Back in February, shortly before the big sell off in gold we warned that we have some "Horrible News For Goldbugs - Paulson Is Bullish On Gold Again." We may have some bad news again, as the 'bullish' sentiment this time comes from none other than the muppet master, after Goldman released a note overnight saying that "gold is set to glimmer as growth tarnishes." To wit: "We reiterate our constructive outlook for gold prices in 2012 and our 3, 6-and 12-mo forecasts of $1,785/toz, $1,840/toz and $1,940/toz, respectively. We acknowledge, however, that continued strong US economic data poses growing risk to our forecast for rising gold prices. Net, we reiterate our view that at current price levels gold remains a compelling trade but not a long-term investment, and we continue to recommend a long position in Dec-12 COMEX gold futures." Yes, that's great - we have only one word: Stolper That said, the only saving grace to an all out wipeout is that Goldman appears quite set on getting QE at all costs, potentially as soon as April - a move which would send the metal soaring as the Chairman can not have his cake and eat it too, absent a few helping hands from the CME of course.
Back to the GS note, it can be summarized as follows:
Long Gold: Buy December 2012 COMEX Gold (initial value of $1,800.5/toz, current gain $318.3/toz)
While gold prices have returned to trading with a strong inverse correlation to US real rates since late December, at sub-$1,700/toz they remain below the level implied by the current 10-year TIPS yields. We believe that despite last fall’s decline in 10-year TIPS yield to -15 bp, the gold market may have been expecting that real rates would soon be rising along with improving economic growth, leading to a sharp decline in net speculative length in gold futures. Accordingly, a simple benchmarking of real rates to US consensus growth expectations suggested a level of +40 bp by year end. In our modeling of gold prices to real rates, this higher level of real rates would be consistent with the current trading range of gold prices. As we look forward, our US economists forecast subdued growth and further easing by the Fed in 2012, which should push the market’s expectations of real rates back down near 0 bp and gold prices back to our 6-mo forecast of $1,840/toz. Consequently, we continue to recommend a long gold position.
None of this is at all new or surprising. What little informative value is here, is in Goldman's overview of the reasons for gold's plunge last December.
The December European funding shock may have further depressed gold prices
While this shift in real rate expectations helps explain most of the decline in gold prices last fall, the sharp decline in gold prices to $1,540/toz in the second week of December stands out as significantly below the level implied by the market’s expectation of higher real rates. From a news flow perspective, the most apparent catalyst was the disappointing European Summit. From a positioning perspective, this move coincided with a sharp decline in COMEX net speculative positioning with ETF gold holdings and real rates little changed. Finally, this move lower was likely exacerbated by prices trading through their 200 day moving average.
The most striking feature of this sell-off was the collapse in front month gold lease rates a couple of weeks earlier, which was likely driven by demand for US dollars from European banks. Late last year, the appetite for European banks in the US$ bond market was very low, so banks had to swap their € debt into US$ in order to get US$ funding, creating a significant supply/demand imbalance, as observable from the widening of the €/US$ cross currency basis swap. Similarly with gold, this demand for US$ funding reportedly led banks to offer physical gold in the swap market and bid gold forwards to hedge. These flows mechanically led to a steepening of the contango of the gold forward curve, and a sharp decline in the gold lease rate which is the spread between LIBOR and the gold forward rates.
Although this large move in the gold lease rate preceded the sharp sell-off in gold prices, the link between both moves is not obvious. Higher gold forward rates offered an arbitrage opportunity between physical gold and future prices as investors could capture the gold forward rate by initiating long physical gold positions (via ETFs for example) and selling COMEX gold futures against them. The price impact of this arbitrage would, however, likely be limited since it involves both a long and short gold position.
What is striking, though, is that the ECB’s aggressive actions to ensure liquidity to European banks, especially the LTROs, have broadly coincided with shifts in gold positioning. Gold prices returned to trading with a strong negative correlation to US 10-year TIPS yield soon after the first LTRO in December. Further, front month gold lease rates increased sharply after the second LTRO at the end of February, to reach their highest levels since last August. We therefore expect that the normalization in the gold lease rate that took place earlier this month will be key to assessing whether the December funding stress of European banks generated an additional de-rating of gold prices. Should that be the case, we would expect additional near-term support to COMEX gold prices.
And while Monday morning quarterbacking is great, this is basically a three month delayed retelling of precisely as we said back in December when contrary to everyone else, we said that rising gold lease rates indicated a bottom in gold. Sure enough, they did.
More importantly, Goldman is now selling gold to muppets. Be warned.