Gold profits from dollar weakness

One of the factors for the strength of gold can be attributed to the weakness of the US dollar.

It appears that the dominance of the United States is waning, thus putting pressure on the greenback and eroding the dollar's value.

Some media outlets have reported that oil producing and exporting countries are searching for payment alternatives for the US dollar.

At the beginning of October, a British newspaper reported that Gulf Arab states were in secret talks with Russia, China, Japan and France to replace the US dollar with a basket of currencies. The Independent's Middle East correspondent Fisk cited 'unidentified sources' in Gulf Arab states and Chinese banking sources in Hong Kong.

The report said that the proposal was for trade in crude oil to move over nine years to a basket of currencies including the Japanese yen, the Chinese yuan, the euro, gold and a new, unified currency planned for some of the nations in the Gulf Co-operation Council, which includes Saudi Arabia and Kuwait. However, major oil producing countries denied the rumours.

Nevertheless, the dollar index stays under pressure against the major world currencies. The dollar index dropped approximately 17% from the peak of around 90 that it reached beginning of the year. The dollar is heading rapidly towards the low of around 71 traded at the beginning of 2008. The dollar weakness puts upward pressure on commodities such as oil and gold.

Inflation hedge

Another reason that gold is shining again might also be that investors are looking for a hedge against inflation. Although no signs of inflation are being seen at this moment, nor for the near future.

However, investors worry about the consequences of the current world wide monetary policies of central banks. The monetary easing policy of the Federal Reserve Bank and the European Central Bank might sooner or later provoke inflation risk.

If the inflation risk is not a big deal at the moment, why is gold performing so strongly? This could also be due to a 'flight into safety'. Although stock markets are rebounding, investors are also looking at save havens such as bonds and gold.

The volatility futures (VIX), a panic-indicator, are showing the risk aversion of investors. Stocks are being bought, albeit with a kind of a fire insurance. The VIX-spot shows a relatively high level of 22, far above the low 10's reached at beginning of 2007. At the height of the panic due to the credit crisis, the VIX reached a level of 80. This level will only be reached again in the event of another (financial) crisis.

Monetary policy watch

For now, markets are in a remarkably good shape. Investors are able to profit from this strange development, but have to be aware of the conundrum: rising stock markets accompanied with higher bond markets, a relatively high VIX and rising commodity prices.

As long as the money tap of the central banks are open, people might not fear that much. However, investors should be aware that as soon as monetary policies are tightened again, the 'easy money' will disappear. The Central Bank of Australia recently kicked off by increasing the interest rate with 25 basis points to 3.25%.

Which Central Banks will follow suit?