Bugs get squashed as gold prices drop

The yellow metal is losing its shine

GOLD bugs are being squashed. Prices are collapsing, and the selling momentum is picking up: after falling by 5 per cent on Friday, the yellow metal shed a further 8 per cent yesterday, falling as low as $1,356 per troy ounce in London trading. It is now around 30 per cent off its 2011 peak, and stuck at two-year lows.

“Investors are turning away from gold,” says David White of Spreadex, “using the price fall as justification to unwind positions, and take money out of what was once considered a one-way bet”.

FIRING THE GOLDEN GUN
The rout was triggered by news that Cyprus may have to sell its gold reserves as part of its bailout deal. But Cyprus’s reserves are small – 14 tonnes according to the World Gold Council. This potential selling pressure is unlikely to have a major impact on the gold market, where annual demand is 4,800 tonnes.

Nevertheless, traders have been spooked. Hunter Hillcoat of Investec says “speculation over Cyprus having to sell its reserves has triggered fears that other struggling euro members may also have to sell their holdings.”

France, Spain, Italy, Portugal, Greece and Cyprus – Eurozone nations with precarious public finances, that might need to tap their reserves as part of a bailout – hold around 5,700 tonnes between them. Even though their central banks are only permitted to hawk 400 tonnes annually, a glut of supply on this scale could hammer gold prices lower.

It currently seems as though there is only downside potential to holding the yellow metal. Damien Courvallin of Goldman Sachs points out that both the Cyprus crisis and the slowdown in the pace of the US economic recovery did not buoy gold prices, as many would have expected. Excluding the last few days, gold remained in a range roughly between $1,550 and $1,610 over the last month. Courvallin says that this is because traders believe the Cyprus crisis to be contained, and the recent US slowdown is unlikely to derail a broader recovery in the second half of 2013.

Even though recent US economic data – notably employment and retail numbers – have been weaker, minutes from the US Federal Reserve’s latest meeting noted that a number of board members favour tapering its asset purchase programme, currently $85bn (£56bn) per month, from the middle of this year. These asset purchases debase the dollar, and in that environment, traders prefer holding gold.

However, talk of tapering is likely to cap the upside potential of the yellow metal. And even if easing is not tapered soon, analysts expect that it will be over the next couple of years, as the US recovery gathers pace.

LOSING ITS SHINE
And gold’s potential doesn’t stack up when compared to other asset classes. Peter Sullivan of HSBC argues that European equities – particularly in the UK, where he forecasts earnings per share to rise by 9 per cent this year – look attractively valued. He likes high yield, high-beta stocks in the energy, food retail, telecoms and financial sectors, arguing that they “offer attractive valuations in a low interest rate world”. Sullivan is not alone: over the next three years, Anders Nielsen of Goldman Sachs is expecting strong returns from global equities.

Given that gold does not pay a yield, and downside risks are prevailing, many investors will fancy their chances in equities, rather than holding what has become a speculative trading commodity. And since equities will find support from central bank easing programmes (the Bank of Japan recently joined the list of aggressive monetary activists), they should continue to perform well.

Forex markets reinforce the bearish case for gold. Traditionally, the yellow metal has an inverse relationship with the dollar. One reason is because most gold transactions are executed in dollars – as the dollar rises, gold becomes relatively cheaper, and vice versa. With many analysts expecting dollar strength gold may suffer further.

In a note, Morgan Stanley said that “as long as US policy remains supportive of asset prices, we would expect the dollar recovery trend to remain intact”. By the end of 2014, it forecasts the euro to fall against the dollar, from $1.31 to $1.19, and sterling to fall from $1.53 to $1.41.

Both Societe Generale and UBS recently raised their dollar-yen forecasts to ¥110, from just below the ¥100 level where the pair currently sits. Further, the dollar will also find support from continued talk of the Fed tapering its asset purchases.

THE OUTLOOK FOR GOLD
After recently lowering its 2013 year-end forecast to $1,450 (which was breached on Friday), Goldman Sachs now predicts that gold prices will fall to $1,270 by the end of 2014, which may also have catalysed a change in traders’ sentiments. And based on technical analysis, Societe Generale notes that gold has formed a double-top chart pattern, indicating a possible fall in prices to $1,265.

Nevertheless, some are still confident that gold is worth holding. Investec’s Hillcoat argues that it still has safe-haven appeal: “We retain a positive view on gold on the basis that the world’s economic problems are not solved.” Julian Jessop of Capital Economics agrees, arguing that if nations were forced to sell their reserves, the need for safe-havens would be back in vogue, and gold prices could rise once again.

Gold bugs may be getting mauled, but in the long run don’t underestimate the possibility that they may just have the last laugh. But even if gold does stage a revival, one thing is clear: the violent sell-off over the last few days clearly suggests that the yellow metal is no longer an easy one-way bet.