Is gold losing its lustre?

Hopes and expectations of more Fed quantitative easing in the wake of a run of weak US data, including the US May jobs report, has been attributable to the bounce in gold prices over recent weeks. However, Fed Chairman Bernanke dampened such hopes in his speech to Congress, in which he did not indicate a desire to move towards more QE. The Fed is unlikely in my view to embark on more QE any time soon.

Clearly, should the Fed implement more QE it will help to renew the attraction of gold. Once again markets will see the consequences of Fed QE as a means to debase the USD. A shift in Fed stance cannot be ruled out if US economic conditions worsen further and/or the Eurozone crisis escalates. Assuming no more QE and no more USD debasement, gold prices ought to decline over coming months.

One of the biggest factors putting downward pressure on gold prices has been the strength of the USD. While I do not expect the USD to continue to strengthen at the same pace as it has done recently, further gradual gains in the currency are likely. My FX forecasts predict a further small gain for the USD index by the end of the year but I also believe that the recent run up in the USD may have been too rapid. Assuming that the USD continues on a gradual upward trajectory I expect it to exert a negative influence on gold prices.

Gold appears to have lost its sensitivity to risk aversion. Indeed, gold’s relationship with risk has actually inverted over recent months, with a negative but significant relationship registered over the past 3 months between gold prices and my Risk Aversion Barometer. In other words as risk aversion goes up, gold prices actually drop.

The lack of reaction to higher risk aversion shows that the lustre of gold as a safe haven has faded as investors pull capital out of this as well as many other asset classes. However, gold’s drop is not unusual when compared to other commodity prices, with oil and copper prices falling too and gold maintaining a strong correlation with these commodities.

Some deterioration in sentiment towards gold prices has been reflected in the drop in speculative appetite for the commodity. Speculative demand for gold hit a cyclical high in August 2011 but since then there has been a steady reduction in appetite for gold from these investors. Indeed, CFTC IMM data reveals that speculative gold positioning dropped well below its three-month average. However, positioning is still well above its all time lows reached in February 2005, suggesting if anything, there is scope for more declines.

On top of the drop in speculative appetite for gold the technical picture has turned bearish. Since March 2009 at the height of the financial crisis the 100 day moving average price of gold had been trading above the 200 day moving average. On 27 March 2012 the 100 day moving average crossed below the 200 day moving average. Moreover, gold is now trading below both the 100 and 200 day moving average prices which sends a bearish technical message. Over the near term some key levels to look for are the 100 day moving average around 1658 on the topside and trendline support around the 1530 level on the bottom.

Another determinant of gold prices is demand from India and China. Growth in both countries is slowing, suggesting that gold demand is also weakening. While I certainly do not expect a collapse in demand from either country I have no doubt that compared to last year the strength of demand will be softer over coming months. Although I still look for a soft landing in China the Indian economic picture has clearly deteriorated while the Indian rupee has weakened. A weaker INR means that has become increasingly more expensive to import gold to India for domestic purchasers.

Overall, a weaker real demand picture taken together with reduced speculative appetite implies little support for gold prices. Moreover, a firmer USD in general will continue to weigh on prices. Perhaps a dose of inflation would help gold prices but there is little risk of this given the still sizeable amount of excess capacity in major economies.

Uncertainty about QE will help to limit any downside pressure on gold prices but elevated risk aversion will provide little assistance to gold. If however, the Eurozone and global picture deteriorates further gold will find itself with a lifeline but only if this means more currency debasement and a Fed engineered lower USD. If not, a further decline is on the cards and I forecast a drop in gold prices to around USD 1475 by the end of the year.

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Central banks ready to act

Markets are in wait and see mode ahead of Greek elections with range trading likely to dominate market action, albeit with a slightly risk on bias. US data disappointed once again, with jobless claims coming in worse than expected, compounding the growing fears about deterioration in US job market conditions. Perversely the poor jobs data coming against the background of soft May CPI inflation data have fuelled expectations of Fed action at next week’s Federal Reserve FOMC meeting.

It is not only the Fed that markets believe may act, with reports overnight suggesting that there may be some form of coordinated action by central banks should the Greek election outcome prove to be unfavourable. On this front, the news appears to be a little more encouraging as expectations that pro bailout parties will garner relatively more votes has grown as reflected in the 10% rally in Greek shares overnight.

If it takes weak economic data for markets to rally nowadays then there will be plenty available today, with declines expected for the May Empire manufacturing survey and June Michigan confidence, while industrial production is only likely to register a marginal gain in May. While the data may add more fuel to the fire, I suspect it will still be insufficient to result in more Fed balance sheet expansion.

European Central Bank (ECB) President Draghi is scheduled to speak today but I doubt he will suggest a move towards another LTRO or Securities Market Purchases. On the subject of central banks the Bank of Japan will announce its policy decision today but I expect no change in stance despite the fact that the 1% inflation goal remains a long way off. Currencies will remain in ranges but hopes of central bank action and a favourable outcome to the Greek elections will provide support for risk currencies and keep the USD under pressure.

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