Dear MoneyNews Reader,

I'm a big believer in gold and what it has historically told us about the future economic climate. And I can't question the precious metal's role as a store of value.

But, blink and you might miss the ongoing rally this lustrous commodity is currently experiencing.

In my Sept. 24 column I concluded that the price of coffee hardly reflected this staple's fundamental situation and that the smart play might be to get long of this primary agricultural commodity. Since I wrote Coffee Bonanza Brewing, coffee futures on the New York Board of Trade have risen as much as 12%.

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  As a market analyst, I have to rigorously question a variety of biases, views and opinions as time progresses and investors' opinions change. So this week I take a deeper look at the rationale that is forcing gold to rise and I weigh that against the likelihood that either it will continue to spike or that the latest speculative binge will deliver nothing but fool's gold.

As I have pointed out in this column over the last two weekends, gold may lose its shine if the dollar keeps rising. However, when measured in foreign currencies, the rally in the price of gold has only just gotten underway.

This week I want to serve up what I consider to be the most likely scenario for the price of gold - based on several tiny clues that I have uncovered.

The reasons for gold's recent rise are relatively straightforward:

• Commodities have experienced a boom as demand for raw materials has risen. In fact in the three years to September, gold has lagged the broad performance of the CRB index by 15%.
• Commodities as an asset have jumped 73%, while gold has only put in a 58% rise.
• In the space of five years the pendulum at the Federal Reserve has swung from fear of deflation to fear of inflation - that uncertainty has created a bullish environment for gold
• Rising interest rates are detracting from competing investments. Should the Fed overburden the economy, slowing growth deters investors from buying equities, directly boosting the allure of gold
• Finally, gold is looking more bullish to overseas investors, as I pointed out graphically last week. Gold is rising no matter what currency it's viewed in

Follow the Dollars

But now that I have described that rosy backdrop for gold, we need to examine whether its current price fully reflects the sentiment - or it's simply waiting to blast off.

My analysis requires that I examine the role of this 600-pound gorilla sitting in the corner of the room.

By that, I am referring to the role that the dollar is playing today. Its strength feeds directly back into my previous comment that gold is rising relative to other major currencies.

This point is essential in determining whether gold is merely catching up with other commodities or in the last throes of its upswing.

Since a weak dollar is traditionally the cornerstone of a gold boom, we are now seeing apparent independent strength in the precious metal's price across the board.

But is the current dollar surge making gold's breakout appear bigger and better than it really is? If so, many investors are likely to be enticed to show up late to the party - only to find that the punchbowl is dry.

In an effort to illustrate that point, I have reproduced a chart below showing two years of gold's price action in both U.S. and Australian dollars.

Look at the similarities between movements in the Australian dollar and those of the price of gold. The relationship is quite clear, but it's one that seems to have changed within the past month, as gold has gone off to the races.

Now, that sets off the alarm in my head because like the Canadian dollar, the Aussie is a commodity currency. That means that the fortunes of these currencies are tied to the underlying demand for raw materials.

Both Australia and Canada are abundant in minerals, precious metals and other basic materials. Hence there is a strong demand for mining materials, especially as the turn in the economic cycle has a strong tendency to boost consumer appetite for currencies tied to these products.

So as you go back to the chart, you'll see that the real "break of trend" comes at the far right of the picture, as gold smashes its December 2004 high, leaving the Aussie eating dirt.

In fact, the peak of the Aussie's rally came in March of this year and the trend since then has been sideways to down.

Australia is the second-largest gold producer with an annual output of 261 tons, putting it behind South Africa's 345 tons in 2004. The United States was third with 259 tons.

But if demand for gold was so strong, wouldn't that be evident in the price of the Australian dollar?

Historically, gold rises when the prices of other goods rise or fall sharply. Remember that periods of rapid inflation are more common than those of deflation. But that relationship in recent years has been sketchy to say the least.

Core consumer prices stood at a 2.7% in February 2001 just as gold was strolling the sidewalks at its low of $253.85 an ounce. In contrast, that same measure of inflation came in at 2.1% in September, having risen from a lowly 1.1% at the start of 2004.

While it is true to say that rising inflationary pressures might have fueled gold's performance that is stretching the argument somewhat.

Perhaps gold is reflecting brewing future inflationary pressures.

After all, recent minutes from the Fed's September meeting - at which it raised rates by a further one-quarter point - clearly conveyed members' feelings that energy-induced pressures were higher than they were at August's meeting.

But with the benchmark 10-year note yielding just 4.48%, long-dated yield rates - upon which mortgage rates are based - are lower now than they were when the Fed started raising rates a little over one year ago.

So we see that it is only a thin veil covering the inflationary element affecting gold. We should take it with a grain of salt.

You have to wonder whether the recent gold spike is merely idle speculation. After all, the story is so hard to refute that perhaps it merits hedge funds jumping in with both feet. They often get the blame for pushing markets too hard, and maybe this is another clear example.

A Clue from the Futures Market

While it is impossible to pinpoint who's buying up shares in which mining stocks or determine whether investors are hoarding gold, it is possible to figure out which players are stacking up sizeable trades in the gold futures markets.

This led me to look at the so-called "open interest" in the gold futures market.

Open-interest splits allows us to take a look at what sort of buyers and sellers are in the market, what they do with their positions and how they change positions from week to week.

The data, which is released by the Commodity Futures Trading Commission (CFTC) in the Commitment of Traders Report each Friday afternoon, provides especially useful insight into the commodities market, since positions are divided between "commercial" and "non-commercial" users.

Commercial refers to end-users of the underlying commodity who take advantage of the market primarily to hedge their own production. Non-commercial includes anyone who is merely speculating on the underlying commodity.

I've heard the expression "The pros selling to the schmoes" applied to the interpretation of open interest. The "pros" are the producers, who are pretty good at reading the market. They are seasoned traders who don't get greedy.

With that in mind, it seems this might be precisely what is going on right now in the gold market. The speculators are actually increasing their long positions while the producers are fulfilling this fresh demand by selling to them.

Looking at the data for the week ending Oct. 13, I noticed three significant elements to the report:

First up, the total open interest (or overall number of open positions) stood at a record number (for every seller, there is a buyer), implying that overall interest in the contract is at a record value.

Second, the rise in open interest was fueled by non-commercial buying (by the trusty schmoes). So the simple view that gold will go higher is manifesting itself in more and more buying. But this is merely speculation. I'm not saying they are wrong - I am merely lining up the available evidence.

Third, commercial long open interest had actually fallen back somewhat. That means that as prices are rising, actual producers are bailing out of the market.

Do they know something we don't?

This week the value of the dollar once again approached its highest level for 2005, ten-year bond yields rose to a six-month high of 4.5% and consumer price inflation exploded, hitting its highest point in 25 years.

With energy prices reportedly having risen by 12% in September - the largest jump ever - you have to wonder whether gold investors are blindly falling in love with the precious metal without regard for the consequences.

Gold has not only reached a fresh high for the current bull run, but it finished lower on the week. Its failure to close above last week's $476.05 high may mean that buyers will open the box only to find a bar of fool's gold instead of the real stuff.

Andrew Wilkinson
Senior Newsletter Editor

P.S. If you have been following our commentary recently, you'll know that here at MoneyNews and Financial Intelligence Report, we'd been bouncing around the idea that perhaps the price of crude had gotten ahead of itself.

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