Seeing President Sarkozy (and his tasty missus) over here last week reminded me that we haven’t touched on the old bling market for a while.

On the 17th March gold peaked at $1030; over the following three days it fell by over 12%. So, after rising to a level that confounded all but the most extreme optimists, is the precious metal following the ‘Grand Old Duke Of York’ theory and marching back down the hill again?

Or, as many in the business suggest, is this a healthy and much needed correction before a move onto bigger and better things?

Luckily the Paddy Power Traders have friends in high places. We managed to persuade GFMS, the top metals consultancy firm, to publish their annual survey this week, so we could see what the insiders are thinking.

Why’s Gold So Special?
Apart from being heavy and shiny, it’s a tangible asset; it’s real. You can see it, there’s no credit risk, governments can’t print more of it and, if you’re strong enough, you can even carry it around with you. Put another way, Gold is the Mr Dependable of the investment world; it’s the best possible insurance against economic, political and financial mayhem. If you want a quick refresher before tackling this article, check out A Crock Of Gold.

You a gold fool?

Commodity Or Currency?
Around 10% of the gold produced is used in industry, but by far the largest amount, around 75%, is used for jewellery. Investors make up the rest. But gold isn’t just a commodity; it’s a sort of pretend currency as well. Historically gold was used to support, or give credibility to, a currency; now central banks hold billions of the stuff (as an alternative to holding Euros, Dollars or the Vietnamese Dong, for example) for a variety of reasons:

Diversification- gold trades differently to currencies; its price is (at least partially) determined by supply and demand rather than government policies (or mistakes).

Economic security-highlighted by the current woes, gold remains independently credit-worthy and unworried by rising inflation.

The USA holds around 75% of its reserves in gold, the EU around 50%, but the international average is nearer 10%.

The investment community is just as ambiguous in their treatment of gold. Some banks trade gold off their forex desks, others off their commodity desks. Many of the professional systems quote gold against a currency, generally the Dollar, yet gold futures are traded off the commodities exchanges.

So, the messy answer is, “yes, gold’s a commodity and a currency.”

So What Kicked Off The Latest Gold Rush?
Supply
Gold mining production was negative over the year, its lowest level in eleven years. Crazy, I know, what with all that demand out there and prices skyrocketing. The trouble is gold mining companies have the reaction time of Jade Goody, or a brontosaurus. They can’t just stick their hand in the ground and pull out a few ingots; extracting gold from the mines is a slow and costly business. Also, strikes, safety issues, and power shortages disrupted production, especially in South Africa. It’s no great surprise that China became the number one producer last year.

Demand
The main demand for gold, by a country mile, is from the Jewellery sector, but note the interesting split last year. For the first half of the year Jewellery demand saw a 22% rise on the previous year, but, but, but in the second half, when prices took off, Jewellery demand fell by 9% on the previous year.

Up until last August gold had been biding its time, up a bit, down a bit, but unable to break above the $700 level. Then Bear Stearns popped up and said, “I think we’ve got a problem Houston,” followed by HSBC saying, “Ah, about our US sub-prime mortgage subsidiary; we’re going to have a closer look at how it’s doing.”

Widespread panic in debt and equity markets, a falling Dollar and the fear that panicky rate cuts would feed inflation saw a mad scramble for commodities.

The demand that drove gold up through the $700 resistance and onto the heady heights of $1000 came from the investment community. Hedge funds, pension funds, exchange traded funds and the investment bank trading desks all piled into the market.

And here’s one of the problems; the gold market is only a fraction of the size of global bond and equity markets. This was fine when all it had to cope with was a few gold bracelets for Mr Sarkozy each year. But when the collective investment world got the ‘apple fritters’ and tried to switch en-masse from its dodgy bank shares the gold market couldn’t cope.

What’s Changed?
Well, inflation’s still very much alive and kicking; the oil price is looking comfortable above $100, and rice grain has become the latest food to inflict misery on shoppers and late night curry eaters. Fears of higher inflation will continue to push gold prices higher.

There’s still a lot of uncertainty and distrust surrounding the banking sector. Noticeably, the recent fall in gold coincided with the quarter-end rally in equities. The IMF threw their hat into the ring, suggesting that credit crunch losses could reach almost $1 trillion; if this dart-throw is even close to the bull’s-eye then there’s a whole graveyard of skeletons still waiting to make an appearance. If panic returns to the market then the gold bull market should remain on course.

The subject of a weaker Dollar is likely to continue for longer than Brian Ashton remains as England Rugby Coach. Weaker economic growth and the need for further rate cuts will keep pressure on the greenback.

But here’s the paradox; sharply rising commodity prices may at first trigger or exacerbate a growth downturn, but eventually weak growth gets its revenge, as falling real demand triggers speculative liquidation. Or, to put it simply, what goes up must come down.

The cosy assumption has been that the emerging markets, especially China and India, will be able to withstand the slowdown in the US. There are plenty of Germans who feel the same about Europe being unaffected, but the Irish, Italians and Spanish already reckon differently. With a big chunk of China and India’s growth coming from exports to the US and Europe they’re likely to see lower figures over the next year.

The International Monetary Fund sees a 25% chance of a world recession, though this is defined as global growth of less than 3%. China’s had a re-think and decided to up last year’s growth to 11.9%, but with inflation running at 8.7% there’s even more reason to calm things down a bit.

What’s New?
The IMF knows a profit when they see one. On Monday they voted to sell $11 billion of gold, around 13% of their total gold reserves. One reason for the lack of panic in the market was that the vote still needed to be ratified by US Congress, which is unlikely to happen ahead of November’s presidential elections. The other reason is that the IMF aim to sell without disrupting the market, possibly by placing the gold with central banks. Ironically, given the current crunch on credit, part of the reason for the sale is due to a sharp reduction in lending to nations in financial crisis. With less nations in need of the loans, which provide income to the IMF, the decision was taken to revamp the Fund’s finances with possible switches into bonds and equities.

Dark Arts

The chart’s interesting and has caused a few bears to wake up and have a scratch. The end of March saw a break of the trend line dating back to August. Not only that, but the 21-day moving average, taken as a trend indicator by followers of the dark arts, is now pointing down. However, thanks to the recent rally in the oil price, gold rallied sufficiently to clamber back inside the uptrend.

Back In The Real World
The squeeze in the gold price caused by the clamour for safe assets should serve as a warning when the reverse happens. Sure, some of that money will be in it for the long term, but a lot was down to either funds looking for a temporary safe haven or speculators who guessed that funds would be looking for a safe haven.

The 12% drop in March was a foretaste of what could happen if too many investors rush for the revolving door without forming an orderly queue.

People in the know still seem to believe in the gold story. I’m not sure if that’s because they’re better informed or just have a vested interest. The GFMS survey for 2008 gives a best guess that gold could reach $1100, but that talk of $1200 was wide of the mark.

I reckon the short-term fate of gold, like the Japanese Yen, is closely linked to the sub-prime credit crunch mess; if you think there’s more bad news to come, it’s a buy. If you think we’re over the worst, sell. For what it’s worth I think there’s more bad news to come, and my missus gives me a weekly update on rising food prices. So I would be in the King Midas camp. But take note of this health warning, my record in trading gold is almost on a par with ex-UK Chancellor, Gordon Brown.

And when you’ve made your fortune, do yourself a favour, take £14 out of back pocket and treat yourself to the classic The Good, The Bad & The Ugly. Here’s the appropriately named Ecstasy of Gold, taken from the film and re-hashed by Metallica.