LONDON (Reuters) - Investors' love affair with gold may appear to have cooled, but that would be a misleading conclusion to draw from the fall in physical holdings of the precious metal.
Gold's popularity will return because investors fear inflation and sovereign downgrades, even if the U.S. currency continues its ascent and makes the precious metal more expensive for holders of other currencies.
The stampede to gold is likely to resume later this year, when tighter monetary and fiscal policy to rein in potential inflation and government deficits respectively reinforce fears of financial, political and economic instability.
But for now, many investors expecting a more benign environment than they have seen in the last couple of years and wanting to keep their exposure to gold have shifted their money from the physical to bullion producers.
"As long as risk aversion is low investors will prefer equities to the metal because physical gold is a synonym for fear," said Eugen Weinberg, commodities analyst at Commerzbank.
The clearest evidence of a retreat from physical gold can be seen in the holdings of the world's largest gold-backed exchange traded fund, SPDR Gold Trust, down more than 20 tonnes to about 1,111 tonnes since December 29.
Spot gold hit a record high of $1,226.10 an ounce on December 3, more than 40 percent above the levels seen at the start of 2008. Investors switching allegiance since then have pushed prices back to around $1,100 an ounce.
"At the moment, we see more upside through gold-related equities, but that could change very quickly," said Omar Kodmani, senior executive officer at Permal Investment Management Services.
Major gold producers include Toronto-listed Barrick Gold (ABX.TO) and New York-listed Newmont Mining (NEM.N).
The large amounts of money pumped into the global economy by central banks and governments and low interest rates around the world to stabilize the financial system and boost growth after the credit crisis, mean price pressures in the pipeline.
Inflation, often triggered by a shortage of resources during times of robust growth, erodes wealth, which can be protected by including gold in portfolios.
Deflation is usually the result of negative growth, which hits corporate earnings, equity prices and corporate bonds.
"If there is either a deflation or an inflation scare, gold as a commodity usually responds well," Kodmani said. "In case of deflation, gold is a stable alternative alongside government bonds of highly rated countries."
Kodmani's comment on government bonds leads us to a source of uncertainty -- government deficits, which in many countries are ballooning to the extent that credit rating agencies are threatening downgrades.
Greece, where the budget deficit hit 12.7 percent of gross domestic product last year, is the most recent example. It sparked one of the biggest euro zone crises since the single currency was launched in 1999.
"Gold is a crisis hedge ... we want to make sure we are positioned for gold trending toward $2,000 an ounce," said John Brynjolfsson, chief investment officer at Armored Wolf
"There is a vulnerability in the global market ... in the sovereign sectors ranging from Greece to the U.S. and Japan."
The risk of government default is one reason why some emerging market countries such as China plan to diversify their reserves into gold over coming years.
Standard & Poor's on Tuesday threatened to downgrade Japan's sovereign credit rating unless it produced a credible plan to rein in its soaring debt.
The risk of sovereign downgrades has sent many investors scurrying for the security of U.S. Treasury bonds. To buy these, investors need dollars, which on Wednesday surged to six-month highs against the euro because of Greece.
"Over the last six weeks or so, people have been asking whether the dollar has bottomed, that has prompted some selling out of gold," said Robert Talbut, chief investment officer at Royal London Asset Management.
But whether dollar strength is sustained could depend on plans by U.S. President Barack Obama's proposals to rein in high-stake U.S. banks and their trading activities.
The drastic proposals could rewrite the world financial order, but a lack of detail means that for now, the status quo will be maintained, fund managers said.
(Editing by Sue Thomas)