The Morning Gold Report: Gold Falls Through Key Support

Aug 11 p.m. (USAGOLD) -- Gold has extended sharply lower after penetrating the range low at 845.50 (02-May). Further downside potential must be considered at this point, but it is also important for our clients to remember why they buy gold in the first place.

The vast majority of our client-base buys physical gold as insurance against adverse movements in the more traditional asset classes, where the vast majority of their wealth is held. Equities for example have benefited from commodity price relief in recent weeks along with the rebound in the dollar, although probably not as much as many may have expected.

That is a strong indication that the current drop in gold prices should be utilized to either make an initial purchase, or add to existing holdings. We like to remind our clients that paper selling in gold provides physical buying opportunities.

The Indians have certainly taken this to heart. In the past eight months that gold has been trading above $800 an ounce, substantial physical demand has built up. Jewelry interest last week from the world's largest physical buyer of gold was considerable ahead of 850/845. We anticipate that buying interest below this level will be even more robust.

With no significant central bank sales in the offing that we're aware of and mine production continuing to decline, it raises the question: Where is the physical supply going to come from to satisfy the anticipated increase in physical demand?

That question highlights the other side of the volatility issue -- gold could rebound just as quickly as it came down.

Gold Consolidates as the Dollar Remains Firm

Aug 11 a.m. (USAGOLD) -- Gold is consolidating within Friday's range. A firm dollar and ongoing weakness in oil prices continue to weigh on the yellow metal.

The dollar surged higher last week, getting a significant boost on Thursday and Friday after ECB President Trichet highlighted risks to growth in the Eurozone. This sparked a rather significant shift in ECB monetary policy expectations and a precipitous drop in the euro.

Given the high rate of inflation, the ECB was expected to maintain a tightening tact into 2009. The recent pullback in energy prices provided sufficient cover for the ECB to hold steady on rates last week, but economic growth is now deteriorating at much more rapid pace. This raises the likelihood that the ECB will be holding steady on rates for the remainder of the year, and there is growing risk that they may actually cut rates.

The prospect of interest rate differentials staying static and perhaps narrowing, sparked an exodus from long euro positions, which benefited the dollar. The firmer dollar in turn pushed gold prices back to the low end of the 3-month range.

Throughout the 3-week rise in the dollar there had been market rumors of government intervention. GoldMoney founder James Turk may have uncovered the smoking gun; noting that US government paper in custody for central banks had jumped from $2,349 bln to $2,409 bln between 16-Jul and 07-Aug, an annualized growth rate of more than 38%. When governments intervene in the FX market and buy dollars, they will usually use those dollars to buy US treasuries.

Despite the recent short-term rise in the greenback, the fundamentals that have resulted in the long-term dollar downtrend remain in place. The Fed also opted to leave interest rates unchanged last week. Fed funds remain less than half of the ECB's refi rate (4.25%), which is hardly a dollar favorable spread.

In fact, it is looking increasingly less likely that the Fed will be raising rates this year as the US economy continues to struggle, despite softer oil prices. Fed funds futures are showing the odds of a rate hike in Q3 are a mere 8%. Chances of a rate hike before year-end have dropped to 42%.

If interest rate differentials remain steady, I'd still take a 4.25% yield over 2% yield any day. Nonetheless, shifting expectations are driving recent moves in the FX market.

The debate now raging in trading rooms around the world is where will the next shoe drop. Where does the risk lie? The consensus last week was that there is a greater risk than many had anticipated in Europe. As traders reverse out bets that hinged on Europe being somewhat insulated from the credit crisis, the euro has tumbled.

The Eurozone economy may be showing heightened signs of weakness, and there have certainly been increased indications of credit/liquidity crisis fallout there, but the dollar is far from being the safe-haven currency that it once was. In a weakening economic environment, where inflation is still a major concern, gold is far better choice for wealth preservation.

The big question now is: Is the rebound in the dollar sustainable? With the US economy still quite weak, inflation still high, the banking sector still looking rather vulnerable, and the housing market still not showing any signs of bottoming...there is still cause for skepticism.