Gold -- Further Thoughts & Conjecture

This article is a supplement to yesterday's post on the
gold price.

Let me start with the macro-indicators I follow to track
gold. First is the activity of the Fed's Open Market Committee.
The Fed's Treas./gov.related/repo portfolio determines the
growth of monetary liquidity. Growth of this portfolio is an
important precursor of inflation and the direction of the US
dollar. From 1998 through 2004, the FOMC portfolio compounded
at a 9.2% annual rate. That was rapid and strongly inflationary
growth. It set up the trashing of the US$D and helped trigger
the bull market in gold. Since the end of 2004, the FOMC
portfolio has compounded at a low 2.8%. So the Fed has been
tightening up on monetary liquidity. For the entire 1998 -
2006 period to date, the portfolio has grown 7.2% annually --
still on the high side -- but the inflation potential is
coming down and the case for a stable US$D has improved.
One reason gold tends to do well late in each calendar year
and early into the next is the fact that the Fed tends to
add extra liquidity to the system for the holiday season.
That has yet to occur this season.

The second main factor I follow is a broad composite of
sensitive materials prices. With global economic recovery and
then expansion, this index has moved up sharply since 2002
and is still holding a firm uptrend. However, this industrial
commodities composite has been flat since the spring of this
year mainly reflecting a slowing of economic growth. The index
does have a moderate seasonal bias favoring late autumn -
winter. So far, the composite is treading water.

The oil price is the third major factor I track regarding gold
as it is an inflationary linchpin. As you know, oil has been
retreating since this summer. The oil price has a strong
seasonal component favoring December - February. It remains
to be seen whether the first good cold snap will trigger a
significant price rally.

I would have to say that the gold price has diverged markedly
from my composite macro-indicator in 2006, the retreat from
the blow-off May high notwithstanding. With the recent rally
in gold, that divergence is accelerating again. Now, since
there is abundant historical evidence documenting the
occasional high volatility of gold, no one can say this
current seasonal rally will not be fulfilled. I would say
to watch FOMC activity, and how oil and sensitive prices hold
up if you are long, since I think there is $100 - 120 per oz.
downside price risk.

As mentioned yesterday, gold enthusiasists with a geopolitical
bent might do well to watch the current political struggle in
Lebanon. Today's assassination of Pierre Gemayel only
underscores the growing instability in this small but critical
corner of the world.