GOLD: AS THE USD DECLINES

12:40pm EST 24-Nov-04 Morgan Stanley

North America

November 24, 2004

Economic Trends

Currencies

Gold: As the USD Declines

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Link al grafico mensile dell'oro dal 1975

Link al grafico giornaliero dell'oro (ultimo anno)

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- Not yet a bubble

In our view, the gold price does not appear to be in a bubble in terms of its 25 years of price history.  If anything, its 54% rise of the lows in the summer of 1999 now looks like a return to trend.

- USD down, gold up

The dollar's decline is keeping gold attractive as the natural beneficiary of USD bearish sentiment.  In our view, as long as USD bearishness persists, and the Bush administration implicitly sanctions a softer USD, the gold price can continue to rise and lend extra support to AUD, CAD and ZAR.

- Seasonal lift to gold at year-end

While most studies conclude that there is no dominant seasonal pattern to gold, at least from the demand side, we found that there is an end-year rise in the price of gold over the past 25 years.

- Market factors could continue to support higher prices

Supply could remain constrained going forward if net de-hedging continues to outweigh central bank sales.  Demand could increase further if geopolitical tensions remain high, petrodollars continue to flow in the Middle East, and Asian currencies appreciate relative to the USD as we expect they will.

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Golden opportunity or golden bubble?

Gold is stretching up to $450/oz, marking 16-year highs.  At the same time, the gold price does not appear to be in a bubble in terms of its 25 years of price history.  If anything, its 54% rise of the lows in the summer of 1999 now looks like a return to trend. In this note we review the close relationship between the USD and gold and quantify the impact of a change in the USD on the gold price.  We also consider various factors, including seasonality, market structure that could support the gold price and macro policy risks that could drive it lower.  In our view, as long as USD bearishness persists, the gold price can continue to rise and lend extra support to AUD, CAD and ZAR.

Quo Vadis?

The dollar's decline is keeping gold attractive as the natural beneficiary of USD bearish sentiment.  This is due in part to the fact that gold is priced in USDs:  a stronger dollar naturally buys more ounces of gold.  The gold price is inversely correlated with the USD to a fairly high degree, on average 30% as the table on the next page suggests.  Even so, on a rolling basis the correlation between the USD and the price of gold appears to be intensifying at the moment, heading toward 55%. To the extent that the USD is driving gold higher, gold is further strengthening certain currencies.  Based on our correlations, the currencies most likely to appreciate relative to the USD in line with a rise in gold prices are AUD, CAD, JPY, EUR and ZAR.

The Gold-USD rolling correlation is rising
While a correlation with gold alone is not enough to recommend the commodity currencies, it is a feather in their cap.  For example the price of gold has been positively and strongly (between 27% and 34%) correlated with AUD since the 1980s.  At the moment however, our view on the AUD is that it can go lower thanks to several fundamental drags on the currency including the current account deficit.  Similarly ZAR shows a positive 12-17% correlation with gold. In tandem with the recently strong ZAR performance, we see no reason to think ZAR cannot keep gaining.

Quantifying the impact of the USD decline on gold

We also quantified the impact of a change in exchange rates on gold.

Specifically we estimated the relative change in gold prices for a given change in the exchange rate at the one-month and one-week frequencies.  These are uniformly suggest that the average monthly change (say .05%) in the Fed's major USD index is responsible for about a 1$ change in the price of gold.  Of course with the USD currently in freefall, we would expect much larger impact on gold.

'Tis the season...for gold prices

In addition to gold rising on the momentum of the USD decline, there may also be a small seasonal factor at play. Generally speaking, most studies conclude that there is no dominant seasonal pattern to gold, at least from the demand side.  However, we found that there is an end-year rise in the price of gold over the past 25 years.  Exhibit 2 plots this year's price of gold month-by- month against the average seasonal index factors.  It suggests that, at the very least, we do not expect seasonal impediments to further rise in gold.

Market factors decreasing supply and raising demand

It's worth mentioning that the supply and demand characteristics also suggest gold prices will continue to rise from current levels.  The supply side is principally driven by mine production, and while this has been stable to falling over the past two years, central bank sales and the net hedging by producers has been more key to overall supply.  The second Washington Agreement on Gold went into effect this September, regulating European Central Banks' sales of gold to 500 tonnes per year over the next five years.  These banks account for 40% of existing stocks of institutionally held gold and by selling stock they have increased supply in the market though only at the margin.  Net hedging by producers gained market attention in 2000 when they began reducing the amount sold forward, and so far this reduction in supply has outweighed the increase generated by central bank sales. Overall supply could be more constrained going forward. The demand side is driven largely (80%) by demand for jewellery and particularly in Asia and the Middle East.  Demand in these regions could increase further if geopolitical tensions remain high, petrodollars continue to

flow in the Middle East, and Asian currencies appreciate relative to the USD as we expect they will.

Macro risks to a USD/GOLD rate

Imagine gold were a currency the way other monies are.  What macro factors would influence the USD/gold rate?  This rate is susceptible to a number of currency-related factors.  For example, the risk of intervention by the Japanese MOF to support USD/JPY could stop the rising gold price in its tracks. Another risk to gold prices is the possibility of increased hedging again. Declining interest rates had brought down the contango in gold; now, the return to rising rates may well make selling forward more attractive and possibly generate interest in hedging, thus increasing supply.  Yet, despite these potential macro risks to gold the Bush administration's effective green light to a softer USD, has given the gold price freedom to rise.  As long as the USD keeps going, gold may too.