Gold prices broke below the technically significant level of $1143 per troy ounce in the third week of July. Every analyst worth his salt advised his clients to exit positions as we near the much speculated Fed rate hike in September.
Should One Write Off Gold?
We decided to dig a bit deeper before taking a call.
In the hands of a Central Bank, interest rates have a double role as both brake and accelerator. When a central banks wishes to slow down an economy it increases rates and when it wishes to stroke growth it reduces interest rates. The objective for applying brakes is to prevent economy from overheating, inflation being the ugliest effect of it. Similarly, the accelerator is pressed to speed up stalling economy that is growing below its potential.
The idea behind starting the article from the basics is because most talked about event in town is forthcoming rate hike by Federal Reserve.
While mainstream media and analyst community are convinced about the inevitability, recent US economic data did not quite pass the smell test for a booming economy that needs to be slowed down.
Sample some of them
US GDP growth has not exactly been on fire. After sharp rebound from 2009 lows, GDP has been clocking mostly around 2-3% growth till 2013. Post 2013 it has been barely averaging 2% growth with March 2015 quarter actually growing at 0.2%.
The basis for assumption of strong growth has been based on trends in housing, unemployment and consumer spending.
US Core CPI, Feds preferred indicator has been hovering between 1.5-2% with little signs of spiking higher. With commodity prices at decadal lows and China continuing to export deflation (we had highlighted global over capacity problem in the November 2014 Issue of Finapolis), it is very difficult to visualise CPI spiking in US.
This was a data market was much exited about last week. While per se the number is good, look at from the context of data prior to 2007, it is hardly sign of an overheated market. Current data is at least 50% lower than the lowest number printed between 2000 to 2007!
In view of stochastic nature of this data, we relied on a 12Moth moving average to detect a trend. The picture actually looks quite dismal. For an economy which gets close to 70% of its GDP from personal consumption, this actually is bad news.
The current expansion which started in 2009 is already one of the longest in history. (The boom and bust, better defined as expansion and contraction, business cycles of the U.S. economy averaged 38.7 months in expansion and 17.5 months in contraction between 1854 and 2009. According to the National Bureau of Economic Research). We are probably close to the end of expansion cycle by historic standards.
In last few cycles Fed had started tightening about 3 -3.5 years into expansion. This time however we are into sixth year of expansion and without any rate hike.
To sum what we have is: inflation nowhere in sight, economy barely cruising along, severe global headwind to growth, reasonable employment scenario, consumers refusing to loosen purse strings (who can blame them with their near death experience barely six years back?).
Given above what explains the eagerness by Fed to hike rates? Actually what it wants to do is normalise rates as far as possible before next down cycle hits.
Looking at the US treasury yields( 10 Year UST at 2.25% today, down from 3% in December 2013!) the US bond market does not seem unduly worried).
US dollar index is at 96.70 which is well below 100.39 hit in March 2015.
In fact except for the base commodity market which are influenced by Chinese slowdown, every market which should be jittery about rate hike, is sanguine.
Only market which has corrected sharply is gold. Post data about lower than expected accumulation by Chinese Central Bank over last few year triggered massive attack on gold price(actually should be good news for gold as it has managed to hold above $1150 without Chinese help all these years!). It sliced through the technically significant level of $1143/troy oz and dropped all the way to $1077/troy oz before recovering.
Will It Fall Much Further?
Technically $1064 is a strong Fibonacci level, above which $1084 zone is minor support zone. Next strong support is at $940 levels.
Downside momentum usually is dictated by trader positioning. Given the prolonged disinterest in the asset class it would be surprising if there are significant long positions left at this level to unwind. Hence analyst predictions of $800 or Rs 22,000 are probably an exaggeration.
Another supporting factor is cost of mining, which being around $1000-1100 should offer support (There have been analyst reports suggesting cost of mining is far lower, but the profit and loss statements of major miners do not show that kind of margin).
Why Should One Buy?
The elaborate ritual being played out by Federal Reserve of normalising rates is based on the assumption that US economy can cruise along without favourable rate environment. Given that the current US expansion is into its sixth year and also commodity markets deflating, all major economies slowing, there is a significant chance of global recession if not outright deflation going forward.
China has over last decade exported inflation across globe with its vociferous appetite for raw material. With its economy sharply slowing, it will export deflation not only in commodities but also in finished products like we are currently witnessing in steel, tyre etc.
The factors which resulted in the collapse in 2007, have not gone away, they have only grown bigger.
If above outcome materialises, what would be the response of central banks?
One can argue Indian equity markets would be an attractive safehaven. Perhaps it will be, one never knows. But it does make sense to buy a little insurance in form of gold. After all insurance is cheapest when nobody foresees likelihood risk!