Yellow metal may fall below $1,200

Last Updated: Mon, Sep 02, 2013 05:09 hrs

There are two good reasons for the recent strength in gold prices. First, physical buying around the world, in markets such as Hong Kong, Vietnam, Turkey and India (at least until May). This has been evident from high physical premiums, as well as volumes being exported from the UK. Second, an absence of selling from physical gold-backed exchange-traded fund (ETFs). About 650 tonnes of gold were sold by ETFs between mid-February and early-August this year. Since then, this institutional selling has stopped, removing one of the main factors driving prices lower earlier this year. In combination, these two factors have tightened the gold market significantly, leading to a backwardation in prices at the front end of the curve.

Is the rebound in gold prices sustainable? Perhaps not.

US interest rates are rising, raising the opportunity cost of holding gold. Higher interest rates have the effect of raising forward gold prices, so if the rise in interest rates is accompanied by a fall in medium-term inflation expectations, spot gold prices might become particularly vulnerable. Just as the introduction of Quantitative Easing (QE) was unequivocally positive for gold prices because it reduced longer-term treasury yields to abnormally low levels, so its potential withdrawal may turn out to be unquestionably negative for gold prices. If the Fed goes ahead with tapering QE3, there is therefore a danger that institutional selling of gold might resume over the remainder of the year.

Demand from developing countries has supported gold prices in recent months. For investors in many of these countries, gold has performed perfectly in its traditional role as a store of value, protecting wealth from currency debasement. Although gold prices might have been relatively weak in dollar terms, in local currency terms prices have held up well. As many developing currencies weaken, however, support for international gold prices might gradually diminish. Not only are local investors increasingly priced out of the global market, but with countries' foreign exchange reserves falling as their central banks defend currency parities, so target benchmark holdings of gold are likely to decline, too, restraining potential central bank buying.

In India, tensions between investors and policy makers have been central to the local gold market. While investors have sought a safe haven for their wealth in the face of wide current account and fiscal deficits, the government has found it increasingly difficult to rein in these imbalances in the face of high imports of gold. This helps to explain the government's decision to raise gold import tariffs to 10 per cent, but ultimately Indian demand for gold would be more effectively reduced by policies that address the root causes of the country's twin fiscal and current account deficits.

In the months ahead, the most important factor driving the dollar price of gold is likely to be US monetary policy. The risk of higher US interest rates points towards downward pressure on international gold prices, and we would not be at all surprised to see gold prices at or below $1,200 a ounce before year-end.

For investors in the developing world, the effectiveness of government policies will be equally important. If current account and fiscal deficits show no signs of improving, the risk of further currency debasement will remain a strong incentive for investors to increase their gold holdings.

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