Gold is unique commodity due to its properties such as physical demand, reserve currency, safe haven, inflation hedge, technical application and so on. This makes it most sought after commodities. Hence, there are various factors that drive the gold prices. Gold had a eleven consecutive day of gains, something it has not achieved since mid-October 2006, when it rose for nine days in a row. Gold prices have hit a high of $1623.95/oz and are on record high. We all know that gold is the fall back position when the world markets are struggling. Investors love gold in times of turbulence and in time of financial crisis gold is the king of investments.

Gold prices are highly correlated to movement in currency market. Over the past few months there has been a growing amount of interest in the currency markets, especially the pound, the euro and the dollar. There are two major factors driving the value of the euro; interest rate differentials and the European debt crisis. At this stage, only the debt crisis is having an impact on Forex trading. The Euro has been dragged through fresh skepticism by the Greek crisis, and the dollar continues to be questioned as the reserve currency of choice. Market has become highly sensitive to market rumors, happening. Lots of events occurred. However, focus still continues to be the euro zone and its crisis, its bail out and the US debt situation also leaves the dollar in a growing state of uncertainty.
Money Pouring into Safe Havens in Q2’2011

There has been lots of uncertainty across the globe. Tensions are building as Greece’s sovereign crisis, US debt situation and legislative inaction in US is keeping the market on toes. Hence, money keeps flowing into the safe havens like Swiss Franc, Japanese Yen and king of crisis situation- Gold. Risk appetite of investors has been falling. Investors have withdrawn from the riskier assets and currencies of Emerging Markets.

Source: Bloomberg
Correlation of Currency and Gold
Gold is widely regarded as a currency in its own right and thus, during times of US dollar weakness, gold

often increases in value as many investors choose to own gold rather than US dollars. Australia’s role as a major producer of gold and other commodities means the Australian dollar is seen globally as a ‘commodity currency’. Currently the correlation of Australian Dollar and Gold is at 87%With the currency volatility and the debt-contagion risk in Europe, investors are gravitating toward something tangible like gold. Dollar has been weakening on back of US fiscal deficit and prospects of QE-3. Euro fundamentals don’t appear to be too strong either. Fears of sovereign crisis spreading to Italy, Portugal and Ireland remain high. However, rising of rates by ECB from 1.25% to 1.5%

Source: Bloomberg

is giving support to euro. Also, ECB and EU remain united in efforts to avoid default of any euro zone nations. This is taking Euro higher and in turn supporting gold.
Euro zone Crisis 
Continuous on and off of euro zone crisis has been supporting gold since the year end 2010. As the credibility of sovereign-debt situations continues to worsen, the credibility of the underlying fiat currencies will continue to come into question which will keep supporting Gold. With Italy, Spain, Ireland and

Portugal worries intensifying and Greece bailout still a huge question investors are fleeing to gold. Added to the mix, Moody’s rating agency unexpectedly slashed Irish government bonds to junk status which sent borrowing costs to the highest levels since Ireland joined the Euro zone. The International Monetary Fund and European Union rescued Ireland last year with an enormous emergency loan. Since then, fellow debt-laden euro zone nation Portugal has also been forced to seek an EU-IMF bailout, while Greece’s rescue has been deemed insufficient.

European leaders have agreed a new €109 billion bailout package for Greece under which private bondholders will be called on to participate for the first time, contributing a target of further €37 billion. Ireland has won from euro zone leaders a reduction of around two percentage points in the loans it gets from the European Financial Stability Fund, and greater flexibility in how it uses the bailout money, Irish Prime Minister Kenny said. This has given temporary relief to the crisis. However, markets are somewhat disappointed with the lack of details on reform of the EFSF.
US Debt Issue and Prospects of QE-3
The debt situation also leaves the dollar in a growing state of uncertainty. If Congress is forced to make serious cuts in the Obama administration’s proposed budget, it should strengthen the U.S. currency – but further legislative inaction and the very real specter of a U.S. debt default could just as easily provoke a run on the dollar. President Barack Obama failed to win agreement from the U.S. Congress to reduce the government deficit. Lawmakers are working on budget cuts as they attempt to prevent an American default before an Aug. 2 deadline. Congress is in talks aimed at raising the $14.3 trillion U.S. debt ceiling before Aug. 2, the date when the government is projected to exhaust its borrowing authority. The dollar fell as a bipartisan Senate plan to cut the U.S. deficit and increase the debt limit faced resistance from House Republicans.
The United States may lose its top-notch credit rating in the next few weeks if politicians fail to increase the country’s legal borrowing limit and the government misses debt payments, Moody’s rating agency has warned. Standard & Poor’s placed the US rating on negative outlook on April 18th which meant a downgrade is likely in 12-18 months. This week S&P said there’s at least a 50 percent chance it will cut the AAA rating within 90 days on risks a stalemate will endure beyond any near-term deal to raise the U.S.’s debt limit. . A lower credit rating would cause havoc in financial markets around the world and increase borrowing costs for the US government and businesses, further harming public finances and weighing on the economic recovery.
US Labour Market
Lack of recovery in US labor market is further lending support to gold. Non Farm payrolls does not show sign of recovery and US Unemployment rate has risen to 9.2% from 8.8% in early 2011. The US economy added just about 18,000 new jobs in June even as the unemployment increased marginally, a government report showed. The rise in payrolls was significantly lower than the 105,000 forecast by economists. Meanwhile, the unemployment rate rose to 9.2% last month from 9.1% in the preceding month, the Department of Labor said. The data for April and May were revised down by 44,000. Overall, the gain for May was revised downward to 25,000 from the initial report of 54,000.

Source: ITI Research and Bloomberg

Inflation and Gold

Inflation pressures among advanced as well as developing nations remain high. Higher inflationary pressure lends support to gold prices. Inflation in China accelerated to a three-year high in June as the consumer price index (CPI) increased 6.4 percent, according to the National Bureau of Statistics. The CPI had risen 5.5 percent year-on-year in May. Inflationary pressures over the Euro zone remain mostly unchanged as the year-on-year figure held at 2.7% in June while the monthly result was flat. The core CPI figure over the year however edged up to 1.6% from a previous 1.5%.

Source: Bloomberg and ITI Research

Currency and Gold Outlook: 
More than rupee strengthening it has been the Dollar weakness which is holding INR appreciation. As long as US government doesn’t come up with the concrete solution for its debt problems dollar will be hammered. But it looks unlikely that US will let it default. It will find solution on its debt problem and that would give some support to dollar. Euro region leaders have found some solution to their crisis but still whole mechanism has to be worked out. Hence, it will be the swiftness in action of the decision makers that would determine which currency will hold strong in the long run. For shorter duration, moving with the markets would be advisable.
Aussie Dollar continues to be strong as Gold keeps hitting new records. Producer prices rose 0.8% q/q and 3.4% y/y, but signaling continued pipeline pressures for the Australian economy, despite the firmer AUD, and would imply that the Reserve Bank of Australia’s attention should be on hiking rather than cutting rates. This also should support Aussie Dollar.

EUR/USD (SPOT) – Monthly Chart

AUD/USD (SPOT) – Monthly Chart

Aug 2011

Source : Bullion Bulletin