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Gold Price Forecast: Bullish Breakout Faces First Test - Levels for XAU/USD

Gold Price Forecast: Bullish Breakout Faces First Test - Levels for XAU/USD

Christopher Vecchio, CFA, Senior Strategist

Gold Price Forecast Overview:

  • After reaching fresh yearly highs earlier this week, the gold price bullish breakout may be facing its first test of fortitude: a return back to its former consolidation’s resistance.
  • Given the outlook for real yields and gold price’s historical relationship with volatility, the fundamental bias remains bullish for precious metals.
  • According to theIG Client Sentiment Index, the gold price rally may be due for a breather.

‘I Think I Can, I Think I Can’ – Gold Prices Edging Higher

Like The Little Engine That Could (you can probably tell that I’m a new parent), gold prices have slowly but surely climbed higher, overcoming resistance earlier this week to breakout to fresh yearly highs. The bullish breakout potential for gold prices has been on our radar for several weeks, given the technical posture of price action in recent months coupled with what has been an increasingly strong fundamental backdrop.

And the fundamental backdrop remains strong, if not strengthening. Increased trade tensions between the US and China have not gone unnoticed, threatening to undermine an already fragile global growth environment. Coupled with signs of increased positive test case rates and hospitalizations rates in the United States (there can’t be a second wave if you don’t beat the first wave), concerns have set in that the coronavirus pandemic will have real staying power over the coming years.

Commentary previously issued on the matter remains valid: “the backdrop of increasing macro uncertainty caters to one of the talking points from the Federal Reserve’s June policy meeting…which was that interest rates would be staying at current levels for the foreseeable future, perhaps through 2022. Fresh signs that the global economy’s two largest economies, the United States and China, are not ready to re-open and begin the path to normalcy has provoked another reach for safe havens.”

WHY DO ‘REAL YIELDS’ MATTER TO GOLD PRICES?

Increasing risk aversion, noted by the continued weakness in US Treasury yields following the June Fed meeting, highlight one of the most important fundamental underpinnings of precious metals’ rallies: environments that produce falling real yields tend to be the most bullish (particularly for gold prices).

Real yields are inflation-adjusted yields: in this case, the US Treasury 10-year yield minus the headline inflation rate. Why should market participants care? Both trading and investing are about asset allocation and risk-adjusted returns: they’re about achieving specified required returns given the trader’s or investor’s wants and needs.

If inflation expectations are rapidly increasing, you would expect to see fixed income underperform: the returns are fixed, after all. Why would you want to have a fixed return when prices are increasing, ergo, higher inflation? On a real basis, your returns would be lower than otherwise intended.

Falling US real yields means that the spread between Treasury yields and inflation rates is decreasing. If precious metals yield nothing (no dividends, coupons, or cash flows), they would be in a more favorable position to hold, relatively speaking, when US real yields fell.

Gold Volatility Continues to Drop, However

Gold prices have a relationship with volatility unlike other asset classes, even including precious metals like silver which have more significant economic uses. While other asset classes like bonds and stocks don’t like increased volatility signaling greater uncertainty around cash flows, dividends, coupon payments, etc.gold tends to benefit during periods of higher volatility.

Heightened uncertainty in financial markets due to increasing macroeconomic tensions increases the safe haven appeal of gold. Now that there are plenty of signs that no V-shaped economic recovery will occur, and the Federal Reserve intent on keeping the liquidity spigot open for the foreseeable future, the winds of an inflationary US economic environment are blowing through financial markets.

Read more: How Do Politics and Central Banks Impact FX Markets?

GVZ (Gold Volatility) Technical Analysis: Daily Price Chart (October 2008 to June 2020) (Chart 1)

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Gold volatility (as measured by the Cboe’s gold volatility ETF, GVZ, which tracks the 1-month implied volatility of gold as derived from the GLD option chain) is trading at 20.23, still less than 25% of the absolute high set in mid-March near 85.50. We still maintain the belief that, given the current environment, falling gold volatility is not necessarily a negative development for gold prices, whereas rising gold volatility has almost always proved bullish.

In our last update on June 16 it was noted that “the recalibration of the 20-day correlation suggests that the traditional positive relationship between gold prices and gold volatility is beginning to normalize.” Now, the 5-day correlation between GVZ and gold prices is 0.99 while the 20-day correlation is 0.41; one week ago, on June 18, the 5-day correlation was 0.71 and the 20-day correlation was 0.38; and one month ago, on May 28, the 5-day correlation was 0.57 and the 20-day correlation was -0.39. Such developments have and should cater to higher gold prices.

Gold Price Technical Analysis: Daily Chart (June 2019 to June 2020) (Chart 2)

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On June 24, gold prices were able to reach a fresh yearly high, following through on the June 22 breakout the sideways range carved out between the April 14/2020 high at 1747.72 and the April 21 swing low at 1661.42. This was expected, as we noted ahead of the breakout that “given that gold prices rallied into this consolidation, the market retains an upside bias.”

The measured move, derived from the high/low range between 1675 and 1748, calls for a move towards 1821, now that resistance is broken. Failure to achieve a topside breakout through 1748, and instead produce failure below 1675, would give gold price action the hallmark of a topping pattern, insofar as the measured move lower would be targeting 1602.

Gold Price Technical Analysis: Weekly Chart – Inverse Head and Shoulders Pattern (June 2011 to June 2020) (Chart 3)

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Gold prices have made significant progress within the confines of the multi-year inverse head & shoulders pattern, achieving their highest level since November 2012 earlier this week. It thus still holds that the rally into and through the 76.4% retracement (1714.66) must be viewed in context of the longer-term technical picture: the gold price inverse head and shoulders pattern that was triggered in mid-2019 is still valid and guiding gold price action.

Depending upon the placement of the neckline, the final upside targets in a potential long-term gold price rally, if drawing the neckline breakout against the August 2013 high at 1433.61, calls for a final target at 1820.99. This dovetails neatly with the measured move on the daily timeframe looking for gold prices to rally into 1834.02.

IG Client Sentiment Index: Gold Price Forecast (June 25, 2020) (Chart 4)

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Gold: Retail trader data shows 66.86% of traders are net-long with the ratio of traders long to short at 2.02 to 1. The number of traders net-long is 4.05% lower than yesterday and 10.44% higher from last week, while the number of traders net-short is 5.84% lower than yesterday and 23.05% higher from last week.

We typically take a contrarian view to crowd sentiment, and the fact traders are net-long suggests Gold prices may continue to fall.

Positioning is more net-long than yesterday but less net-long from last week. The combination of current sentiment and recent changes gives us a further mixed Gold trading bias.

--- Written by Christopher Vecchio, CFA, Senior Currency Strategist

DailyFX provides forex news and technical analysis on the trends that influence the global currency markets.

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