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Will Gold Stay in a Sweet Spot?


That depends on overall global growth.

I've had several readers ask me about my current take on gold.

My bearish outlook for gold has been premised on the prospect of continued weakness of jewelry demand in Asia (especially India), coupled with stable inflationary expectations in the US that would tend to reduce the speculative, or "investment" demand for gold.

As per my expectations, jewelry demand has indeed been weak in Asia -- particularly in India. This is a development that must be watched closely as jewelry demand (again, particularly in India) is by far been the single largest source of global demand for gold. However, the expected weakness of jewelry demand in India and elsewhere has been somewhat countered by a surprising uptick in jewelry demand from the mainland Chinese. This development should be monitored closely.

Regarding inflation, as evidenced by today's figures -- CPI (-1.5%) and core CPI (+1.4%) -- disinflationary forces are well entrenched. Note that virtually all of the August month-over-month increase in the CPI (+0.4%) was due to higher gasoline prices. By contrast, the prices of almost everything else were broadly flat, and many key sectors are experiencing mild deflation. In addition, if we analyze various leading indicators of inflationary expectations such as survey data, the TIPS market, and other indicators, the thesis of sustained disinflationary inertia is confirmed.

Notwithstanding the fact that inflation and inflationary expectations appear to be in check and that the crisis atmosphere -- which until recently, drove a wave of safe-haven buying -- has subsided, global speculative investment demand for gold has remained relatively robust with a notable rise in interest in China.

Thus, it appears that gold is currently in a bit of a "sweet spot" in which the second derivative of global jewelry demand is turning upward while speculative investment demand remains robust.

How long can this "sweet spot" be sustained? This depends on overall global growth.

First, jewelry demand -- which is by far the most important component of global gold demand -- is sumptuary and discretionary. As such, it depends on strong economic growth. If global growth continues to surprise as it has all over the world, jewelry demand could recover from currently depressed levels.

Second, global growth implies stability in global financial markets. And stability in global financial markets and global growth implies relative weakness of the US dollar. Weakness in the US dollar is generally positive for gold, even if for no reason other than the fact that gold is a global commodity. In this capacity, even if there's no change in the overall global supply-demand balance for gold and there's no change in the trade-weighted currency price (value) of gold, the US dollar value of gold will tend to rise if the US dollar weakens relative to other currencies.

Third, the prospect for speculative "investment" demand also boils down to the outlook for global growth. Notwithstanding all of the hype about money-printing and the prospects for hyperinflation, there's virtually zero threat of inflation any time soon in the absence of economic growth. However, if growth surprises to the upside, so will inflation. And this would be supportive of speculative investment demand for gold.

Thus, in my view, the bullish case for gold currently rests on the prospects for upside surprises in global growth. Likewise, the bear case for gold currently rests on the prospects for global growth disappointments that would dampen global jewelry consumption demand, keep inflationary expectations in check, and be supportive of the US dollar. Right now, the outlook for global growth is improving. And as long as this pattern persists, gold will likely remain strong.

Note that due to the positive global growth surprises listed above, I haven't added to the GLD short since I initiated it at $94.00, nor do I plan to. My short on GLD will be stopped out somewhere above $100.5.
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Position in GLD.
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