Despite last week's drubbing, the fundamentals for gold remain particularly favorable.

Gold has fallen about 17% from its highs, and most of the drop occurred last week. The news was ugly particularly out of Europe, yet gold was no longer seen as a safe haven. The only solution to the ugly news was more of the same - Europe would "kick the can down road" a little bit further. This also would seem to be gold positive, but it wasn't. So what gives? The best I can discern is that gold came under heavy selling pressure due to forced liquidation of other assets.

The fundamentals for gold - falling interest rates or rising bond prices - are gold positive. Bonds (particularly at the long end of the curve) are looking a bit stretched after correctly anticipating the Federal Reserve's announcement to do Operation Twist, but the Fed will be in the Treasury market buying and is committed to keeping rates low for a long time. Furthermore, the Federal Reserve's commitment to keep short term rates low (and below the level of inflation) through 2013 is another positive for gold. Nothing has changed (except the price) since the last time (June 1) I discussed gold fundamentals.

Two other points regarding fundamentals are worth considering.

One, several reports in the media suggested it was strength in the US Dollar that was responsible for gold's weakness. Wrong! As the weekly chart of gold shows (see figure 1), Dollar strength equals an opportunity to buy gold. The indicator in the lower panel shows those times since 2004 (and we could could go back even further) that trends in the Dollar were favorable. (This would be when the indicator is up.) The indicator is due to "pop up" at the end of this month again suggesting strength in the Dollar. As the vertical lines show, Dollar strength was THE time to buy gold over the past decade.

Figure 1. Gold v. Dollar Strategy/ weekly

Larger Image

Two, gold is falling because the US economy is entering a recession, and by definition, a recession is deflationary. First, I don't think it is news that the US economy is entering a recession. You may not hear it reported on CNBC because our problems (i.e., a weak stock market) are due to Europe. The "R" word is barely mentioned. Anyway, I digress. By my estimation, the US economy has been contracting since July when long term Treasury yields broke higher, and the oncoming recession has been confirmed by the bear market in equities. Gold should have sold off months ago if the US was entering a recession. The point of all this is that there is very little correlation between a recession and the price of gold. If interest rates go lower during a recession, which is very common as the Fed attempts to stimulate the economy, then gold will go higher.

In summary, the fundamentals for gold remain unchanged and are favorable. Commonly held beliefs as to why gold was weak last week don't hold up.