Nomura Explains Why Gold Went Down, And Why It Is Going Back Up
Tired of all the trite meaningless propaganda from Economic PhDs who crawl out of the woodwork every time there is a downtick in gold, proclaiming in big bold letters that the Gold "bubble" has burst, only to crawl right back in when gold soars $100/oz in the days following their latest terminally wrong proclamation? Or, alterantively, wondering what will happen to gold from this point on? Then the following report from Nomura is for you. As Saeed Amen analyzes: "In this article we explain why the price of gold has fallen in recent weeks. Notably, price action during Asian hours has become very bearish, which had not been the case in previous unwinds earlier in the year. In addition, it is likely that losses in risky assets such as equities helped precipitate unwinding of very heavily extended long gold positions. However, the key reasons for being bullish gold remain; namely, a very low interest rate environment and the potential for long-term demand from Asia. Also, the potential for gold’s status as a safe-haven hedge to tail risks arising from various uncertainties due to the European debt crisis is likely to be enhanced, especially now that short-term speculative positioning is relatively light. Also on a short-term basis, we have begun to see some reversal in gold back upwards during Asian hours, after the unwind." Overall, informative but nothing new to regular readers: gold liquidations on market plunge (confirming ironically that gold is now among the most liquid types of investments in the market) as had been predicted months ago, and the same long-term fundamentals for the metal once the current stock downturn shakes out all the weak hands.
Why Did Gold Go Down:
In recent weeks the gold price has fallen significantly from around $1900 to $1535 (intraday). Gold is now trading near our Q3 target of $1650. The size of the move was far more significant compared to other recent unwinds, like those in May or August. One of the key factors for our long-term bullish view on gold is Asian demand. As discussed in FX Insights – Gold, gold, 6 July 2011, the majority of end-user demand for gold is from Asia. From an Asian valuation perspective, gold is also relatively cheap (
Gold has not been supported during Asian hours
One way to proxy Asian demand for gold is to look at how gold performs during Asian trade. Over the past few years, gold has generally appreciated during Asian hours, reflecting strong demand for the metal. However, recent weeks have shown weakness in Asian hours (Figure 1). On previous occasions when gold traded poorly, such as in May and August, it remained relatively robust during Asian hours, with any sell-off tending to come in London and New York hours, suggesting that Asian investors were supporting an unwind of Western investors’ long gold positions.
This contrasts with the recent fall, which has been noticeable across multiple time zones. In the very short term, we believe a reversal would need to be led by appreciation in Asia. Although a few data points do not constitute a trend, on Tuesday and Thursday gold rose by 2%, its largest moves higher during Asian hours since October 2008 and perhaps a signal that it could be turning back up.
Gold has declined more than would be suggested by moves in rates
The last FOMC meeting did not expand the Fed’s balance sheet (i.e. QE3), which would have been bullish for gold (see Give Gold Some Credit, 19 August 2011 for some discussion about the relationship between QE and gold). However, the Fed has committed to keeping rates low until mid-2013, as well as embarking on Operation Twist, which should be gold-supportive. Indeed, in Figure 2 we plot inverted real rates against gold and find that the price action has been detached in recent weeks. This suggests that it is difficult to attribute the fall in gold purely to the lack of QE3.
Gold sold off at the same time as equities
Although gold can trade like a tail-risk hedge, it often trades like a risky asset. This has been evident in recent weeks where we have seen a strong positive correlation between gold and the S&P500 (Figure 3), which we use as a proxy for risky assets. The rationale is that heavy losses in risky assets forces investors to unwind other positions to free up cash. As a liquid asset and also with heavily extended net long speculative positioning heading into this episode, gold has suffered (Figure 4).
Speculative positioning is lighter in gold – back to tail-risk hedge?
However, with positioning now at relatively low levels, it is likely that gold will trade more in line with the fundamental factors we have discussed, namely low real rates and the potential for continued Asian demand, which are broadly positive. The lack of positioning could also enhance gold’s status as a tail-risk hedge in the continued uncertainty around the European debt situation.
Tail risks in Europe
Developments in Europe have become the main market driver recently. In recent publications we have analysed both our base case, which involves no Greek default and the tail risk of a Greek default (see EURUSD: Our Central Case, 5 September 2011 and EUR/USD – The Greek tail risk, 7 September 2011). In short, we think that both our central case and the tail-risk scenario are likely to be negative for risk sentiment.
Even if Greece continues to meet its obligations and avoids a disorderly outcome, there are serious doubts regarding the EFSF’s capacity to intervene credibly in the sovereign debt markets of Italy and Spain once it takes over this role from the ECB without significant leverage (for a discussion on how this may be achieved see EFSF 2.0, 3.0 and beyond, 30 September 2011). Despite the barrage of policymaker meetings next week and the fact that the various options regarding EFSF leverage are on the agenda, we do not expect any decisions to be made any time soon (see also G10 FX Insights - The Missing Bazooka, 30 September 2011). Until we have better visibility on this issue, however, we believe markets are likely to exert renewed pressure on Italy and Spain as we approach the takeover date. Furthermore, the Greek saga continues with Troika inspectors’ delayed return to Athens causing further delay in the disbursement of the sixth instalment, EFSF 2.0 ratification pending in many EMU countries and various headlines regarding the possibility of a change in the terms of the 21 July agreement.
The bottom line is that both our central case and Greek tail risk are likely to cause a new round of risk aversion in global markets in the next few weeks and exert further downside pressure on EUR. We have been trading EUR/USD from the short side since 25 August (see Sell EUR/USD spot) and have recently restructured our shorts (see Positioning for the euro break, 22 September 2011).
Bar the unlikely event of a major breakthrough by European policymakers in the next few weeks, we expect gold to benefit from a new bout of risk aversion as the market re-assesses yet again the chances of a new systemic crisis. This point is further enhanced by noting that the correlation between gold and EUR/USD has turned negative recently. A similar, albeit greater, correlation shift occurred during the first phase of the Greece crisis in May 2010 (Figure 3). This lends further support to the idea that gold tends to function as a safe-haven hedge in cases of European risk events that have a systemic impact.
We have seen that gold’s recent fall has been accompanied by heavy deprecation in Asian hours. This contrasts with relatively robust Asian price action during earlier periods of gold weakness in May and August. We think that a reversal of this trend back to gold appreciation in Asian hours is the key to a short term reversal and we have begun to see this in recent days. We also find that the correlation between risky assets and gold has been higher than usual in recent weeks. Hence, we suggest that heavily extended speculative net long gold positions have unwound to free up cash for other losses in risky assets, like equities. With short-term speculative positioning net longs at relatively low levels, it is likely that fundamentals, as opposed to positioning, are likely to drive the price of gold again.
We continue to view long-term fundamentals, such as low real rates and the relative cheapness of gold when viewed from an Asian perspective, as bullish for gold. At the same time, gold’s attractiveness as a tail-risk hedge against the continued uncertainty in Europe is likely to be another factor that should support the price of gold in the short term.