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Gold Faces Bearish Trend Change as QE2 Expiry Looms Ahead

Gold Faces Bearish Trend Change as QE2 Expiry Looms Ahead

2011-05-14 07:07:00
Ilya Spivak, Sr. Currency Strategist
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Gold_Faces_Bearish_Trend_Change_as_QE2_Expiry_Looms_Ahead_body_Picture_4.png, Gold Faces Bearish Trend Change as QE2 Expiry Looms Ahead

Gold Faces Bearish Trend Change as QE2 Expiry Looms Ahead

Fundamental Forecast for Gold: Bullish

Gold prices largely decoupled from the risk on/off dichotomy that ruled financial markets in the aftermath of the 2008 credit crisis and subsequent recession, managing to remain well-supported throughout. Broadly speaking, this largely reflected the prevalence of “extreme” bullish or bearish opinions on the merits of the global recovery, both of which saw gold as an attractive store of value.

For the bulls, the central fear was and is inflation. In their scenario, a rapid snap-back in global growth would see central banks unable to reverse ultra-loose monetary policies fast enough to avoid a rapid appreciation in price growth, debauching paper currencies and making a hard asset like gold an attractive alternative. Meanwhile, the bears didn’t believe that mounds of deficit spending would yield more than a temporary reprieve, forecasting the recovery to fail as governments withdrew support. This would cause paper assets “artificially” buoyed by stimulus to collapse anew, once again highlighting gold’s attraction as a tangible substitute.

Sizing up the current landscape, such extreme views appear to be increasingly giving way to a more moderate position. The balance of steadily (albeit slowly) improving leading economic indicators and lingering risk factors like the Euro Zone debt crisis, turmoil in the Middle East, and aggressive Chinese monetary tightening producing an outlook calling for a slowly grinding recovery rather than a rapid lurch upward or downward. Broadly speaking, this appears to rob the gold advance of the impetus to continue.

The looming expiry of QE2 stands as the catalyst sparking rally’s undoing. At April’s monetary policy meeting, the Federal Reserve pledged in no uncertain terms to allow the second round of quantitative easing (QE2) to expire as scheduled in June. Simply put, this amounted to telling investors that had capitalized on the low borrowing costs the program produced cheaply finance bets across the capital markets, “From this point forward, you are on your own, and if yields rise then so be it.” Needless to say, the size of the US budget deficit and the amount of new bond issuance that it implies – not to mention the recent S&P downgrade of the US credit outlook – suggests borrowing costs will indeed move higher as bond prices decline once Ben Bernanke and company take to the sidelines.

Presented with such stark reality, investors began to book profits on their Dollar-funded exposure, sending all of the assets that had benefited from the QE-assured status quo – with gold among them – broadly lower while the greenback enjoyed a robust recovery. This process has been well underway for the better part of the past two weeks and more of the same is likely ahead as the QE expiry deadline looms ever-closer, though surely not without its fits and starts as larger-scale repositioning runs into short-term bargain hunters. - IS

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