Dollar's pain sets record gold up for more gains

LONDON (Reuters) - Record high gold prices may look stretched in the short-term but the dollar's decline and the specter of inflation are painting a bullish picture for prices later this year and next.

The precious metal jumped to a high of $1,043.45 an ounce as the U.S. currency slipped against a basket of major currencies, sparking fresh interest in gold as an alternative asset.

While its ascent may be vulnerable to profit taking in the short run, analysts say in the medium term the metal is well-placed to build on its current gains.

"In the short term, we have to see some price action above the previous high," said Standard Chartered analyst Daniel Smith. "We have to see the market close (above there) a couple of times to suggest we have consolidated at these new highs."

"But overall, we are going to see the market continue to push higher," he added. "I would expect it to hold onto these gains... as people lose confidence in the dollar."

With the U.S. currency still dented by reports -- quickly denied -- that some Gulf Arab states were considering using currencies other than the dollar for oil trading, the metal is comfortably supported at these levels.

Talk of countries diversifying out of the U.S. dollar and into other assets is helping the long-term investment case for gold, market watchers said.

"In terms of the price move we have seen today, it appears that this is broadly a result of concerns about the U.S. dollar and the whole reserve currency issue," said Rozanna Wozniak, investment research manager at the World Gold Council.

"There have been rumors that some countries in the Middle East are looking at moving away from pricing oil in dollars, and that broadly reflects a wider concern about the US dollar and the ongoing debate over what other currencies should be part of the reserve currency mix."

ROOM TO GROW

While traders are nervously eyeing the weight of near-record speculative long positions in U.S. gold futures as a sign gold has become overbought, its gains this year, compared to other commodities, have been relatively modest.

Even at record highs gold is up only 18 percent this year, while copper has risen 99 percent and oil more than 60 percent. Weakness in jewelry demand in particular has been fingered by market watchers as a major factor weighing on prices.

Jewelry demand was down nearly 15 percent in the first half of 2009 compared to a year before, according to metals consultancy GFMS. Jewelry buying was by far the largest source of gold demand last year.

But even there, some good news has been heard, with demand from India, the world's biggest gold consumer last year, picking up ahead of the key gold-buying festival of Diwali on October 19.

Indian demand is being helped by the strength of the rupee versus the dollar, with the Indian currency hitting a four-month high against the unit on Tuesday.

INVESTMENT DRIVEN

But while a recovery in physical demand will help support prices, the key driver for gold is likely to be investment.

This has soared this year as funds turned to the metal as a hedge first against financial market instability, then, as the economic recovery gained a foothold, against inflation.

"So many traditional investors want to hold a proportion as a hedge against a high inflation environment," said Jesper Dannesboe, senior commodities strategist at Societe Generale.

"Fund managers tend to hold a small amount of gold in their portfolio," he said. "(But) if you add it together, it's a fairly huge amount."

Central banks so far have broadly been content to keep interest rates low, but while this may jump-start economic growth, in the longer term it may lead to rising inflation -- something funds are keen to protect themselves against.

"Some parts of the market are talking about deflation in the here and now, but some are looking forward to the possibility that inflation will rear its head at some stage," said Rozanna Wozniak.

"We have two big issues at the moment -- currency uncertainty and inflation uncertainty." Both are likely to stimulate further gains in gold.