In 2007 price explosion in both gold and oil has been nothing short of spectacular. Gold rose from approximately $650/oz. at the start of the year to reach record highs as it currently trades at $886/oz. Oil had a similar parabolic run rising from $50/bbl to break above the $100/bbl barrier in the first week of January. Given the extraordinary strength of the moves traders are naturally asking – can $1000/oz gold be on the horizon and can oil maintain and exceed the $100/bbl level?
We believe the answer to each question is quite different and furthermore may translate into interesting trading opportunities in the currency market in the year ahead.
[B]The Case for $1000oz. Gold[/B]
Although some market participants still view gold as the true store of value, the global financial system has been off the gold standard for nearly half a century and while the majority of central banks continue to hold some gold reserves, market demand for the yellow metal is far more a function of sentiment rather than value. After all, the reason modern economies moved to electronic is money is the sheer impracticality and inflexibility of the gold standard. After a few trips to the store it becomes tedious to pay for your carton of milk with gold coin.
Gold however, acts as a great counterweight to fiat currencies which inevitably become inflated and lose value as governments attempt to stimulate consumer demand by increasing money stock. Indeed, inflation sparked by escalating food and energy prices has been the dominant theme in the second half of 2007 amongst nearly all G-10 economies, Although core CPI readings have been relatively contained, headline CPI in US has skyrocketed from 2.0% last year to 4.3% currently. In Eurozone CPI readings increased from 1.9% to 3.1%. Furthermore monetary supply figures continue to expand at double digit rates. Although the Fed has ceased publishing the M-3 composite numbers, data from the EZ and UK shows growth at 11.3% and 11.7% respectively. Thus, while central bankers attempt to re-assure the markets that core inflation is under control, traders are not fooled. It’s difficult to argue that price pressures are contained when a cup of coffee at Starbucks costs upward of $5.00.
Gold also rises when investors lose faith in the fiat currency, which typically occurs during time of economic turbulence. The last great bull market in gold coincided with a very serious recession in the United States. Although few analysts predict a massive contraction in economic demand this year, the financial problems caused by the sub-prime fiasco are clearly not going away and should the credit crunch conditions lead to a significant slowdown in economic activity in 2008, they will likely create a further crisis of confidence in the US dollar and drive demand for gold.
Finally, massive reserve accumulation by emerging growth nations such as China, Russia and India has created vast pools of capital, most of which is invested in US fixed income securities. If these central banks choose to diversify even a small portion of their holdings into gold, the price for the precious metal is likely to rise. In fact China just opened its first gold futures exchange and prices advanced as much as 10 percent on the first day of trading. In short, continued inflationary pressures, continued monetizing of bad debts from the US housing sector and the possibility of Central Bank diversification ensure that gold’s future is likely to be bright as it targets the $1000/oz level in 2008.
[B]Oil – Slowdown in Sight?[/B]
Oil has been the other great commodity story of 2007. In fact as 2008 opens for business the fastest-growing bet in the oil market these days is that the price of crude will double to $200 a barrel by the end of the year. According to Bloomberg, “Options to buy oil for $200 on the New York Mercantile Exchange rose 10-fold in the past two months to 5,533 contracts, a record increase for any similar period. These contracts – which are the cheapest way to speculate in energy markets - appreciated 36 percent since early December as crude futures reached a record $100.09 on Jan. 3.” But are oil traders getting ahead of themselves? The demand for crude has been predicated on two key drivers –geo-political risk and global growth.
The latest saber rattling in the Straight of Hormuz notwithstanding, geo-political tensions in the Persian Gulf have cooled considerably as fears about Iran’s nuclear capabilities were proven to be exaggerated. If we progress through 2008 with relative diplomatic calm, the risk premium embedded into the price of crude is likely to compress.
The other component of oil demand – global growth – may cool as well. Certainly, there is no denying of the impact of Chinese economic growth on the price of crude. (Every day 1000 new automobiles hit the streets of Beijing as China has become the second largest importer of oil after United States). However, a slowdown in US economy is likely to put the breaks on Chinese demand as well since much of that country’s growth has been driven by capital investment designed for export production. If US economy manages to drag the rest of the global demand down with it, the price of crude is likely to recede from its present lofty highs.
[B]AUDCAD – A Currency Bet on Gold/Oil Divergence[/B]
If our thesis on gold/oil divergence proves correct than the AUDCAD may be an interesting way to express that view in the currency market, Australia, which is the second largest exporter of gold in the world, continues to perform exceedingly well. In fact the last employment and retail sales data have handily beaten markets forecasts as demand continues to boom, Under these conditions any thoughts of monetary easing cannot even be entertained. In fact if anything, traders anticipate that the RBA may tighten once again if growth continues at this torrid pace.
Not so in the case of Canada, where economic data recently hit a bump. Canada, which is the largest supplier of oil to the United States is inextricably tied economically to the price of crude. Furthermore, because Canada is also US’s largest trading partner, its economic growth is highly dependent on demand from the neighbor next door. If US growth begins to suffer, Canada’s may as well. Already we’ve seen signs of trouble in the Canadian economy as retails sales have been tepid, suggesting consumer demand may be waning. Bank of Canada has acknowledged these problems and has already lowered rates by 25bp last month. Some market participants anticipate further rate cuts as the year progresses. Thus in 2008 we may see an environment where the Australian economy supported by gold and continued demand from China, outperforms the Canadian economy hobbled by lower crude prices and slowdown of the US economy. This dynamic could benefit the AUDCAD cross especially if interest rate differentials begin to expand. The pair therefore merits consideration as a possible play on these macro economic trends.
