Gold Drops to 8-Month low

New York (Sept 25)  Failure for the US equity market to extend its recent correction and broad USD strength has been significantly gold-negative. Gold’s negative correlation to the S&P 500 has been consistently negative this year as investors have avoided diversification, favoring risky assets. As US stocks headed higher gold has fallen to $1208.86 with little demand generating at even these low levels. With the ECB potentially dragging their feet on further accommodating policy (perhap more clarity at Draghi speech this afternoon), and gold no longer getting major support from geopolitical risk, gold bulls might be interested in the Swiss gold referendum on November 30th. There are three mains points: 1) that the SNB must hold 20% of its asset in gold 2) the gold must be held in Switzerland and 3) the SNB can’t sell any of its gold reserves. Major Swiss banks suggest that nearly 1500 tones would need to be acquired over a three year period. This development would clearly be bullish for the precision metal.

XAU at risk as Fed exits QE?

The optimism on US recovery and the hawkish Fed expectations will certainly keep the selling pressures tight in XAU/USD. The significant surge in gold prices has started in 2007-2008 as the Fed launched its first QE program to counter the liquidity crisis post-Lehman default. The inflationary fears due to massive liquidity injection lifted the XAU/USD above $1,000 toward the end-2009. The gold hit $1,920 per ounce on September 2011. As the Fed intervention did not result in irrepressible inflationary pressures, the gold prices are seen stabilized at $1,200-1,500. However as we approach the lower band of past four-year trading band, multiple factors enter the game and the price direction becomes difficult to predict.

Today, the market sentiment improves regarding the US economy. The Fed gently tapers its third QE program and the monthly bond purchases are scheduled to end in October 2014. This will bring us to the new era of policy normalization. The Fed’s 4.5 billion dollar balance sheet will start contracting. Will follow the first Fed fund rate hike. Although the timing remains uncertain, the first Fed hike is estimated by the second half of 2015. From a technical perspective, the Fed normalization could stimulate normalization in gold markets and possibly shift the gold levels toward $680-1000 (2008-2009 trading band) should the critical $1,150-80 support breaks. This said, the markets are not pricing in the coming ECB expansion yet. Should the ECB liquidity partially counter-balance the Fed tightening, the normalization in gold markets will certainly be delayed.

Risk of correlation breakdown

On the opposite side, the geopolitical tensions and the safe-haven demand keep the XAU/USD bid above this critical support. Yet if the US economy is ready for normalization, it should be good news for risk lovers. As the risk appetite improves, the gold allocation in investment portfolios should automatically decrease, thus further weigh on gold prices. Following this reasoning, we can also explain why the SPDR Gold Trust holdings retreated to 774.65 metric tons, the lowest since December 2008.

At this point, we still need the hedging / risk-diversifying characteristic of gold in investment portfolios, simply because the end of cheap liquidity can temporary hit the stock/bond values, increase volatilities and keep the demand in gold sustained before the tighter Fed policy becomes the new standard. However, we see a fresh breakdown in negative correlation between S&P 500 stocks and XAU since September 16-17th Fed meeting. The 40-day correlation between the US stocks and XAU turn positive for the first time this year, fueling doubts that the portfolio managers cannot safely count on gold hedging mechanism. Should this situation persist, the $1,150-80 support will come under higher pressure.

Is the sharp reversal in correlation dynamics temporary?

As the ECB expansion is poorly priced in, a tangible explanation is perhaps the gold demand ex-investment/hedging purposes and the lower gold supply. In fact, the gold prices falling towards $1,200 elicits strong demand in physical gold markets as Asian and Middle East markets are highly price sensitive. The gold demand in China and India, world’s biggest gold buyers, are expected to accelerate in the fourth quarter, while the latest reports show that the scrap supply will drop 17% in 2H. The classical supply-demand mechanisms should thus sustain the gold prices before the year-end as the festive/wedding season is expected to have significant boost in the physical gold markets. This seasonal effect clearly distort the short-term shift in correlation dynamics. Hence it is too early to talk about a long-term impact on gold prices. Walking into 2015, we will be closely monitoring a break below the $1,150/80 support, as the Fed/ECB dynamics concertize.

Source: FXstreet