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Gold to Decline on Fading Inflation Outlook, Portfolio Adjustment

Gold to Decline on Fading Inflation Outlook, Portfolio Adjustment

2010-07-03 02:32:00
Ilya Spivak, Sr. Currency Strategist

Despite a crippling decline that bore all the marks of directional conviction, pin-pointing a clear catalyst for last week’s price action became elusive considering gold tumbled even as stocks declined, seemingly erasing its status as a safe-haven asset developed over the second quarter. An array of explanations followed, with many attributing the move to portfolio re-allocation. Put simply, this argument suggests that traders sold off their gold positions to beef up margins and raise cash having taken losses on other assets amid a widespread return to risk aversion while the yellow metal struggled to maintain upward momentum having set a record high at $1265.

Another plausible interpretation points to eroding inflation expectations. Increasingly lackluster US economic data has trimmed investors’ expectations for recovery in America and the world at large, particularly as other engines of expansion also falter. Indeed, debt-cutting measures and rising financing costs promise to keep Europe sidelined for the foreseeable future, Japan remains mired in deflation, and China is stepping up efforts to slow its buoyant growth amid fears of overheating. On balance, this translates into a tepid outlook for price growth, eroding investors’ demand for an inflation hedge that had driven gold prices higher through 2009 and the beginning of this year. Indeed, the US 2-year breakeven rate, the spread between nominal and inflation-adjusted 2-year Treasury yields, has dropped to an eight-month low, hinting traders are betting on decidedly weak price growth for the time being. Interestingly, the 20-day correlation between the 2-year breakeven and spot gold has jumped to 0.63, the highest since late April.

In either case, the outlook for gold in the week ahead seems to favor further losses. Arguments favoring continued risk aversion run parallel to those calling for a period of low inflation, amounting to reflections of growing concerns about the fate of the global recovery. Absent an unlikely boost in confidence, the distinct possibility of a marked slowdown from last year’s break-beck rebound and increasingly loud calls for a “double dip” promise to keep the yellow metal firmly on the defensive.

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