How high will the gold price go in the face of the current equity market correction?

Gold has had a good week, but how long can the current strength last?

The dollar may be "mighty", but gold is also strong

Once in a while the standard inverse relationship between gold and the dollar decouples, as wider economic or political events are pushed to the fore.

Inevitably the relationship resumes after a certain period of time has elapsed, but how long it takes varies with the circumstances.

In the case of the current environment in which gold is now pushing up towards US$1,240 and pundits are once again referring to the dollar as “mighty”, it might very well be short-lived.

Markets are jittery, yes, especially as those 21st century pillars of corporate power, Amazon and Google are reporting weaker than expected numbers. Treasury yields are rising, recent US housing numbers weren’t exactly encouraging, and in the background there’s the ever-present uncertainty surrounding President Trump’s trade war with China.

On the other hand, the US economy remains in great shape, even if stock market valuations are correcting to take into account the new monetary policy environment. On a global scale, growth continues, despite the headlines generated by one or two overleveraged emerging market economies, and although there is a great deal of sound and fury around the upcoming US mid-terms, the results are unlikely to impact the broader economic picture.

The Fed remains resolute in its plans to continue incrementally raising interest rates, and that will continue to exert considerable the same downward pressure on gold that’s take the price down from well over US$1,350 an ounce two years ago to recent trades down towards US$1,180.

So, is the current uplift the start of a major correction, or simply a spike caused by jittery investors still getting used to normalised economic conditions after a decade of easy money following the global financial crisis?

Trading volumes on the index of global volatility, the VIX, tell an interesting story. The VIX has risen in response to the recent sell-offs in the market, but not commensurately. This has led some to conclude that the VIX itself has been somewhat flatfooted or that most major investors are so well hedged there hasn’t been any need to pile into the index as selling accelerated.

The alternative view of course is that those who trade in and out of the VIX are pretty sanguine about recent market falls. It’s widely, if only tacitly, accepted that equity valuations have been frothy for years, propped up by the lack of viable alternatives for the generation of capital gain and yield. The heavy dilution of fiat currencies is only now coming to an end, and a correction in the equities that are priced in these currencies seems inevitable.

On the other hand, there may be significant headwinds head. There’s the uncertainty around Mr Trump’s presidency of course, and the difficulties market watchers have in interpreting the rhetoric put out both by his supporters and his detractors. But more significantly, there’s also the very real probability that the current strength in the US and global economy is as good as it’s going to get, and that from here on in the cycle will once again start to turn the other way.

If that’s true, then the Fed’s policy of monetary tightening may turn out to be less than propitious, as Mr Trump, in his populist way, has been arguing all along.

Under those circumstances there may be significant scope for further gold price strength, and one or two analysts are calling a gold price as high as US$1,400 over the next couple of years, in the event that the Fed “blinks” on rate rises.

Will it happen?

Bank of America Merril Lynch thinks so. It regards gold as both the “simplest” and the “most complex” asset class in the world. Gold’s ability to drive valuations elsewhere is limited, the bank says, but as a responsive asset class it can be very sensitive.

Thus, if the market focus shifts away from global economic growth and turns instead towards the burgeoning US deficit and China’s credit bubble, sentiment will likely drive more investors towards gold.

But the Fed’s role will still be crucial. If it holds its course upward pressure on gold will only take it so far. For now, punters are looking at short-term negativity in equity markets for guidance. But ultimately it will take more than a correction on the S&P to push gold much beyond its current levels.

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