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Real Gold Supply, Demand Pressure Prices Lower

The trends in real demand look decidedly lackluster, with gold for the manufacture of jewelry as well for industrial and dental use clearly tracking lower (the former for over a decade and the latter for at least three years).


Meanwhile, supply seems to be picking up. Indeed, mine production has snapped a multi-year downtrend with output rising for the first time in close to seven years. Further, gold scrap such as jewelry melted down for its metal content is on the rise as well.


Reasonably enough, if real factors were the only forces driving the market, falling demand and rising supply suggest the price of gold ought to have declined over recent years.

Investment Demand is the Top Driver of the Gold Rally

Naturally, reality has proven to be quite different from what real supply and demand would suggest, with gold prices hitting all time highs this year. In fact, it appears investment demand lies behind the metal’s spectacular performance, with retail buyers doing a fair bit of the heavy lifting in pushing prices higher.


The patterns behind investment demand and its interaction with the spot price suggest the rally witnessed over the past ten years is becoming increasingly vulnerable. Exchange-traded funds (ETFs) have become an increasingly attractive vehicle for gold exposure given their ease of use compared to physically buying bullion, with “soft” investment now on pace to overtake its counterpart for the first time ever. However, while ETFs make buying gold comparatively easier, they equally make liquidating the investment easier as well, making for a far more violent downturn than would otherwise be the case should traders’ sentiment reverse.

More worrying still, it appears that gold’s appreciation has become the impetus for demand, the precise opposite of how an asset is normally expected to behave. Indeed, linear regression studies suggest that a whopping 89 percent of the variance in the spot gold price is explained by variance in the holdings of the SPDR Goldshares ETF (GLD), the leading exchange-traded fund tracking the metal.


Gold: A Bubble on the Verge of Bursting?

With real supply/demand conditions pressuring prices lower, it seems clear that robust growth in investment interest is the only way for gold to continue to advance. However, the rally has become a self-fulfilling prophecy, with gold’s appeal to investors dependent upon its continued gains. This leaves the door open for a sharp reversal at the first hint of a meaningful setback, an outcome that promises to look all the more dramatic because of the proliferation of ETFs as a vehicle for gold investment.

Where might such a setback come from? Looking at the most recent headline explanation behind gold’s appeal, it seems the story begins with inflation expectations. Throughout 2009, the price of gold tracked intimately with US breakeven rates – the spread between yields on regular and inflation-indexed 10-year US Treasuries that is used as a gauge of investors’ price growth expectations – amid concerns that quantitative easing would debauch paper currency. Ever the standby store of value, the metal proved attractive as central banks around the world resorted to effectively “printing” money, a policy that many feared would engineer a period of runaway inflation.

The likelihood of such an outcome seems resoundingly unlikely, however. Looking at the US as a benchmark test case, the amount of money actually created by the Federal Reserve’s liquidity injections is a function of the money multiplier, a ratio measuring the total impact of a deposit into the banking system after it expands through lending and borrowing while cycling through the banking system. Data compiled by the Fed’s St. Louis branch reveals that currently, the money multiplier is hovering near 0.8, the lowest levels in over 25 years. This means that for every Dollar created via quantitative easing, only 80 cents actually makes it into circulation. Going further, a Fed measure of the velocity of money (the speed with which it changes hands) has also fallen multi-decade lows.

While some of this can surely be attributed to sluggish economic activity, that doesn’t tell the entire story. The unprecedented scale of the 2008 credit crunch has engineered a major shift in consumer behavior, with personal saving among heretofore famously spendthrift US households sharply outstripping borrowing. Put simply, Americans have become keener to save than borrow. It is small wonder then, that the money injected into the system translates into smaller final amount than would normally be the case, and does so at a slower pace: in order for the fractional reserve banking system to multiply deposits, people must be willing to take out loans. On balance, this means that despite the Fed’s “artificial” creation of liquidity, a catastrophic period of inflation is unlikely because the mechanisms of monetary policy transmission are not operating as they should. As this becomes apparent, gold is increasingly likely to lose its appeal as an inflation hedge.

More recently, price action noted since the end of the first quarter has seen gold take up the role of a safe-haven asset, with spot showing a strong inverse correlation with the S&P 500 benchmark stock index. While the festering EU debt fiasco and its ominous implications for the global economic recovery hint that further risk aversion is likely ahead in the near term, it seems only a matter of time before the fallout from the crisis is priced into the market and loses its ability to meaningfully shock investors. On balance, this suggests gold may move higher in the near term but also that these gains are inherently limited, offering another likely stumbling block that threatens to undo the rally.

Ilya Spivak, Currency Strategist
Sumit Roy, DailyFX Research


While our approach to technical analysis is overwhelmingly classical, we are inclined to incorporate other forms of analysis for longer-term outlooks. In this analysis, we will look to take advantage of some Elliott Wave analytics to help reaffirm where we see things headed for gold prices over the coming months. Ultimately, we would not at all be surprised to see the price of gold near current levels by $1200 at year's end. However, what will happen between now and end of year? Here is how we see things playing out.


For now, the market remains confined to a very well defined multi-year bull trend that has resulted in record highs into the $1200's thus far. A medium-term higher low now appears to be firmly in place by $1045 (2010 low) and we expect this higher low to be confirmed on a break to fresh record highs beyond $1250 over the near-term. This should open a measured move upside extension towards the $1350 area before the market finally looks to carve out a more meaningful and longer-term top. Classical technical analysis suggests that any moves towards $1350 will result in some overextended readings that warn of a much needed corrective pullback, while Elliott Wave analysis seems to confirm.

Since basing out by $680 in 2008, the market has been in an up-trend that looks to be in the final stages of a 5-wave sequence. The low that was set earlier this year by $1045 completed the 4th wave of the sequence, and we contend that the market how now entered the 5th and final wave, before a major medium-term corrective pullback and shift in the trend materializes. As far as the wave sequence goes, the 3rd wave needs to be the largest of the 5 waves, and this would confirm that should we indeed be in the 5th wave, any additional upside cannot extend much beyond our projected high by $1350.

As such, look for some more upside into July, August and September, before seeing the market finally top out and start to trade back down towards $1000 into year's end. Fundamentally, we believe that this should translate into some more risk aversion and flight to safety buying in the third quarter, before risk appetite finally starts to pick up again in the final quarter of 2010.

Joel Kruger, Technical Currency Strategist