Gold price plummets again as hedge funds rush for the exits

There’s still plenty of fear and even panic evident in stock markets around the world but the safest of safe havens, gold, isn’t getting much love. In trading today, gold dropped below $700 an ounce for the first time in over a year, marking a huge retracement of the multi-year rally that saw the precious metal peak at an all-time high of over $1,000 back in March.

What’s going on? On the one hand, the risks that investors typically try to use gold to counteract — inflation and a weakening dollar — are diminishing. And at the same time, a lot of big investors that used borrowed money to juice bets on commodities including gold are pulling back and unwinding their trades.

Consider these two graphs which plot the price over the past three months of the SPDR Gold Trust (Symbol: GLD) against the Powershares DB US Dollar Index Bullish fund (UUP) and the United States Oil Fund (USO):

The rising value of the dollar and the cratering price of oil have helped reassure investors that, at least for now, inflation and currency devaluation aren’t big risks ahead. In fact, much of the worry of late is of deflation and depressions.

Gold is acting as it almost always does, moving in the exact opposite direction of the value of the dollar. In large part, you can blame the slowing world economy for that. With many nations, not just the United States, now facing recessionary times, the dollar looks a little more appealing as a place to ride out the storm. And demand for all sorts of commodities used in industry is plummetting, hurting both commodity prices and the currencies of commodity producers like Canada, Norway and much of Latin America.

But another explanation behind the recent moves of all these currencies and commodities is the unwinding of a popular and, no doubt, highly-leveraged trade used by hedge funds, Wall Street firms and other big investors. For the past few years, it was a great idea to borrow money in currencies with low interest rates, like the US dollar, and invest either in commodities or in currencies from major commodity producers. As long as interest rates stayed low and the dollar stayed weak while commodity prices kept rising, the trade paid off. But when the dollar began rallying and the economic outlook deteriorated, that bet was a huge loser. With added pressure to pay back borrowed money from credit crunched lenders, the big players had to exit their positions in a hurry.

None of this is to say that the markets are always right. With the U.S. government putting trillions of dollars on the line to restore faith in the banking system, the future value of the dollar has to be in question and the possibility of rampant future inflation can’t be discounted. There’s also been a huge disconnect between the falling price of gold futures contracts and seemingly insatiable demand for gold bullion coins and bars from retail investors around the world. That suggests there may be plenty of the kind of fear that pushes gold prices higher waiting for the short-term selling to end.