Sell physical gold and buy futures

Last Updated: Sun, Apr 21, 2013 04:50 hrs

On March 24, I had written about a possible weakening in gold prices. At that time, gold was trading at about $1600/ounce in New York, down from the all-time highs of $1900-plus. Since March 22, the price of gold has fallen by another 15 per cent, down to $1350.

Despite the fall, it is psychologically difficult for Indians to sell gold, given traditional confidence in the yellow metal. In addition, gold has seen a 10-year bull run, from about $300 in 2002 to over $1900 in 2012. The temptation to buy on dips is high.

Technically speaking, the pull-back from $1900 to $1600 did not make it clear if the big trend had reversed direction, or if this was just cooling off and profit-booking after an overheated phase. The crash in the last 15 sessions however, indicates the bull-run is really over.

Corrections of over 25 per cent don't occur in a commodity without either a big shift in supply-demand, or changes in some fundamental factors. We'll come to the fundamentals later, but there has clearly been a massive change in sentiment, which has indeed caused a shift in demand-supply.

The fragility of sentiment can be gauged from the fact that the crash was triggered by fears of Cyprus selling 14 tonnes. This is tiny. New York and London taken together can trade over 300 tonnes a day, even if one ignores the Middle East and Asia.

A supply of 14 tonnes would hardly have been noticed in normal times.

A second "fear-factor" was changing institutional and hedge fund attitudes. George Soros has cut his gold holdings and made public statements indicating loss of faith in the metal. Various institutional players have issued bearish advisories. There have been rumours of central banks gearing up for sales as well.

What about fundamentals? This gets interesting. Gold is a hedge against inflation and against currency weakness. Globally, inflation isn't a problem since growth is slow. The US is likely to see inflation falling further if the Fed cuts back on the quantitative easing programme. Europe is also low-inflation; China has seen a fall in inflation; Japan is trying to reflate out of deflation. India is an outlier, but India too is seeing falls in wholesale inflation if you believe the latest data.

Inflation reducing means downwards pressure on gold prices, but currency weakness should be a counter-balance since currency weakness is definitely visible. Europe is still in crisis with Cyprus the latest domino. The Japanese gamble of doubling the central bank's balance-sheet could go disastrously wrong since Japan's debt is at 250 per cent of GDP. The USD has gained only because every other "hard" currency is shaky.

Part of the price drop is due to leveraged speculators cutting losses. But trends develop momentum once they've run a certain distance and net declines in gold prices look likely over the next year at the least. Another bull run could, however, be sparked by one of the following events: A surge in inflation, more currency fears, some disaster like a war, earthquake or terror strike.

Falling gold prices should be good for India's current account deficit. It's the second-largest import item after energy. The big crash has also scared off Indian gold-buyers, who might have bought on a smaller dip. So this should definitely lead to some relief in the Finance Ministry.

Gold has a habit of range-trading between $250-400 for decades. It could drop back into that range over the next two or three years if the global economy sees a full-scale turnaround. The dangerous thing is that Indian households hold between 22,000- 25,000 tonnes (the RBI has about 550 tonnes). The nominal value of gold holdings could be drastically reduced in a big correction. That may have an inverse wealth effect on households, leading to weaker consumption.

Reducing value also affects loans taken against pledges of the metal. This has hit NBFCs like Manappuram and Muthoot, which have seen defaults. Banks could also run into problems if gold prices fall much more. ICICI and SBI in particular have fairly large exposures to loans against gold. Jewellers who hold inventories bought at higher prices could also be in some trouble.

Lightening up on gold now seems like an obvious trade. There's also a disconnect between physical gold and gold futures prices in India. Physical gold is at a premium of 5-6 per cent, which suggests that households have not yet woken up. There is a possible arbitrage here, selling physical gold against delivery and buying futures.

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