We delve into the current drivers of the gold price; why it has recently been falling in all currencies; how it may affect your trades; and where it may be headed.
Gold's recent performance against the macro backdrop
There is currently a lot of uncertainty in the market, and for a number of reasons. The US volatility index or VIX is back above 20%, signifying fear within the market. The spike in credit metrics, such as the spread between US LIBOR versus the overnight indexed swap is at its highest level since June 2010. This spread is considered to be a measure of the health of the banking system; the wider the spread, the greater the reluctance of banks to lend to each other. Given this, one might be of the impression that gold should be a good place to invest considering it is seen as a safe-haven asset; however this has been far from the case. The precious metal has been sold down from the recent high of $1558t/oz to around $1500t/oz.
Interestingly, the metal has been falling in all currencies, although given the recent pullback in AUD/USD, Australian-dollar denominated gold has been outperforming USD-denominated contracts. So, we ask, is gold losing its glitter?
The bullish case for gold appreciation
There are still a number of reasons why traders should be long gold, and we believe that the metal should continue to appreciate in the long-term, despite the potential for EUR/USD to weaken. Interest rates around the world are not going up anytime soon as pricing pressures are abating, and given the actual level of inflation in major economies, it means the value of money is actually being eroded. Some are calling this 'negative real interest rates' (when inflation is higher than the actual benchmark interest rate); this is traditionally a good hunting ground for gold which, as a tangible asset, holds its value. Central banks in recent times have been diversifying out of US dollars and increasing weightings of alternative currencies (including the yellow metal), which have been key beneficiaries. Notably, China has been vocal about increasing its reserves. Unlike base metals, there really isn't a lot of new supply scheduled to come into the market in the foreseeable future. Although producers are increasing production, there are not a lot of tier one mines being discovered globally.
What has sparked the sell-off?
We believe the recent sell-off (despite the fear of a Greek debt default) has been more about the strength of the USD than any of the actual fundamentals of gold. Market consensus is that Greece is insolvent and will have to restructure at some stage in the future, maybe not next week or month, but it will happen. If this is not done in an orderly fashion, the ripple effects could be huge, and gold (in our opinion) should rally despite potential euro weakness. Deflationary forces will come into play (not just in equity markets) if this occurs, with a 'let's buy later when prices are cheaper' mentality, with purchasing also in real assets such as consumer and durable goods being affected. Ben Bernanke recently highlighted this in his Q&A session, stating that the most likely reason for the Federal Reserve to print more money would be because of a Greek default or restructure. Rest assured that if the Federal Reserve is going down this road, so will the European Central Bank and the Bank of England. If this scenario was to come to fruition, gold (and more so, silver) would fly.
Gold's number one headwind – the euro
The main reason why gold could continue to see downside pressure would be USD strength and a general sell-off in EUR/USD. Traditionally, the precious metal is priced in USDs, so if the greenback strengthens, the physical commodity has less appeal, which would result in traders selling gold. In our view, the euro has longer-term downside risks, and if you look at the bond and credit markets, they are clearly saying that in the next five years the chance of a Greek debt default is extremely high. This is where we are likely to see a play-off between euro weakness and safe-haven buying into gold. However, this is probably not going to happen anytime soon. With the Federal Reserve's QE2 program over, in our opinion, the US will also avoid a technical default and raise the debt ceiling, which could aid the bullish case for USD appreciation.
How will this affect your trades?
In the short-term, to have a view on gold, one should probably also have a view on the EUR/USD pair. It seems to be holding up quite well above 1.40, trading in a range of around 1.41 to 1.44. On the downside, if we see a break of key support at 1.3970 (May 23 low) this could indicate a move to 1.35 and spur further weakness in gold.
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Updated: 01/07/11
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