December 04, 2010

Gold is off to the races again - can the Aussie keep up?

This week, Business Insider revealed the key market predictions for 2011 by your favorite investment bank: Goldman Sachs.  Many of their predictions are very bullish and essentially call for a global rally almost across the board. A few notable exceptions are seen with some exchange rates.


With this information on hand, let’s focus on the prospects of Gold and the Australian Dollar.  As we all witnessed, Gold has had an incredible run in the past 10 years. After reaching an all-time high of $1,424 in early November, the precious metal dropped almost $100 but it has since been off to the races again closing the week at $1,414.

Spot Gold – Daily Chart

Goldman’s predictions call for a near 20% increase in Gold towards the end of 2011.  Considering how fast Gold has risen since last summer, this is much less than a remote possibility.

Taking nothing away from this massive bull-run, a huge component of the Gold price increase is the loss of value in the US Dollar.  When you value Gold in other currencies, the price strength is somewhat muted, particularly against high yielding currencies such as the Australian Dollar.

Gold in Australian Dollar – Weekly Chart

The all-time high of gold valued in Aussie Dollars appeared during the darkest days of the financial crisis. Against the strength of the Australian Dollar buoyed by numerous rate increases from the Australian Central Bank, Gold’s ascent has since been hampered. The first attempt at breaking the previous record earlier this year fell short of reaching that target.  However, technical factors as well as the increasingly favorable market sentiment for Gold make a strong case for a second attempt at breaking through the all-time high of A$1,565 from early 2009.

To get there, a few technical hurdles still stand in the way.  The next major resistance levels towards breaking through on the upside are A$1,491 and A$1,538.

Gold in Australian Dollar – Daily Chart

If you believe in Goldman’s prediction of a 20% increase while the Australian Dollar remains relatively flat, Gold valued in Australian Dollars should break the previous record and line up at approximately A$1650 very close to Goldman’s forecast for Spot Gold valued in US$. But is there a chance that Goldman could be wrong and the Aussie Dollar might rise much more than just 3%?

Considering that Australia is one of the world’s top commodity producing countries, its currency is invariably influenced by the demand for commodities.  The demand for raw materials and commodities is bound to accelerate in coming years.  That demand will keep the Aussie Dollar a hot item, perhaps more so than the demand for Gold does.

Looking at recent price history, the Aussie Dollar bears some resemblance with Gold having reached a recent high just above parity with the correction following suit.

Australian $ versus US$ – Daily Chart

It has been off to the races again this week however, falling just short of parity at 0.9925.  In assessing the prospects for the Australian Dollar going forward, we cannot exclude the outlook for the US Dollar from this equation though. At the present moment, a big factor speaking for the Aussie Dollar is the huge interest rate differential of about 4.5% in favor of the Australian currency. Now that QE2 has become a reality, Bond yields are set to rise which should be a benefit for the Greenback while giving less of an incentive to implement a carry trade “down under”.

Question though remains, can the US administration afford to finance their gaping deficits at higher financing costs? The sovereign debt crises in Greece and Ireland have shown how fast the rapidly rising cost of financing can bring government finances to their knees.  My guess is that the Fed, with heavy elbowing from the US administration, will continue to create the illusion that inflation is going to be benign. After all, they have done so for at least a decade now. Rising stock prices aside, the real US economy cannot afford a rate hike in the foreseeable future.  It would be far too high a risk to cause a double-dip recession and the certain end of any hope for re-electing the current administration.  It is far more likely that the Australian Central Bank would stop their rate hike cycle, perhaps even reduce rates by 25-50 basis points sometime next year. 

But my guess is that the Reserve Bank of Australia will continue its course and focus more on domestic inflation rather than showing too much concern for a specific currency level. This is unlike China’s approach which, despite higher interest rates, cannot seem to contain domestic inflation that well. The culprit, the Chinese Yuan, could be an important escape valve keeping domestic prices at reasonable levels but China keeps that valve fairly tight.  By contrast, Australia has been using the currency valve ever since the crisis hit which is part of the reason why the Aussie Dollar is so volatile.

It is plausible that some of the demand for Australian commodity exports will suffer with an ongoing rise in the Australian currency.  However, if Goldman’s bullish global market projections are turning out to be correct, demand for commodities will be even higher and Australian commodity producers should have no problem finding buyers, even at elevated prices.  In this context, the Goldman projections for a mere 3% increase in the Australian Dollar are rather modest. The Aussie Dollar may not be able to keep up with the rise in Gold prices, but taking a historic perspective into consideration, the Australian Dollar is still way “down under” from its peak in the 1970’s.


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