Gold - sailing amidst a storm
Precious metals fell have been trading weak after a brief rally in the previous two months as concerns over a rate hike by the Fed in the near term increased. Global sentiment stabilized from the jitters seen after the Brexit vote and a risk-on environment weighed on precious metals. While the Fed still hasn’t indicated a clear timeline for its next rate move, rhetoric from Fed officials over the past couple of weeks has been hawkish. Yellen indicated that the case for a hike has strengthened which led markets to start pricing in a rate hike this year. Consequently, the dollar has rebounded and investment sentiment in gold has cooled off with global ETF holdings witnessing the smallest inflow in four months. Indian and Asian physical demand is however showing some signs of pickup with a sharp narrowing of domestic discount in India to $16 compared to $100 during some days in July. China’s gold premiums also jumped to $3.5 an ounce compared to $1 last month.
The market has been broadly grappling with conflicting signals as relatively hawkish commentary from Janet Yellen and some other Fed officials increased chances of a rate hike in the recent days but a weak jobs data brought uncertainty back into picture. September rate hike odds are near 32% while December odds are close to 60%. Broadly, the short term direction of precious metals will remain hinged on Fed policy outlook and incoming US economic data. In this context, the September meeting will be very crucial to provide a clear direction to markets. We have seen that gold has been stuck in a broad range of $1300-1360 in the recent months as there isn’t enough evidence to support moves on either side of the range.
Incoming economic data will be crucial as investors have started pricing in more chances of one rate hike this year. While U.S. economic data has been broadly better, it still isn’t good enough to warrant aggressive actions by the Fed and we therefore believe that Fed will not hike more than once this year. The latest set of GDP numbers was a mixed bag as Q2 GDP was revised lower to 1.1% compared to 1.2% in the previous estimate. Growth in consumer spending was up 4.4% y/y, strongest gain since the fourth quarter of 2014.
The labor market has been the bright spot with average hourly earnings witnessing an average 2.5% y/y growth in the first eight months suggesting that wages have started to catch up.
Inflation readings in the US have also been a mixed bad as headline CPI remains lower (avg. 1.0% y/y), but core CPI averaged 2.2% y/y so far this year. The Fed’s preferred measure of inflation, the core PCE has seen 1.6% y/y growth in the first seven months of this year indicating that inflation in the US is not far from the Fed’s 2% target and is higher compared to inflation readings in Euro Zone and Japan.
On the demand front, global gold ETF holdings have surged more than 500 tons so far this year but investment demand is cooling off. Global gold ETF’s saw the smallest inflow in four months in August while SPDR holdings were nearly unchanged after a slight outflow in July. Silver ETF holdings however have increased substantially in the last two months with cumulative inflow of nearly 700 tons during July and August. However, silver has been bogged down by weakness in base metals, especially copper.
Looking ahead, we believe that even as the gold bull trend is intact, it will be difficult for gold to make big incremental gains given that the long side is now a very crowded trade and is vulnerable to liquidation. Net longs in gold continue to be near record levels and markets have been complacent about factoring in Fed rate hikes this year. Given this, any notable hawkish tilt from the Fed could trigger a correction in gold and shake off the excess froth from the market.
A correction however wouldn’t change the underlying long term bull trend as global liquidity will continue to support gold and provide a floor to prices. Additionally, rate hikes by the Fed will only shake off excess froth from the market and provide a healthy correction for long term investors to take fresh entry. In our base case scenario, we believe that gold prices could extend correction towards $1290-1275 and we believe that current circumstances will limit any downside below $1250 even if the Fed hikes once this year. On the upside, we believe that $1400-1425 will be the next target for gold once the correction is done with and a fresh uptrend begins. In the Indian context, long term investors in domestic markets should look at accumulating gold on dips towards Rs.30000 levels as base case with provision to average on potential downside risk towards 29500 as a worst case scenario with potential for the prices to rise towards Rs.32,500/33200 as best case for 2016.