[LFX]

Gold prices have pushed to record highs in recent days, despite rising confidence in the economic outlook and apparently subdued inflationary expectations. Ordinarily, gold would be expected to suffer given this backdrop. Demand for gold is usually a negative function of the performance of riskier assets, which provide a sequence of cash flows whereas gold does not, and a positive function of inflation, which erodes the value of financial assets but not of gold. Several market factors have changed, however, and this should help to keep prices on an upward track for the time being. The USD holds the key to this unexpected strength, although other, more subtle, factors have also been in play. Firstly, investor inflows into gold have been very strong. Data from the Commodity Futures Trading Commission (CFTC) shows that speculative positions on US exchanges reached a record net long level of 239,668 contracts in early October. This is up by 64% from the middle of this year. Also, investment in physical ETFs continues to grow, reflecting widespread interest in gold as an asset class. Unlike traditional financial instruments or paper ETFs, investments in physical gold ETFs have a direct and positive impact on the price of the underlying asset, and each contract confers ownership of a small allocation of metal. Particularly notable has been the shift in the perception of gold from a marginal asset class to a key focus of investment decisions. Late last year, there was a substantial jump in gold buying by retail investors in Western markets.

Before the recession, the emerging markets of Asia were big buyers of gold for investment purposes, but interest in gold has started to be seen much more widely, both due to extra investment vehicles available and a loss of trust in traditional investment classes and financial institutions. Gold’s global acceptance avoids both political and country risk and offers protection against local-currency weakness and potential future inflation. The deep recession, widening government deficits, and the loss of confidence in complicated investment vehicles have all played their part in the recent strong performance of gold prices.

Lower sales of gold by central banks have also helped to tighten the gold market. A loss of confidence in the USD has also helped to take gold higher. Recent months have seen gold revert to its traditional strong negative correlation with the USD, with the EURUSD correlation with gold averaging 62% in the past six months, much higher than the correlation for base metals against EUR-USD. Gold has rallied on the back of USD selling, and market expects further weakness heading into year-end, when EUR-USD is expected to hit 1.55.

Another supportive factor for gold has been the strength of currencies in major gold consuming areas (i.e., India and Turkey). Undoubtedly, the loss of confidence in the US currency is rooted in the uncertainty surrounding the Federal Reserve’s current monetary policy framework.

As long as risks associated with excess liquidity prevail, demand for gold as a typically ‘hard’ asset will benefit. Demand should remain strong as long as there is no tangible commitment by the Fed to shift its focus away from weak economic activity and towards inflation risks. The evidence does not point to a direct causal link between inflation fears and gold prices; it suggests a causal link between the fear of a somewhat ill-timed normalisation – too little, too late – and the price of gold. Interestingly, volatility in gold futures is back to pre-Lehman levels and somewhat lower than volatilities in other asset classes, such as rates, equities, and FX. Gold volatility, however, shares a feature with FX volatility: for both, implied volatility is much higher than what realised volatility would suggest. While the uptrend for gold is likely to remain choppy, market expects further USD weakness by year-end and in H2-2010. This should give gold prices an additional boost.