Precious metals have witnessed an unprecedented selling rout in terms of magnitude and duration. The yellow metal has lot whopping US$240/ounce over last three trading sessions and registered a low of US$1,322/ounce, the lowest level since September 2011. The havoc in the commodity markets has compelled CME Group and Shanghai Gold Exchange to increase margins on gold futures. One cannot ignore the fact that gold prices were due for a correction, considering the unabated “Bull Run” over the last 10-11 years. However, the magnitude of the sell-off has been unfathomable. There have been various reasons, which are discussed as the “culprit” behind the steep slide in prices:
ETF Outflow: Persistent outflow in SPDR Gold Trust ETF Holdings has dampened the investor’s sentiment. The world’s largest ETF has witnessed redemption of literally 196 tons or 15% during this year. Outflows of more than $1bn have been reported out of the SPDR during last week, the third-highest withdrawal on record.
Cyprus story: It is widely reported that Cyprus may sell some 400mn euros worth of gold to partially finance its bailout. At the prevalent price levels, 400mn euros are equivalent to 10 to 12 tons of gold. Rumors mills were churning reports that the gold liquidation plan by the Cypriot government is weighing on the prices. Although, we take this theory with a pinch of salt, as Cyprus gold holdings are at minuscule 13.9 tons, which accounts for just 0.045% of global central bank gold holdings. This is immaterial, if compared with global central bank’s net purchase of 535 tons of gold during 2012. Gold has trumped over other currencies as the reserve asset of choice for central banks looking to diversify away from US dollar and Euro. Global central banks have remained net buyers of gold since 2010. There were concerns that a gold sell-off by Cyprus could set precedence for other debt-ridden nations. Troubled Eurozone countries like Greece, Ireland, Portugal and Spain could be compelled to sell their gold holdings. However, these nations have meager gold reserves, with the combined gold holdings among the mentioned nations amounting to 780 tons, or just 2.5% of total world gold holdings. We infer that even in the worst case scenario, if Cyprus resort to running down its gold reserves, other central banks might not follow suit. These countries are subject to the Central Bank Gold Agreement (CBGA) which limits central bank gold sales. This can be explained by the fact sales under the CBGA throughout 2012 just amounted to 5.5 tons, where Germany only sold some quantum for the purpose of minting commemorative gold coins. Other CBGA members remained completely inactive in regard with exercising their right to sell their gold reserves. Central banks outside the purview of CBGA also refrained from selling gold reserves, except minor sales by the bank of Mexico for the motive of coin-minting.
Monetary policy: The latest FOMC policy minutes reveal that some Fed officials are of the view that the central bank should narrow its bond purchases later in the year and close down it altogether by year-end if the labor market improves. However, Ben Bernanke has clearly stated that the bond buying program would persist until the unemployment rate falls below 6.5%. The central bank does not envisage the labour markets restore to normalcy before 2015. He has also elaborated that the benefits of the monetary stimulus outweigh the likely costs and risks. In fact, several committee members have also expressed concerns regarding the negative implications on economic growth by so the called “sequester” or the federal spending cuts. In Europe, European Central Bank has maintained its accommodative policy and decided to keep its interest rates as low as 0.75%. Elsewhere, the Bank of Japan will stick to aggressive monetary injection in order to achieve its 2.0% inflation target. The apex body has pledged to pump about US$1.4 trillion into the economy over two years. The monetary policy stance across the globe still remains accommodative, whereby we infer that this is not a valid reason for the recent decline in prices.
Flight to equities: Improving US macroeconomic landscape has tilted investor's preference towards riskier assets. This can be corroborated by the fact that US equities have witnessed a strong run during the past few months. Although, there is a certain rationale which conveys that safe haven buying for the yellow metal would prevail at lower levels. Regardless of the positive string of macroeconomic numbers in US, the recovery in global economy remains erratic. This can be explained by the fact that Chinese economy has not yet witnessed any signs of firm footing. The economic activity in China has not been encouraging, which can be manifested by dismal GDP and industrial production growth figures. In Europe, there is still no light at the end of the tunnel. The region remains mired in prolonged recession and high unemployment rate.
Algorithmic Crash – “The real culprit”: It seems that there has been huge quantum of shorts created by investment banks and hedge funds on April 12th (Black Friday), which led to such tumult in gold markets. Speculation is rife that gold futures on COMEX with a value of over 400 tons were sold in hours. Such quantum is equivalent to 14% of the global gold mine supply. Some of the selling also accounted as a result of the physical market participants being compelled to hedge their physical position holdings by shorting on the futures markets. The liquidation was so brutal that all the crucial support levels were effortlessly taken away. It all started with the breach of US$1,530/ounce and then the sequential support levels of US$1,480, US$1,430 and US$1,370 becoming immaterial. The magnitude of sell-off clearly conveys that how speculators (investment banks and hedge funds) can manipulate the paper markets, thus leading to increasing divergence between physical and paper markets.
At the current juncture, the selling seems to be moderating, seeking sympathy from the oversold conditions. However, it is difficult to catch a bottom in the “falling knife” markets and advocate investors to wait for a natural bottom to emerge itself. US$1,270-1,300 is considered to be a formidable support, whereby prices are expected to bottom out. The recovery in prices could be time consuming and gradual, considering the fact there has been steep deterioration on the charts. On the global landscape, uncertain global growth prospects, negative real interest rates in US and accommodative monetary policy from various central banks should aid the recovery in prices. On the physical side, lower prices should encourage pick-up in jewellery demand in countries like India and China, where the bulk of the buyers are price sensitive. Jewellery demand from India and China constitutes almost 45% of gold demand.
Silver prices traded have also witnessed a mayhem, with the white metal retracing from the high of US$27.64 to the low ofUS$22/ounce in the span of two trading session. In addition, below par macroeconomic numbers from China also exacerbated the selling pressure.
At the current juncture, silver prices have managed decent recovery. However, prices still remain vulnerable in the wake of subdued industrial activity in China and Europe. One has to understand the fact that silver is deemed more of an industrial metal rather than a precious metal. Unless, we witness any strong signs of recovery in the manufacturing sector across the globe, the underlying fundamentals remain uninspiring.
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