Gold selling unlikely to be over just yet

London (July 21)  Precious metals have stabilised a little after Monday’s vicious bear onslaught, which saw gold drop by a huge $45 in the space of a few minutes during the Asian session. That was apparently sparked by large sell volumes on the gold exchange in Shanghai. While the extent of the sell-off has surprised even us, we nevertheless had been warning about a move of this magnitude for several weeks, most notably on Wednesday (see “Gold on the brink as Yellen talks up 2015 rate hike prospects” for more). After bouncing off its lows, the yellow precious metal has since been in consolidation mode as traders decide on their next move. But it essentially remains on a shaky footing now that some key technical levels have been breached. Other precious metals such as platinum and silver were also hammered on Monday, but like gold these metals have regained their poise – for the time being anyway.

Evidently, gold is continuing to lose its appeal as investment asset, which explains part of the reason for the subdued demand from China and India, the world’s largest gold consumer nations. Switzerland exported 98.5 tons of the stuff in June, which is a little over 7% less than the previous month. Of this, only about half was shipped to India, China and Hong Kong compared to three quarters in May. The low level of inflation across the major economies is among the main reasons behind the subdued physical demand. Investors are also worried about the apparent slowdown in the Chinese economy which points to lower industrial demand – perhaps more so for silver and copper than gold. Nevertheless, the sharp price falls are likely to lead to increased jewellery demand and central bank purchases. This could provide some support to prices in the medium term. As gold falls further in value, the marginal costs of production will continue to rise; prolonged price weakness will encourage miners to cut back production which could lead to supply shortages and in turn higher prices in the long run.

In the short-term however, the outlook for gold remains bleak. The paper market (options and futures) for gold is much larger than the physical. Speculative selling in the paper market is what is really driving prices lower. This group of market participants are smelling blood after the metal failed to find any “safe haven” demand during the height of the Greek crisis 2.0. Stock markets are rising as Grexit risks are reduced, as well as positive earnings surprises and continued central bank support from not only the Fed, but the ECB and BOJ, among others. The Nasdaq Composite, for example, has hit a fresh record high. At the same time, the US dollar is appreciating on expectations that the Fed’s ultra-loose policy stance will come to and later this year. A stronger dollar does not bode well for buck-denominated commodities; worryingly for the gold bugs, the US currency could extend its gains much further because other major central banks are still dovish. The combination of higher stock prices and stronger dollar may therefore continue to exert intense pressure on gold prices in the near term.

Another important factor, most often forgotten, is sentiment. At the moment, sentiment is decidedly bearish on precious metals – rightly or wrongly, it doesn’t really matter for some traders. Traders like volatility. The sharp price moves that we have seen in recent days mean more traders are probably interested in trying to sell gold than before, as they expect to see further declines in the short-term. At the same time however, the correction potential is huge now – a nasty short squeeze could be triggered if enough of the bears take profit on their bearish positions. But will they?

Gold is currently trading at extremely oversold levels, with the RSI being well below the threshold of 30. As can be seen on the chart, every time the RSI was at these extreme levels in recent past, it preceded episodes of sharp counter-trend moves in the underlying gold price. Will we see a similar move this time or this a “healthy” oversold condition for the bears? Unlike the previous cases, the RSI being oversold is accompanied by the triangle breakout pattern in the underlying price of gold. In other words, this is a confirmed breakout. Thus, while gold may well bounce back a little from these oversold levels – particularly as the $1083-87 area is where several Fibonacci extension levels converge, making it an ideal profit-target area – the most likely outcome is that we will see further follow-through in selling over the coming days.

If we do see a retracement, this could be limited to the old support levels such as $1131.5 or $1143. These levels could then turn into resistance, potentially leading to another leg lower. Alternatively, gold may go on to break below Monday’s low, leading to another vicious drop towards the next support levels, such as those shown on the chart. These include:

$1022/3 – the extended point D of the AB=CD pattern, where the CD leg is 1.618 times the AB leg. This level also corresponds with the 161.8% Fibonacci extension of the XA move. In other words, it is a potentially exhaustion point.

$1000 – first and foremost, this is a psychologically-important level, so we could see increased trading activity around this level, should we get there in the first place.  What’s more, the 261.8% Fibonacci extension level of the BC move, at $997/8, also comes into play here.

$975 – this level is the measured target of the triangle breakdown i.e. it is derived by subtracting the dollar value of the height of the triangle from the base of the breakout around $1143.