Gold\'s recent slump bewilders investors

World Gold Council points to fund liquidation, stronger dollar, stock markets

By Moming Zhou, MarketWatch

Last update: 4:13 p.m. EDT Oct. 23, 2008

NEW YORK (MarketWatch) -- Gold is often seen as an investment safe haven whose price tends to rise when the economy falls into troubles, but its recent slumps have defied conventional wisdom.

Gold futures hit a historic high above $1,000 an ounce a few days after Bear Stearns was taken over by J.P. Morgan Chase & Co. on March 14. But in the recent round of crises triggered by the collapse of Lehman Brothers Holdings Inc., gold has fallen to below $700 for the first time in 13 months. The metal has so far lost nearly $170 this month.

The reason, according to analysts at the World Gold Council, is that the latest bout of the credit crisis has been deeper and more far reaching. Funds were forced to sell desired assets such as gold to meet margin calls, while weakness in European economies lifted the U.S. dollar, which then pushed dollar-denominated gold prices lower.

"The fact that gold did not head higher during the current leg of the crisis seems to reflect a combination of the rise in the dollar, deleveraging of commodity positions, sales to meet margin calls, and the unwinding of the long gold, short dollar trade," wrote Natalie Dempster, an analyst at the WGC, in a research report released Thursday.

Among gold's 160,000 tons of above-ground stocks, only about 12% are used in electronic and other industries, and the bulk of gold stocks are used in jewelry and investment. That's why gold's often immune from economic woes and doesn't move in tandem with other commodities. But this time, the yellow metal is falling in line with industrial commodities.

Crude-oil futures is now more than 50% lower than its record high above $147 a barrel hit in July, while copper dropped to the lowest level since September, 2005, heading for the worst year since at least 1988. Meanwhile, platinum tumbled to the weakest in more than four years.

While concerns about the global economic slowdown played a role in commodities' retreat, "additional reverberations are emanating from factors unrelated to the fundamentals," wrote Diane Vazza, managing director of global fixed income research at Standard & Poor's, in a note released Thursday.

"Commodities too will feel the burden of risk withdrawal as liquidity retreats worldwide," Vazza added.

Credit crunch

Unlike in March, banks and investment funds were facing an increasingly tight credit market recently. The overnight dollar London interbank offered rate, the rate banks charge each other known as Libor, hit a record high of 6.88% earlier this month. The rate was at around 3% in March.

Stocks also stood higher in March, with the Dow Jones Industrial Average trading around 12,000. The Dow has slumped to below 9,000 this month.

"The current crisis has seen much more pressure on gold as an 'asset of last resort,' where it has been sold to meet margin calls when there have simply been so few other viable options available," Dempster said.

Trading in the over-the-counter gold market, where big institutions trade with each other directly in large orders, weakened in the third quarter due to the rise in counterparty risk and the lack of investment capitals, according to GFMS, a London-based precious metal consultancy.

A wave of liquidations occurred in September as funds were forced to raise cash in the face of margin calls and massive investor redemptions, according to GFMS.

The London gold-fixing price -- used as a benchmark for gold's OTC trading - has dropped $164.50 this month. It stood at $720 an ounce Thursday afternoon.

"Trading credit lines are shrinking for key players in the commodities business," said S&P's Vazza.

Gold trading in futures markets also went through a similar declining trend. In the two major global gold futures markets in New York and Tokyo, speculators' buy positions have been falling, while their sell positions have been rising.

Some investment funds were forced to sell even their "most desired assets such as precious metals," said Peter Spina, president of GoldSeek.com. There could be "more victims of the fund collapse and more forced liquidations."

Gold futures traded on the Comex division of the New York Mercantile Exchange have fallen in 10 of the past 11 sessions since Oct. 8 and have lost more than $190 an ounce. Futures slumped 5% Thursday to below $700 for the first time since September, 2007.

"Investors worldwide are selling everything, including the kitchen sink, and gold is no exception," said Peter Grandich, chief commentator at Agoracom, an online marketplace for the small-cap investment community.

Dollar's rise

The U.S. dollar also played an important role in gold prices, as the greenback and the yellow metal often move in the opposite direction.

During the Bear Stearns crisis, the dollar continued its long secular decline, with the euro trading above $1.50.

The dollar, however, has seen a steep rise since late September, with the euro trading below $1.30 Wednesday for the first time since February 2007. The British pound fell to its weakest level against the dollar in five years. See Currencies

A stronger dollar reduced gold's appeal as an investment alternative. "Investors unwound leveraged short dollar, long gold positions, mindful of the long standing negative correlation between gold and the dollar," said the WGC's Dempster.

Some analysts, however, said that in the long term, the U.S. rescue plans to inject liquidity into banks will stir inflation and a devaluation of the dollar -- something that would be bullish for gold prices.

"An extraordinary amount of liquidity has been pumped into the system this year," said Peter Grant, senior analyst at USAGOLD. "I anticipate further debasement of all currencies, including the dollar, which will ultimately drive gold prices higher."

Moming Zhou is a MarketWatch reporter, based in San Francisco.