Good Morning,

Gold's midweek gains were undone in a hurry overnight as the roller-coaster pattern continued amid the standoff developing between the Fed and dollar bears. Depressed by a surging (up .64 to 73.87 on the index) US dollar and a $3 slide in crude oil (to $133.50) the precious metal gave back all of yesterday's gains and fell to a low of $864 ahead of the New York opening this morning.

Strong anti-inflation rhetoric from the Fed's Mr. Plosser (he said interest rates will have to rise) augmented expectations of US interest rate hikes and pushed their possible date of enactment closer to the present. Adding to the dollar's rise were reports expecting retail sales in the US to show a decent gain in the wake of stimulus cheques which were mailed to US taxpayers finding their way into store cash registers in lieu of bank savings accounts, as some had expected.

New York spot trading opened with a $15 (1.72%) loss, quoted at $865 bid per ounce, as players reevaluated the possibility that this could be the week (or indeed, the day) during which gold breaks through the $863 low and heads towards the $850 critical support area. We now look for this break to materialize shortly. The gain in retail sales (up 1% to the strongest level in six months) adds to the case being made for a hike in interest rates. Initial jobless claims moved higher, adding 25,000 individuals to those filing for benefits and import prices rose 2.3% due largely to oil values.

The US dollar broke through the 74 level shortly after the retail numbers hit the wires. Silver was off 55 cents to $16.30 while platinum lost $47 to $1996 and palladium fell $4 to $421 per ounce. Gold's losses widened to $24 and the metal hit a low of $856.50 within ten minutes of the retail figures' release. Bond and treasury markets are now pricing in a 125 basis point rate hike by this time next year, and a 50 basis point increase by Q3/Q4.

We had cautioned that this was going to be an especially intensive Fedspeak week, and it appears as though its spokesmen have hit every mike at every podium with an Is this on? test before talking very emphatically about inflation combat. Such jawboning has been the subject of several tests by now (such as we saw last Friday and yesterday) but looks like it is gaining traction with investors, at least as evidenced by the latest price metrics in commodities and currencies.

Speaking of jawboning, we bring you relevant passages from and address by Federal Reserve Bank of St. Louis President James Bullard who indicated (according to Bloomberg) that:

Policy makers should act later this year to prevent a jump in the inflation rate anticipated by the public that would threaten the central bank's credibility. The Fed's current low target interest rate ``might generate inflationary problems,'' Bullard told reporters after speaking to a Macroeconomic Advisers conference in St. Louis. ``If we don't take action and stay on top of the situation,'' the rise in prices will probably accelerate, he said.

Bullard's message echoes Chairman Ben S. Bernanke's warning this week that policy makers will ``strongly resist'' any surge in inflation expectations, signaling the central bank is done lowering interest rates. Investors now anticipate the Fed will start raising rates as soon as August, futures contracts show.

``After a 10-month period in which the dominant policy concern has rightly been the state of financial markets, policy can begin to address pressing inflationary concerns during the remainder of the year,'' Bullard said. The St. Louis Fed chief, who took office in April, also indicated that policy makers failed to contain inflation in the past four years, when it ``consistently'' exceeded 2.5 percent. He said that his preference is for a rate between 0.5 percent and 1.5 percent.

Reducing the fed funds rate to 2 percent was a ``preemptive'' move aimed at calming financial markets and may not be appropriate as markets stabilize, Bullard told reporters. Bullard indicated the Fed may need to close some channels for liquidity created as credit availability began to decline last year.

Also, stronger regulation of financial institutions may be necessary, Bullard said during the question period after his speech. The New York Fed is assigning examiners at investment banks now that the institutions may borrow from the central bank, he said. While the Fed has been focused on inflation measures that exclude food and energy, the steady rise in prices for those products may require a focus on broader measures, Bullard said.

The rise in inflation ``since 2004 has been due, in large part, to the rapid increase in energy and other commodity prices,'' Bullard said. ``Still, one would expect that policy can be designed to deliver actual inflation rates near target over periods as long as four or five years.'' New York Fed President Timothy Geithner said June 9 that a ``very large sustained rise'' in prices will prompt central banks around the world to pursue ``tighter monetary policy.''

Bullard gave his most detailed economic outlook yet. The U.S. economy has grown no more than 1 percent during the past two quarters. Growth may accelerate to 1 percent to 2 percent in the second half, ``maybe better,'' and return to ``trend'' growth of 2.5 percent to 3 percent in 2009, he said.

Keep an eye out for the dollar at or near 74 on the index, watch for further profit-taking in crude oil and most importantly, remain on alert for a gauge of how substantive the support above 850 proves to be and whether any more robust bargain hunting emerges at current levels. Observers remain apprehensive about the paltry additions to the gold ETFs that have been recorded since the massive 85tonne (about 10% of balances) outflow in April. The gold outlook report from HSBC characterizes the situation as follows:

While no published data are available, we believe hedge funds have been especially active in the ETF space for several months. That would explain the rapid increase in ETF redemptions recently. The combined WGC-sponsored ETFs plus Barcalys iShares, which comprise the bulk of ETF gold holdings globally, reached a peak of combined offtake of cicra 890 tonnes of gold bullion on 13 March of this year. In just six weeks, the figure dropped to 805 tonnes as of 30 April.

Such redemptions in the heretofore firm ETFs, if they signal a qualitative change in investor sentiment, might imply further price weakness. Put into perspective, the level of redemptions in the ETF for that period, is the equivalent of nearly 40% of annual South African output. If redemptions of that magnitude continue, not only could they call into question the notion that ETFs represent near-permanent bullion offtake, but further liquidation could weigh heavily on prices. That said, it is still our view that the bulk of gold ETF investors are likely to hold gold over the long term.

Let's hope that opinion proves to be correct.

Happy Trading.