.

To clarify; since the turn of the century, the euro has moved from below €300 to Friday's €999.92 at the Fix in London. Since the turn of the century, the U.S. dollar has gone from $275 to Friday's $1,355. From that viewpoint we can see that it's currencies that are in a 'bear' market, not gold in a 'bull' market, while gold is simply rising to where it was originally [there is still some way to go on this too]. Looking back over the past forty years with that perspective shows should have fallen far more if they were to accurately reflect their buying power.

If currencies are then in a 'bear' market do we expect them to recover? The maxim, what goes up must come down, takes on a whole new meaning when one applies that to currencies. It nimplies that gold will not fall back to where it came from.

What do the Fundamentals tell you?

Currency fundamentals

• The first question becomes, what will happen to the dollar and the euro? Both the Eurozone Sovereign debt crisis and the coming U.S. sovereign and state debt crises, point to a further real devaluation of both the dollar and the euro. The exchange rate between the two may not vary that much over time as they both slide down together masking what is really happening. But as one of the fundamentals that point the way for gold, we fully expect currencies to continue to lose value in the hands of their governments and central banks.
• The internationalization of the Yuan may cause people to say that the Yuan must rise in value to reflect the economic strength of China. We would argue against that saying that China has pegged the Yuan to the dollar to retain part of its global competitiveness via the Yuan. It does not make sense for them to risk losing such business through an appreciation of the currency. It is far more likely that the Chinese would remove the need for such an appreciation through the persistent issuing of the Yuan globally to take the pressure to appreciate, away from the currency.
• We go even further and say that it is incumbent upon all but the resource producing countries [where local currency values are secondary to the international price of those resources] to do what they can to prevent the appreciation of their currency. We have witnessed both Japan and Switzerland [not resource producers] talk and intervene [Switzerland through interest rate declines] one way or another to prevent an excessive appreciation of those currencies. This is why the head of the World Bank put forward the suggestion that gold be the reference point for value in the first place.

Therefore the conclusion we reach for 2011 is that currencies will not appreciate in value significantly in 2011

Demand and Supply Fundamentals

[We will be going through the detail of these later this month in upcoming issues of the Gold Forecaster]

Supply

• Let it be enough at this stage to say that newly mined gold supplies will not increase by more than a single figure percentage if at all.
• Central bank supplies [we include the I.M.F. in this] will fall by 400 tonnes as the I.M.F. sales have been completed now. Central bankers are now buyers of gold.
• The only other source of supply will be from the current holders of gold. We have seen around 100 tonnes supplied by the holders of the shares of gold exchange traded funds [SPDR in the States has been the supplier] but whether this came from holders seeing a recovery slowly accelerate and persuading them to turn to equities, remains to be seen. They could have been either redeeming their gold from the fund or selling to buy physical gold offshore [worried about confiscation of their gold by governments sometime in the future?]. However, other sales of gold have been sparse.
• Will higher prices trigger 'scrap' or current holder sales? We must wait and see.

Demand

As a theme in the gold market it is appropriate to point out that gold is not only an investment but because of its liquidity justifiably can be called cash. If gold is being accepted as collateral by U.S. banks now, we deem it to be cash. While many believe that selling an investment actually does close the position, we realize that selling an investment requires buying cash or moving into another investment. Cash is an investment. Investors must ask themselves, what type of cash are they referring to? This starts to describe the path of gold back to money acceptable by the banks [something that must be abhorrent to them now]. When seen in this light gold, as an investment, adds another facet to its desirability as an investment.

The largest source of demand in 2010 and in the years before that has been from investment demand. In that figure we prefer to include Indian demand. It has been classified as jewelry demand in the past, but this does not accurately define the purpose behind the buying. The same applies to Chinese demand. Whether jewelry of bar or coin, investors in those countries are buying as a long term investment that hopefully will give them financial security. With India taking well over 500 tonnes of imported gold this year and China importing over 210 tonnes we prefer to add these amounts to Western investment demand whether it is in bullion form or the shares of the SPDR [in particular] Exchange Traded Funds shares. Will one of the several structural crises rushing at us from the horizon encourage more investment in gold? Will the recovery have fund managers, currently holding gold, move them to get out and chase equities of fixed interest investments? We doubt it.

In the developed world gold's high prices enhance the attraction of gold. In 2010 we saw a recovery in the developed world's jewelry market back to former levels even at these high prices. There is no reason, except much higher prices, to think that jewelry demand will now fall.

Industrial demand is on the rise in hi-tech applications that are price insensitive, so demand from this source should move in step with the global recovery.

On balance

Weigh the facts above and ask yourself, which way do you think the gold price will go? Where the Technical picture may be either indecisive of confusing, how do these facts guide you? If you believe that the problems of 2010 will be rectified and the developed world move into full recovery, then there may be better opportunities in equity markets.

If you don't see a rosy future then the above may point you to stay in gold or get into it.

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Currently, we are presenting in the Gold Forecaster, a series called "Financial Earthquakes", covering the main crisis areas in the financial world and what they could lead to, as well as our gold forecast for 2011. We will also give a more details analysis of gold's demand and supply factors in the newsletter shortly.
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