A softer dollar, persistently firm oil, along with good physical interest on dips are all seen as supportive to gold. However, the $900 level must still be regained to improve the short-term technical picture.

The recent declines in volatilities in the FX market, some commodities (including gold) and equities has resulted in a surge in risk appetite. The VIX volatility index has dropped to 17.66, near an 8-month low.

The UBS risk aversion index has fallen to its lowest level in 11 months, prompting UBS to issue a "technical alert" on Wednesday. The alert warning of an "imminent up-tick in equity volatility" amid persistent growth risks, inflation and financial sector losses. Today's data certainly indicates that risks to growth remain.

There is growing concern about the vulnerability of equities, given the inability of the market to sustain the initial foray back above 13,000. If stocks do fall out of bed, there could be an initial period of delevering across a wide range of markets, but we still believe gold will ultimately benefit from diversification flows.

With the gold market range-bound (although suddenly looking more favorable), this is a good opportunity to take another look at the longer-term fundamentals:

The ever increasing global demand for gold has been discussed at great length on our site as well as in the general media. As emerging economies such as China, India and those in the Middle East continue to expand so do their middle classes. These particular cultures have a special affinity toward gold and will continue to be major driving forces in the gold market.

These nations also tend to have large amounts of currency reserves as a result of massive trade imbalances, particularly with the US. Consequently, a large percentage of these reserves are in dollars. Given the long-term downtrend in the greenback there are increasing expectations that these countries will seek to diversify their reserves.

Gold is a likely beneficiary of such diversification flows, as is the euro. No matter how they diversify, it will be at the expense of the dollar. As the dollar declines, it makes gold even more appealing as an alternative asset.

What's really troubling is the potential that this becomes a self- sustaining trend that ultimately could result in massive dollar flight. That in turn heightens the risk of competitive currency devaluations elsewhere in the world.

Investor demand is likely to remain high as a result of speculation, but more importantly it is gold's hedging capabilities -- its ability to preserve wealth -- that is going to have an increasing impact on the demand side of the equation.

Gold is historically viewed as a safe-haven, shelter during uncertain economic and geopolitical times. Gold offers portfolio diversification that is generally uncorrelated with most traditional asset classes. Gold is also the classic hedge against a declining dollar and inflation.

As for supply: US Geological Survey data shows that global gold production peaked at 2,600 tonnes in 2001, which corresponds with the start of the bull trend in the yellow metal. Annual production had dropped off by more than 5% to 2,460 tonnes by 2006. Data from GFMS shows that gold output fell to 2,447 tonnes in 2007.

Increasing demand, less supply. That about says it all and explains the 230% price increase seen in the last 7 years. However, there's more to consider.

The long-term uptrend in the price of gold has encouraged some mining companies (and forced others) to buy back their previous forward gold sales -- a process called dehedging. In 2005 dehedging accounted for 86 tonnes of demand for gold. By 2007, that number had grown to 400 tonnes -- a 365% increase.

As of last year, China has become the world's largest producer of gold and they are a net importer. Russia is the fifth largest producer and they too are net importers. That means that output from two of the top five global producers never leaves their borders.

Political instability, labor unrest, power shortages and high costs have curtailed mine production in many other parts of the world. While price gains are likely to spur further exploration, its been more than a decade since we've seen a major gold find. Mine production is also quite inelastic due to long lead times to find and ultimately extract gold from the earth.

Official sector gold sales are becoming less important. Some central banks have already reduced their gold holdings to the point where they simply won't be selling any more. Other banks are looking at the significant gains seen in gold over the past seven years, evaluating the potential for even higher prices in the future and scaling back their operations under the Central Bank Gold Agreement by choice.

The picture painted for gold is one of a market that is fundamentally strong. If I learned anything in all those economics classes I've taken, it's that higher demand and tighter supplies lead to higher prices. It is likely that the opportunity to buy gold here, below $900 will be viewed as quite a deal with the benefit of hindsight.

Gold Market Movers:

US Philly Fed index rebounded to -15.6 in May, versus -24.9 in Apr.

US TIC data for Mar showed a net outflow of $48.2 bln in Mar, versus outflows of $48.9 bln in Feb.

US Empire State index tumbled to -3.23 in May, well below expectations, versus 0.63 in Apr.

US jobless claims for the week ended 10-May +6k to 371k.

Eurozone GDP for Q1 +0.7%. Germany +1.5%.

Gold, silver gain as dollar's rally stalls, energy costs climb

Fate of US housing rescue in the balance

Barclays profit falls, leaves capital options open