The story of the day has to be the break-out in the dollar-denominated gold price at the same time the US Dollar index is soaring. I think there is an explanation – several actually – and that traders are making the mistake in thinking long-term when in all likelihood this has been a rather short-term four to six-week phenomenon, and one that may last another week at best.

I think it’s prudent to adopt the adage Sell in May and Go Away – until August-September or possibly October, which is the time it will take for the likely outcome of the US mid-term elections to be known. Yes, I am referring to precious metals as well as equities.

Here’s my thinking. Gold has become, for the short-run at least, a currency play; a reserve currency if you will, a place of refuge in a sea of central banks and governments who have lost control, if only momentarily, over monetary stability.

By far the biggest currency trading in the world is done in London, mostly by capital managers in Europe and the Middle East, perhaps as much as 40% of the estimated $4 trillion or more daily turn-over. London also happens to be the biggest market in the world for the exchange of physical gold and silver, or bullion, which is a market that is also largely controlled by central bankers who lend precious metal, like they lend currency, at a cost.

But the gold and silver market is tiny compared to the currency market. In London, it’s roughly one-hundredth the size of the currency turn-over, the upshot being that when currency markets get agitated, there is a spill-over effect on the gold market.

The currency market has moved from a state of nervousness to outright panic in the past six months, all starting with Greece, believed from the beginning to be only the first thread that could unravel the Euro unless stability was brought to bear.

Let’s follow the timeline.

• From the summer of 2009 through October, following immense new debts taken on by most governments of the world, the price of gold lifts from about $920 to about $1050 and traders and monetary authorities start to focus on the weakest links in the sovereign debt ring. As the debt roll-over problem of Greece hits everybody’s radar screen the European finance ministers start to discuss this matter. Gold then pops from $1050 to $1180. Traders then sense that the ratings agencies will downgrade Greece, and the price of gold lifts to over 1210.
• On December 8, Fitch downgrades Greece’s credit rating from A- to BBB+, which immediately lifts the government’s cost of borrowing. With sovereign default on the minds of traders, as few believed in the reform package being discussed by Greece’s Prime Minister Papandreou – a plan to cut the government deficit by four percentage points, as a proportion of GDP, in 2010-2011 — the workers rebel in the streets. Standard & Poor’s ratings for Greece also drop. Traders figure that the Eurozone members will force a tightening in Greece and elsewhere, so traders, perhaps with the help of the European Central Bank, drop the price of gold in just three weeks about $130/oz to $1085. Simultaneously, the US Dollar soars and the Euro drops from 150 to 142. Markets are in sync at this point just before Christmas.
• During early January, traders are focused on the spread between the interest charged on Greek and German debt, which widened to 4% (i.e., 400 basis points), and thinking that Greece may default, they lift the Euro and lift the price of gold again. Gold lifts to 1150, and the Euro to about 145. Markets are still in sync in mid-January.
• Then, for a few weeks, it looks like the situation is controllable. Gold drops to $1065 as the Dollar strengthens. But the Euro drops to 136 and Europeans are starting to get worried that inflation and higher interest rates are on the way.
• On February 10, Papandreou announces a plan to freeze public sector pay and impose higher taxes for low and middle-income households of Greece, and of course the public sector workers revolt. Riot police fire tear gas on demonstrators. European leaders are called into emergency session on February 11 to consider a bail-out. The Euro is stabilized for about a month, but the price of gold lifts from $1065 to $1140. The pressure is now on German Chancellor Angela Merkel, whose people are now polling over 80% against a bail-out of Greece and her party is facing an important regional election.
• On March 3, Papandreou advises his people to either accept lower bonuses and higher taxes or risk bankruptcy. The next day, there is a successful sale of Greek bonds. In the following week, the Greek Prime Minister traveled to Washington to ask President Obama for help.
• But, behind the scenes, March was not a good month for Papandreou and the whole affair unraveled on March 29 when investors no longer had an appetite for Greece’s bonds. Gold then went soaring from about $1090 to the yesterday’s all-time record close of $1239. During the interim, the spread between the yield on Greek and German bonds lifted to 469 basis points (bp) by the third week of April. Then the rating’s agencies stepped in with further downgrades, giving Greece’s credit rating junk status, which was enough to cause the Euro to crater from about 135 to 126. Not even a $1 trillion Euro stabilization plan, supported in part by the IMF, was enough to satisfy traders.
• It was the failed Greek bond auction at the end of March that caused Europeans to flee the Euro and go into gold, which this chart clearly shows.

The moment the European Central Bank raises the borrowing cost for bullion, the price of gold will sink. Moreover, as and when Europeans see that their Euro is far over-sold on a short-term basis, I think they will start selling Gold, Dollars and Yen and buying Euro.

This process can be expected to start shortly, I believe. Gold could quickly drop back to $1100. A couple months from now, I expect California will start a similar process in the USA as what happened in Greece. Well before then, I think the $USD and $GOLD relationship will be back in sync. Then, as and when the US Dollar drops, the workers’ and taxpayers’ riots start, forcing a massive Fed bail-out of bankrupt state and municipal governments, I think that $GOLD will soar again.

In the past several hours, the equity markets in Asia-Pacific and now Europe have strengthened. Spot gold has settled back from about 1248 yesterday afternoon to 1233, so I anticipate relative weakness this morning in the goldminers.

Have a great day.

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