Gold: is the sky the limit?

This resulted in a severe drop, not only of the indexes, but also in the selling of speculative assets. Oil, precious and industrial metals also got hammered. Ironically, the US dollar was seen as a safe haven by investors. However, the rally of the dollar was only short-lived.

Rate cut expected

Initially the dollar strengthened against the euro up until mid August. After that, stock markets bottomed out and then recovered strongly. With signs of a slowing US economy, affected by the ongoing credit crisis, the US central bank, the Federal Reserve, was widely expected to lower the federal funds rate from its level of 5.25 per cent.

The Fed had already lowered the discount rate, an emergency rate, in August by 50 basis points to 5.75 per cent. Normally, this rate hovers around 100 basis points above the federal funds rate. The Fed hoped to ease the money market a bit, but nothing could be further from the truth.

The credit market remained spooked. Banks became hesitant to lend money to other banks causing a severe credit crunch. During the September Fed meeting, Ben S. Bernanke, the Chairman, lowered the federal funds rate aggressively by 50 basis points to 4.75%. This caused the stock markets to roar and the dollar to weaken.

Unfavourable data

Although the authorities declared that the US economy had not been affected by the credit crisis, the market thought differently, supported by the latest macro-economic data. The US labour market showed an August decline when an increase had been expected. Also, the housing market was not showing any signs of recovery. Therefore, the market expected the Fed to cut the interest rate - and it did so, accordingly and cut it to 4.75%.

The dollar weakened against the euro to an all time low. The dollar and gold are usually seen as each other's substitutes. When the dollar strengthens, gold normally declines and vice versa. On the back of a weaker dollar, gold managed to hit an all time high above $700 per troy ounce, entering previously uncharted territory.

Does this mean that gold will continue to sky rocket? That depends on many factors. Technically speaking, gold broke out to the upside and a target could be the first Fibonacci level of around $780. Gold prices may not drop below a level of around $680.

If the dollar weakens further, thus leading to a cheaper gold price for foreign investors outside the US, then gold could rise sharply. However, if the inflationary environment remains low and the dollar strengthens and the US economy does not dive into a recession, investors could take profits or, even worse, dump gold again. Remember that gold is not only a hedge, it is also a speculative investment.