Will the dollar glitter more than gold in '08?

ANALYST'S VIEW

Gold has been in a bull market since 2000, with the nominal price coming very close to its all time high of $854 a troy ounce, which was registered in 1980, before turning below $800.

While the rise in gold prices has been seen as part of a wider commodity bull run, our analysis shows that in real inflation-adjusted terms, gold prices have reached less than half their 1980 high.

In comparison, oil (at its current peak of $97 a barrel) was very close to its peak of $105 reached in the 1970s and copper (which peaked recently at $8,700) was almost at its inflation-adjusted peak of $8,750 hit in the early 1980's.

This suggests that the run-up in gold prices is different than that in commodities, which can be explained by the fact that gold is partly commodity and partly a monetary aggregate.

As part of its role as a monetary aggregate, gold has always been seen as a hedge against inflation. While gold is not a perfect inflation hedge, it does have a very strong link with inflation, even the inflation-adjusted gold price is very highly correlated with inflation. Indeed, the steady if slow rise in the real gold price has coincided with rising inflation in the US, Europe, China and several other countries.

We believe that this phase of the deflationary impact of China and India having joined the global economy is playing itself out. Already, the sharp rise of the rupee is compelling Indian exporters to raise prices.

Likewise, the Chinese government is having great difficulty using monetary tools to cool its economy. Despite a raise in the reserve requirements nine times and interest rates five times this year, inflation in China remains very high. This suggests that it is very likely that the yuan will appreciate more than what the market anticipates.

With global prices rising, the US Fed will find itself in a bind, having to balance growth and market hysteria on the one hand and protect against inflation on the other. We believe, like everybody else, that the Fed will cut rates in December.

However, the real drama will begin after that as likely poor Christmas sales and continuing trauma in the financial sector will push for another cut, while another round of sharp dollar weakness (and rising global prices) will augur against it. If the Fed cuts the rates in January, we could see the dollar really swoon (and gold rise in sympathy), but this will be the last hurrah.

By the end of the first quarter of 2008 (or early in the second quarter), we will see the dollar turn around, surprising most. We look for heightened volatility in 2008, with gold prices ranging between $900 and $650 an ounce. The rupee will remain well bid, in general, but will respond to dollar strength in the second half of the year. We forecast a range of 38 to 40.50 for 2008.