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GOLD: STILL VULNERABLE

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Gold's tumble in recent days, now about 9.5 percent from its late-February high just briefly over $1000 an ounce, is no surprise to readers of NicholsOnGold.com.  Although we remain bullish for the long-term and foresee more than a doubling of the gold price in the next few years, the immediate picture is less rosy . . . and the yellow metal remains vulnerable to further short-term selling.

A number of factors have contributed to gold's decline in the past week and may remain influential in the weeks ahead:

•    First and foremost, the market has had to absorb an absolutely fantastic flow of old scrap.  Record high prices in local currencies around the world -- with a little help from falling incomes and rising unemployment -- has prompted millions of people to cash in their old gold jewelry.  The story in India, historically the world's largest national gold market, often absorbing 700 to 800 tons a year, has been well told in the media -- but people everywhere are cashing in their old gold jewelry.  Even here in the United States, homemakers and working women are holding gold parties where they and their friends sell unwanted jewelry to itinerant scrap buyers.

What matters are prices in local currencies.  Indian rupee prices, for example, are at historically high levels -- so the impulse to sell is stronger than one might imagine from a U.S. dollar perspective . . . and this picture is similar in many countries throughout Asia, the Middle East, and Europe.

Indeed, refiners everywhere are operating at full capacity to convert old scrap into new good-delivery bullion bars in quantities since the beginning of the year measured in the hundreds of tons.

•   Surging investor demand during the first six or seven weeks of the year -- much of it channeled through gold exchange-traded funds -- readily absorbed the inflow of metal from recycled scrap.  But once investors paused for a breath of air the continuing influx of metal weighed mightily on the price.

The combination of rising prices, growing secondary supplies, and surging investment buying created a simply unstable and unsustainable situation as higher prices attracted ever-greater volumes of scrap to be absorbed by investors.  Only an ever-increasing volume of investor purchases could keep prices near $1000 an ounce.  As investor buying relaxed, prices just had to come down.

And, while investor interest can be fickle and fluctuate from day to day, the inventory of old scrap awaiting conversion into bullion bars will continue to weigh on the market for at least another few weeks.

•    Once gold stalled just above the $1000 an ounce level, the short-term technical picture quickly turned bearish as chartists took profits and short covering ensued.  In recent days, selling simply begot more selling and the price came tumbling.

Now, my technical reading shows good support between $900 and $910 -- but a breach below this range could take the market down to $850 to $860 in a wink.  It's important for gold-market participants to remember that long-term trends are always rational but short-term volatility is often emotional and sometimes just meaningless noise.

•    Gold also remains vulnerable near term to further appreciation of the U.S. dollar against the euro and yen.  The European Central Bank meets this Wednesday and Thursday -- and financial markets are anticipating a reduction in the official bank-lending rate.  Perhaps this has already been fully reflected in financial and forex markets -- but, if not, a pop in the greenback could knock gold down another notch.

In addition, the dollar has benefited from some of President Obama's articulate leadership in comparison to the last Administration in Washington and, thus far, notwithstanding the failure to convincingly address the problems within the banking system, the housing market, AIG, and the auto industry.

How long the currency markets continue to favor the dollar is anyone's guess -- but a reversal of the greenback might be the trigger for gold to begin moving higher again.

Longer term, the exchange-rate picture is almost irrelevant.  Gold will be appreciating against virtually all currencies, only a little bit more against the relatively weaker currencies and a little bit less against the relatively stronger currencies.

•    I suspect the worse than expected news on the U.S. economy, particularly the downwardly revised fourth-quarter GDP, has also had a dampening effect on the gold market in recent days.  The narrowing rate spread between ordinary U.S. Treasury securities and U.S. Treasury Inflation Protected securities (TIPS) is an indicator of declining inflation expectations.

In my view, investors who are downwardly revising their expectations of future inflation based on the economy's dismal past performance are looking through a rear-view mirror . . . and are missing the forward-looking signposts of debt monetization and rapid money-supply growth, growth which promises rising inflation after long and variable multi-year lags.

Looking ahead, any surprises are likely to be positive for gold.  Policy makers in this country and abroad are in uncharted territory without any clear road maps to navigate through the global credit mess and worldwide recession.