Are we missing the flaws in this gold rally?

LONDON (Reuters) -

The stars have aligned for gold prices, leaving them just a short hop from record highs, but as bullion bugs celebrate, the rally appears to have flaws.

Prices have been swept along to 18-month highs at $1,023.85 -- opening the door to record levels at $1,030.80 -- on a wave of dollar weakness, inflation concerns and technical momentum.

But in the rush, a few issues do not sit easily with the bullish show, including ultra-stretched long speculative positions on the New York futures market, tame physical investment and little movement of gold in non-dollar terms.

I'm not bearish gold, but this has gone too far too fast. I don't think that all the ingredients are in place for this to be a sustainable rally, said John Reade, metals strategist at UBS in London.

On the face of it, the case for investing in gold looks compelling on a number of fronts on a longer-term basis.

The dollar is seen weakening further, making dollar-denominated gold cheaper for non-U.S. investors and heightening its appeal as an alternative asset.

Europe's leading central banks have agreed to a third pact to limit sales of the metal, while China already has raised its stockpile by some 75%.

Those scrambling to get in front of potential inflation, predicted by many as leading economies seek to untangle themselves from stimulus spending and near-zero interest rates, have also flocked to the shiny stuff as a hedge.

A STRETCH

Most of the run higher has been led by major flows into the U.S. COMEX gold futures market, with trading investors and speculators vastly increasing long positions, leaving the price vulnerable to rapid and sharp falls.

The latest weekly Commitments of Traders report published by the Commodity Futures Trading Commission showed net long positions had widened to a massive 224,676 as of Sept. 8 compared with 184,501 a week earlier.

Positioning looks set to extend more, but the longer it gets, the bigger the risk.

Everybody is saying the market is too long, but no-one wants to sell, said Ronald Leung, director of Lee Cheong Gold Dealers in Hong Kong.

There's too much money in the world as central banks take easy policy and as funds push up the market with the money. They see (the) gold market as easy to manipulate...like a casino.

But flows into exchange traded funds, the beneficiary of gold buying earlier in the year, have not kept pace with the latest price surge, and physical demand from the jewellery sector has gone cold.

Inflows into gold-backed ETFs have picked up a little after plateauing over the summer months, but remain well down on the first quarter's record levels.

On the currency front, the dollar has fallen to one-year lows against a basket of major currencies, while the euro looks set to hit $1.50.

As a function of dollar weakness with an inverse correlation, gold is pulsing higher as the dollar falls, but that does not equal optimum conditions for the metal, some say.

This is not a bull market for gold, it's a bear market for paper currencies, led by the dollar, said Sean Corrigan, chief investment officer at Diapason Commodities Management in Switzerland.

A look at non-dollar denominated gold also shows an unfamiliar pattern as the current rally is not being replicated.

Sterling-priced gold, for instance, is only at its highest since April, while bullion in commodity currency the Australian dollar is struggling to revisit recent two-month highs.

FEAR FACTOR?

The other missing link to the current rally is fear, gold's usual cheerleader when prices are surging.

There is no real fear, which would be supportive for gold in the medium term, said Eugen Weinberg, commodities strategist at Commerzbank.

The market is not concerned any more about the economy or about the health of the financial system, and I think this will not be sustainable.

Gold last got through the psychological $1,000 barrier and hit a record high in March 2008 -- coinciding with the collapse of Bear Stearns and subsequent distressed sale to JPMorgan.

Mike Lenhoff, chief strategist at Brewin Dolphin, looking back at the financial crisis, notes how each time gold raced up in crisis mode, it quickly sold off again.

I don't think gold bullion is going much beyond where it has got to already. It had its chance to fly with the mother of all financial upheavals, and it didn't. (Additional reporting by Chikako Mogi in Tokyo; Editing by Sue Thomas)

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