Reflecting on the market reaction to the Egyptian revolution, if it can be called that, I found it rather surprising that gold, which usually reacts dramatically to any geopolitical action, has been so subdued. It did spike by around $25 after the first weekend of protests, but on February 8, nearly two weeks after the protestors first came out on the streets of Cairo, gold remains around $1,350, about the level it was at the start of the protests and 5 per cent below its highs at the start of the year.
Given that (a) Arabs (and us other less sophisticated emerging economy types) love gold and (b) in times of crisis/uncertainty/terror even our sophisticated cousins from developed economies start buying gold, this calm suggests that something unusual is up.
One possibility is that the market believes that the worst of the crisis is over; that the domino effect that started in Tunisia will be contained; and that all will return to manageable geopolitical stability. This seems a bit far-fetched; whatever the new political contours of the Middle East, it is hard to believe they will not be substantively different than they had been for the past few decades, and even harder to believe that this will not involve frequent blasts of instability, or at least uncertainty, over the next few years.
A second possibility – and one that I am more attracted to – is that market believes that the gold price is already too high. Now, I know this flies in the face of a lot of current analyses, but much of these analyses are driven by the fact that there are gold bugs hidden under every rock in the market — and many of them have taken strength and gained stridency from the long period of dollar weakness. On the other hand, there are very few people (with the exception of my old friend, Andy Smith) who are intrinsically gold bears. Which may explain why you never hear that side of the story.
Now, I am not a full-time gold bear — although I do have a marriageable daughter, which means I am short gold, by definition. So, while I may inadvertently be talking about my own position, I feel that the fact of no gold spike during/after what has to be a major world-changing event in the West Asia is something worth listening to.
Indeed, gold has been acting strangely for a few months now. Normally, gold and the dollar have a strong inverse correlation — often as high as 85 per cent; this means that whenever the dollar strengthens, gold weakens and vice versa. However, since the start of the Irish wave of the European sovereign debt crisis in November last year, this inverse correlation began to break down. While the dollar rose almost 6 per cent by early December, gold also put on a kick, rising 4.5 per cent to a high of $1,422 an ounce. Clearly, traders who were selling euros out of concern about the future of the eurozone, were buying both dollars and gold in sufficient volumes to break the normal historic correlation.
This would suggest that the spike above $1,400 was driven by euro weakness, which should be reversed when the euro recovered. Sure enough, as Germany put its considerable weight behind the single currency in early January, the euro strengthened back to $1.38 and gold fell sharply to $1,312, as long-gold-short-euro positions were unwound.
Full circle to the Egypt crisis and gold is back to its apparent current steady sate of $1,350.
So, where do we go from here?
Well, the dollar is already showing a wee bit of strength, and we need to note that 10-year US treasury yields, which had been poised for a rise, shot higher after the US employment report, even though the non-farm payrolls were not particularly positive. At 3.65 per cent, it is currently at the highest level it has been since May 2010.
Clearly, the bond market, in definitive disagreement with Mr Bernanke, believes that US growth is getting better and/or that the long period of free money is sure to create some inflationary pressures, despite the still yawning output gap in the US. Since the bond market is usually right, I believe we will find – sooner rather than later – that the Fed will have to back away from its grotesquely aggressive QE2 (or quantitative easing two) programme.
This will be good news for the rest of the world, since it will curtail the tidal wave of money that is pushing up inflation in many countries. The dollar will strengthen and gold — well, my wallet tells me that anything above $1,250 is much too high.
