Comex gold strengthens and reaches a new high of 1266.5 in European session. The Chinese government's pledge to increase flexibility of RMB has spurred commodity demand and this benefits gold. Moreover, WGC's quarterly report on central bank gold holdings and flight for safe-haven asset amid sovereign crisis in the Eurozone also boosted the yellow metal.

China's signal to end the 2-year peg with the dollar has sent commodities higher. WTI crude oil price remains firm after soaring to as high as 78.87 earlier in the day, extending the +4.61% rally last week. Base metals also surge with zinc gaining more than +4% and copper adding over +3%. Price actions suggest that the market focuses on increase in purchasing power in China, instead of loss of competitiveness in Chinese exports, after RMB appreciation.

In our opinion, we view current strength in commodities and commodity currencies unsustainable. According to the People's Bank of China, this would be a return to 2005's managed floating exchange regime based on market supply and demand with reference to a basket of currencies. The floating bands will remain the same as previously announced (0.5%). The central bank also said that a more flexible RMB exchange rate aims to help curb inflation and the asset bubble but the appreciation should not be big as China's real effective exchange rate (REER) has already appreciated due to decline in the euro and heightened inflationary pressures. Therefore, it's reasonable to expect only a gradual and small scale appreciation of RMB within a year. While long-term appreciation in RMB and its benefits on purchasing power may boost commodity demand, the near-term impact is not significant.

Moreover, the Chinese government will likely implement further tightening measures to curb inflation and excessive lending. This should cool down the economy and slow demand.

At the same time, impacts of RMB appreciation vary on different commodities. According to Deutsche Bank, sugar, coal and lumber should benefit the most while the impacts on oil and base metals are virtually zero.

According to a report on central bank reserve holdings by the World Gold Council, the Russian central bank increased gold holdings by +26.6 tons in 1Q10, followed by +4.9 tons in April. Philippines also purchased 9.6 tons of gold in the first quarter. This, together with Saudi Arabian Monetary Authority's upward revision of holdings, fuelled speculations that central banks in Asia and the Middle East want to buy more gold.

We have a light economic calendar today and focus will still remain on RMB appreciation. We expect strong stock market in the US, given rallies in Asian and European bourses. Robust market will continue to boost commodities higher but investors should caution as the strength may not sustain.