A surge in the price of Gold...

Just as the dollar has been steadily losing value, the price of gold has surged passed $1500 to the ounce. This is once again a reflection of the dire conditions that monetary authorities around the globe find themselves in.

The U.S. is facing challenges from various fronts, starting out with a growing interest rate decoupling with the rest of the world. As central banks across the globe begin tightening rates, the federal reserve is sticking to its stimulative plans. The situation is further exacerbated by the fact that the second $600 billion quantitive easing program will end by next June and there are no plans to introduce an additional round which means that we can expect a sharper slope between the short end and the rest of the yield curve.

Last but not least, there are growing signs that China's appetite for dollars may be dwindling. This can be seen with the steady appreciation of the Yuan against the dollar, which means that Chinese authorities may be shifting its policy on exchange rates. Other countries in the region are likely to follow suit.

The U.S. monetary authorities are not the only one's experiencing trouble. The Euro is also under pressure despite the ECB's 25 basis point rise in its target rate. Serious trouble seems to be brewing in the peripheral countries, most notably Greece, where there is growing anticipation that some sort of restructuring is in the works. Most pundits would agree that this is the only viable option considering the country is stuck in a perpetual cycle of weak growth. Restructuring could include "reprofiling" its debt which is basically extending its maturity whilst keeping the rest of the conditions intact. It could also include a haircut which would hurt the banks that hold Greek paper.

Finally, we have Japan that is reeling from the disaster that ravaged a large chunk of the country. Reconstruction will take place, but this will occur over the longer term and its impact on growth wont be felt for a while to come. The disaster will also give Japanese industries an excuse to relocate their remaining factories to mainland China. Add to this a weak government and it becomes difficult to see how the country is going to pull itself out of the mess.

No wonder then that gold is surging.

A bottomless pit?

The dollar has been on a long term downward spiral ever since reaching a peak in 2001. The most recent plunge has been caused by a growing disconnect between the U.S. and the rest of the world. This disconnect is a result of the following factors:

• A surge in commodity prices and signs of overheating of the economy in emerging markets is prompting a growing chorus of central banks to tighten rates. The ECB was the latest to raise rates last week in response to a commodities fueled steady rise in headline inflation.


• The second round of quantitative easing still has a couple of months to go and there is talk of a possible third round if things dont improve.


• A U.S. government shutdown may have been narrowly averted but the upcoming confrontation on raising the debt ceiling would have far greater consequences in the event that an agreement is not reached by around May 16 in which case the government would no longer be able to honor its debt obligations.

In summary, the dollar is weakening because other currencies, especially those of "commodity rich" countries provide an attractive hedge against inflation and because the unique "dual mandate" status of the Fed effectively forces it, in the context of the current environment, to be less proactive on the inflation front. Although the Fed will eventually have to tighten rates, there will be a lag in timing relative to the 18 other countries (mainly emerging) that have already embarked on hikes.

correlations from different angles

Correlation measures are meant to provide an idea of the relationship between two variables. It answers the question as to how one variable relates to another. Do they tend to move in the same direction? Do they move in the opposite direction or are they actually unrelated to one another? Correlation figures can also be misleading because they tend to change over time. A negative correlation between say two variables could suddenly turn highly positive or vice versa. So correlations can be useful in devising a portfolio but one needs to be aware of this major caveat.

There are also other, more subtle factors that should be considered when studying correlations. Take "Cat Bonds" as an example, which are insurance linked bonds that basically pay out in the event of a specific natural disaster such as the earthquake/tsunami that recently ravaged Japan. Looking at the correlation between this particular sub asset class and the stock and general bond markets, even over long periods, one gets the impression that they are not related (see graph). In fact, their very nature should ensure that for most events there should be no positive correlation, but like for any investment, this rule can break down when "extraordinary" events occur. The Japanese quake was extraordinary in the sense that it was not only the largest experienced in Japan but also amongst the top five largest in the world for more than one hundred years. This should therefore be considered as an "outlier" event, something of extremely rare occurrence but which can provoke the sort of correlations that one is trying to avoid in the first place.

Here is an outline of the sequence of events that would help explain the sudden sharp rise in correlations between Cat bonds and the equity markets: The Japanese earthquake/tsunami devastated a large part of the north of the country, causing an estimated $25 billion in damages to be covered by insurers. This is on the back of a series of other natural disasters (albeit at a smaller scale) since the beginning of the year, which have depleting the reserves that insurance companies had set aside for such events. On the stock market front, the Japanese disaster comes on the back a number of other events that have the potential of derailing the global economic recovery. These include the ongoing European sovereign debt crisis that seem to be worsening, turmoil in the Middle East that show no signs of ebbing and commodity prices that continue to rise. In the context of such a backdrop it is no surprise that markets would respond with a correction following the damage caused to the third largest economy in the world. Still, these are extraordinary events, never before observed in such a configuration and are unlikely to repeat themselves. Nevertheless, it is important to note that no matter how rare an event may be, it still has the potential of occuring and by not accounting for it is understimating the risks involved.