SPOT GOLD PRICES recovered an early 2.1% tumble on Tuesday, rising above $780 an ounce as Japan’s Nikkei stock index closed almost 5% lower after Tokyo traders got back to work following a public holiday on Monday.

The Japanese Yen shot 3% higher on the forex market as “carry trade” debts – used to fund better-paying trades outside zero-interest-rate Japan – were pulled home in response to the weekend’s demise of Lehman Bros. and Merrill Lynch, plus the ongoing threat of collapse at Washington Mutual and AIG.

Oil prices sank below $92 per barrel while the FTSE100 index here in London fell 6.7% below last week’s close.

Short-term US government bonds slipped back, meantime, unwinding half of Monday’s record drop in 3-month yields and pushing the yield on six-month Treasuries more than 0.14% higher to 1.61%.

But “don’t be surprised if the US Fed cuts interest rates [today] as a last resort to save the financial system,” as Subodh Gupta, an analyst at Anand Rathi Commodities in India – the world’s No.1 gold consumer – said to Reuters this morning, not even with US consumer-price inflation likely to stand at 5.5% for August when announced at 08:30 EST.

“Gold may bounce back on the Dollar’s weakness,” he believes.

The US currency held the Euro below $1.42 and capped the British Pound at $1.78 this morning, while the futures market raised the odds of a 0.25% cut at today’s Fed meeting to better than nine-in-ten – up from a mere one-in-twenty this time last week.

Medium-term Japanese bond prices meantime leapt to catch up with the global “safe haven” panic, pushing the yield offered by five- to ten-year debt down to 1.0% as traders backed the Bank of Japan to keep its rates on hold for the 16th month running tomorrow (Weds).

The yield offered by UK government bonds also sank this morning, despite a record jump in the official rate of inflation to 4.70% annually – almost twice the Bank of England’s target.

Under UK regulations, the BoE chief Mervyn King was obliged to write an open letter to the finance minister, explaining why inflation is now so high. But after blaming “largely unanticipated” rises in the cost of raw materials globally, he instead claimed that the current slowdown in economic activity “could, if severe, result in inflation falling below [the 2%] target in the medium term.”

Six-month UK gilt yields dropped 119 basis points on the news to 4.47%.

Growth in the UK money supply has held above 10% year-on-year since the spring of 2005 – and “Few empirical regularities in economics are so well documented as the co-movement of Money Supply and Inflation,” as Dr.King himself noted in a series of speeches early this decade.

German Bund prices also rose sharply on Tuesday, pushing two-year yields down 13 basis points to 3.59% despite the official EuroStat agency pegging Eurozone inflation at 3.80% per year.

“Things are not adding up,” reckons Bart Melek, global commodity strategist for the BMO funds in Toronto. “Markets are not behaving in a consistent manner.

“Negative [real] interest rates, systemic risks in the financial sector and the credit crunch are all making many fixed-income assets, equities, and real estate a risky proposition.”

In due course, however, “investors could well start building their gold positions again given other asset classes have lots of risk and only limited upside,” Melek believes.

Following the weekend’s demise of two Wall Street giants, Monday saw the credit rating of AIG – the world’s biggest insurance group – cut two notches by the major rating agencies.

The company said last month that a one-notch downgrade would force it to find an extra $13.3 billion in collateral for raising new funds. Any further cuts will trigger “early termination” payments of $18bn on AIG’s senior debt, says the Financial Times.

A failure at AIG would cost Bill Gross’s Pimco – the world’s largest bond fund managers – some $760 million according to Bloomberg, since he sold “credit default swaps” to insure the ailing insurance group’s debt early this summer.

Over at Washington Mutual meantime – now vying with AIG as “most likely to fail” in the wake of Lehman and Merrill’s demise – “Think happy thoughts!” said a morale-boosting e-mail from Bob Bjorklund, head of Capital Strategies, to his staff last Friday.

Yesterday the sixth-largest US bank tumbled 27% at the New York Stock Exchange, taking its losses since March to more then four-fifths and valuing WaMu down at the take-overprice then offered by J.P.Morgan Chase.

WaMu’s bonds were downgraded to “junk” status Monday by the three major credit-ratings agencies. It’s set to take a $19 billion hit from bad mortgage loans over the next 30 months.

J.P.Morgan is no longer looking to buy WaMu, says a source quoted by the Seattle Times. Bank of America chief Kenneth Lewis – who bought Merrill Lynch for $50bn at the weekend – told CNBC yesterday that he’s not interested in WaMu, either.

“The failure of a bank its size would test the strength of the US deposit insurance system,” says the Financial Times, “and its ability to maintain the confidence of the nation’s savers.”

Washington Mutual held some $143bn in FDIC-insured deposits at the end of June – three times the size of the Federal Deposit Insurance Corporation’s funds.

“I’ve got to say our banking system is a safe and a sound one,” US Treasury secretary Hank Paulson assured reporters late Monday. “The American people can be very, very confident about their accounts in our banking system.”

Credit spreads on US investment-grade corporate bonds – a key measure of investor stress – jumped further on Tuesday, while the cost of two-year “swap” loans held almost 0.15% above government bond yields – “the highest since the beginning of the credit market meltdown,” according to Manqoba Madinane at Standard Bank.

In precious metals, “Financial market turmoil is calling the shots,” he goes on, with industrial metals platinum and palladium – used primarily in auto-catalysts – sinking by 8% and 11% respectively so far this week.

But “the increased systemic risk in global financial systems – with the greenback losing direction – should mean safe-haven fund flows for gold.

“Upside potential [in Gold] could remain high today.”

Adrian Ash
BullionVault

Formerly City correspondent for The Daily Reckoning in London and head of editorial at the UK’s leading financial advisory for private investors, Adrian Ash is the editor of Gold News and head of research at BullionVault – where you can Buy Gold Today vaulted in Zurich on $3 spreads and 0.8% dealing fees.

(c) BullionVault 2008

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