Four reasons gold will only go higher

Gold has had a good run so far this year, after a stellar performance in 2005. But the good times may have only just begun, says gold commentator Paul van Eeden. The US dollar is under attack on all sides - from threats of Chinese revaluation to the prospect of an imminent halt to US interest rate rises - and that's got to be good news for the ultimate safe haven...

By MoneyWeek

published 27 June 2006

in Features

Even though the gold price has broken out against many currencies in the past several months, I still believe that the major influence on the metal's price remains the US dollar, its exchange rate with other currencies and, perhaps more importantly, its status. It is quite possible that much of gold's strength is being underpinned by position building in anticipation of further weakness in the dollar, and that momentum players are merely exacerbating the relative strength in the gold price.

Gold had a good run in November, and after pulling back briefly in December, seems set to continue that rise. The year started with gold rising more than $20 an ounce in the first week. Here is what I think is driving it:

Minutes from the most recent Federal Reserve meeting indicate that the series of rises in US interest rates may be approaching an end. Rising interest rates have buoyed the dollar and with the prospect that interest rates may no longer continue to rise, the dollar has been weakening.

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At the same time, China said that it will allow interbank spot trading (ie not futures trading) of its currency. This is a major step towards a less restricted foreign exchange regime in China.

The Chinese central bank will publish benchmark rates for the renminbi against other currencies daily by calculating a weighted average of the prices offered by market makers, based on the US dollar-renminbi benchmark rate and the exchange rate between non-US dollar currencies and the US dollar. While this system does not appear to have much renminbi-dollar flexibility, yet, it is a major step towards a more market driven foreign exchange system in China.

This could have major implications for the US dollar because, as I have discussed in these commentaries so many times before, the US trade deficit with China is a virtual guarantee that the US dollar has to decline against the renminbi. It is just a matter of time, and we are clearly seeing indications of progress towards that inevitable event.

Another significant announcement came from China's State Administration of Foreign Exchange (SAFE). It said China should diversify its massive foreign exchange holdings, which are predominantly held in US dollars. SAFE gave no specifics and no hint as to any kind of timetable, but this is not the first time that we have heard such rhetoric from Asia. It is not a matter of 'whether' Asian countries will diversify their dollar holdings, merely a question of 'when'. This, too, has major negative implications for the US dollar.

In short, it seems that everything we have been discussing here for the past two years the topping out of the real estate market in the US, the decline of the US dollar, and the consequent rise of the gold price, among other things is coming to pass. For those who have held long positions in gold, or gold related assets, it's been a good start to the year.

First published on Kitco.com (www.kitco.com)

By Paul van Eeden