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July 20, 2006

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Golden Trading Opportunities

Name: Kathy Lien

Company: FXCM

Learn More About Today's Author
Years Trading : 7

Favorite Movie : Fight Club

Golden Trading Opportunities

Gold Prices on the Rise—Keep an Eye on AUD/USD

The bull market for commodities is back.  After falling close to 25 percent between mid-May and mid-June, gold prices are on the rise once again. Between the middle and the end of this month, gold prices have rebounded 11 percent.  Now that we have also broken back above the key psychologically important $600 mark, the rally could extend all the way up to the $720 high that was reached in mid-May.  The Federal Reserve recently hinted that 5.25 percent interest rates could be the top, and in reaction, the US dollar has fallen quite significantly.  As an additional byproduct, gold prices are higher as traders reverse their long dollar positions.  Gold is not only proving to be a popular anti-dollar position but also a hedge for the impact of rising geopolitical risks and concerns for inflation pressures.   However, not many people realize that going long the Australian dollar and short the US dollar offers a similar opportunity but also the unique benefit of earning interest income. 

Gold is Becoming the Oil Hedge

With other commodities such as oil, silver, and copper also rebounding, many investors have turned to gold as a hedge for rising inflation.  According to recent comments by Barclays Capital as reported by the Wall Street Journal, compared to 1999, institutional money managers have three times the amount of capital tied in commodities at the current moment.  In addition, their survey indicates that pension funds and hedge funds are also looking to increase their exposure in gold by 1 to 10 percent.  Since gold is being used as a diversification tool, it could stay lifted even if other commodity prices begin to fall.  The survey also reports that when it comes to fund based commodity investments, 40 percent of the investments in gold are expected to be kept for three years or longer, and an additional 28 percent plan to hold on for at least 18 months or more.  Gold has always been seen as the world’s ultimate form of safe haven investment and the only true form of wealth.  With so much uncertainty in the world in terms of economic growth and geopolitics, it is no surprise that many investors, big and small have chosen to hedge their investments through gold.   

Economic Risks

The economic risks that have increased the attractiveness of gold as an investment is twofold.  The first is the impact of oil which acts as a tax for consumers.  As oil prices continue to rise, its potential to impact on growth becomes more significant.  The fear is that the current all-time highs in oil will eventually have a more meaningful influence on the pocketbooks of consumers.  According to a study by the IMF in 2000, every $5 increase per barrel of oil causes industrial countries as a group to see a 0.3 percentage point fall in real GDP while real demand sees a greater short-term loss of 0.4 percentage points.  The impact for the US and Europe tends to be even greater since the industrial country average includes two countries (the UK and Canada) that are net oil exporters.  Therefore, the $12 rise in oil since the beginning of the year will probably shave 0.7 percent off of global growth.

The second economic risk is the slide in the US dollar.  Many central banks have traditionally parked a lot of their money in the US dollar.  However, with the growing current account deficit, the soon-to-be-end to the Federal Reserve tightening cycle, and the uncertainty posed by the housing bubble along with oil, the general belief is that the dollar could fall even further.  If this is true, then their dollar-denominated investments could erode significantly as the value of the dollar declines.  The fear that any gains in the US stock or bond markets would be erased by a depreciation in the US dollar has been a big reason why many central banks and hedge funds have been looking to alternative places such as gold to park their money. 

Political Risks

The biggest hotspots that everyone is talking about at the moment are undoubtedly Iran and North Korea.  There have been rumors that North Korea could test a long range missile near Japan while Iran has recently been successful in enriching uranium for the first time.  The UN has called for them to halt further deployment, and they have responded by threatening to end UN contacts.  Although the UN is still trying to seek a diplomatic solution, the US has not ruled out military strikes.  In response, Iran has issued warnings on US interests around the world by saying that they will respond to any blow with “double the intensity.”  Meanwhile, Russia has most recently said that they would supply air defense systems to Iran while China continues its plans to secure oil resources in the country.  With no resolution in sight and these two big powers taking an interest in Iran, any military engagement by the US could get complicated.  Therefore, gold is the best investment in times of geopolitical uncertainties, and this seems to be exactly what traders and investors are doing at the moment. 

Currencies in Lieu of Direct Commodities

If you think that gold is going to continue to move higher, the most logical trade is to buy the commodity outright; however, that may not be the best trade.  Certain currencies are highly correlated with commodities while requiring less margin and offering the benefit of earning interest.  For gold, the closest correlation is with the Australian dollar / US dollar currency pair (AUD/USD).  The two products have an 80 percent positive correlation.  The margin to hold AUD/USD and to earn interest in a regular account is $2000, which compares to an overnight margin of $2,228 for gold futures.  For the mini contracts, AUD/USD requires a margin of $200 compared to $743 for mini sized gold. 

The correlation between gold and AUD/USD comes from the fact that Australia is the world’s second largest gold producer behind South Africa so it stands to benefit greatly whenever gold prices rise.  However the relationship doesn’t just end there. Australia benefits not only from the rise in gold but also the rise in many other commodities.  The country is also a major producer of Copper, Nickel, Aluminum, and Zinc, which are all either at multi-decade or record highs.  There is a limited supply of the yellow metal, and with talk of more central banks such as China possibly shifting additional reserves to tangible assets like gold, the commodity could continue to rise.  However, a real push towards $850 would require significant weakness in the US dollar and maybe even a global slowdown, which is not out of the realm of possibility given the current risks to the US housing market.  What does not require a global slowdown though is China’s continued demand for steel, copper, and zinc.  Therefore, the Australian dollar is the real commodity play from the perspective of gold or more industrial metals.

On the flip side, stronger gold typically comes hand in hand with a weaker dollar.  If the US economy begins to weaken, giving the Federal Reserve reason to pause in August and then maybe even reason to consider lowering rates shortly after that, the dollar will be punished significantly.  During that time, traders will be looking for a safer haven, and in that case, there is no better safe haven than gold itself.  Central banks around the world have already been increasing their gold exposure in fear of a dollar collapse.  The end of the Fed cycle gives them an even better reason to switch now than later. 

Therefore, it makes sense that the AUD/USD has a very strong positive correlation with gold as shown in the graph below.  However, the benefit of trading the AUD/USD over gold is that AUD/USD currently offers the ability to earn interest since Australian interest rates are higher than US interest.  Furthermore, it offers mild diversification off of the same view, which some traders may find beneficial.  Therefore, if you think gold prices will continue to move higher, keep an eye on AUD/USD.

RISK WARNING:
Trading foreign exchange on margin carries a high level of risk and may not be suitable for all investors. Before deciding to trade foreign exchange you should carefully consider your monetary objectives, level of experience, and risk appetite. The possibility exists that you could sustain a loss of some or all of your deposited funds, and therefore, you should not speculate with capital that you cannot afford to lose. You should be aware of all the risks associated with foreign exchange trading, and seek advice from an independent advisor if you have any doubts. Past returns are not indicative of future results.

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