Gold glitters as dollar hit by poor payrolls

Following the poor payroll numbers on Friday, we ask what are the preconditions for the Fed to hike interest rates? First, the economy must clearly be strong. Strong enough to point to inflation having bottomed. Second, in view of that, the market must feel that a hike is needed to keep inflation in check. (After Friday's numbers, the futures moved to fully price in a rate hike by November.) The missing ingredient so far is strong jobs. The US economy is enjoying a pre-election boom, driven by policy. There is thus every likelihood of a post-election slowdown. So even if the Fed does hike, that tightening will be limited. So, for now, the view is that a Fed hike seems unlikely before the second half of the year and, even then, it will be only small.

Friday's numbers were a big disappointment. Nonfarm payrolls rose just 21k in February, well short of the consensus of 130k and our own forecast of 200k. Backward revisions took 23k from payroll growth over December and January. While the unemployment rate was unchanged at 5.6%, that was flattered by people leaving the labour force with the numbers in employment actually falling.

The picture was mixed across employment sectors. There are some small positives. 3k jobs were lost in manufacturing, the lowest number of job losses since July 2000, with further gains in hours worked suggesting that manufacturing payrolls will rise next time. The 24k fall in construction jobs in February is largely attributable to poor weather at the start of the month. That should reverse in March. Temporary jobs, which tend to turn into permanent jobs, also continued to trend higher. Thus while Friday's numbers were poor, we do not expect them to mark the start of a downward trend in employment growth.

The interesting thing to watch will be what the Fed speakers will say now. Most likely, they will continue to say that jobs are coming, it is just hard to pinpoint the month. Fed Chair Greenspan speaks at two events this week - he is before the House Education Committee on Thursday and he is in Boston on Friday - so that will be the next focus of markets before the next FOMC meeting on 16 March.

The immediate market reaction to the payrolls was to sell the US dollar. What's bad for the dollar is good for gold prices. Since mid 2003, USD weakness has continued to support gold, despite the strengthening global recovery. The price of gold rose by 21% in USD terms in 2003, but was virtually flat in euro terms.

The market has consolidated over the last month. The price has dropped back below USD400/ounce since late February as the dollar stabilised against the euro. Speculative net long positions on the COMEX have almost halved since their peak in January. However, they do remain significant, raising the risk of a sharp downward correction should USD sentiment change. We expect further overall dollar weakness in 2004, but some recovery against the euro from 3Q, putting pressure on gold prices in the second half of the year.

Fundamentals are giving mixed messages. Mine production is constrained by strength in producer currencies, but scrap volumes are increasing. On the demand side, jewellery demand is suffering, but China is a potential positive factor - recent sector liberalisation could significantly raise investment. The 'Washington Agreement on Gold', ensuring the orderly release of central bank reserves onto the market, expires in September 2004, but we expect it to be renewed in some form.

Overall, we expect 2004 prices to average higher than 2003 at 380-400 USD/ounce.