Gold Forecast for 2011 Q1

Commentary by

Nick Nasad
Chief Market Strategist

and

Fan Yang CMT
Chief Technical Strategist

The gold rally has been impressive. Did you know that? Have you seen any major publications talking up gold? Have you seen an increase in turn your gold to cash businesses? These might be signs that gold may need to take a breather. This does not mean gold needs reverse much of its rally since 2005, when it was still under 500 USD/oz. Today, after a high near 1430 USD/oz, we would be foolish to expect a major reversal now, unless we are clairvoyant. But even without being able to tell the future, we can see some developments that could point to topping for a significant notable correction of the more recent run-ups.

Let’s take a look at  some fundamental or internal factors and the technical setup.

Fundamental Factors Affecting Gold:

Let’s take a look at the fundamentals that have been driving the prices of precious metals higher this past year as well as some of the pitfalls that may lie ahead.

Let’s start with some of the factors that have pushed up the value of gold in the past year. This is an exhaustive list which includes general fear and uncertainty by wealthy individual and institutions following the crash of 2008, the Fed’s quantitative easing which along with large US deficits is weakening the confidence in the US Dollar, the sovereign troubles in the euro-zone and the flight to gold as the ultimate currency, central bank purchases, buying by newly wealthy Chinese families, high unemployment in the US, the list goes on.

While most of these factors remain in place, the higher valuation of gold could mean that many of these factors may have already been priced in, and the fundamentals may be shifting for some of the others.

Let’s go over some of the bigger items on that list above.

Gold as Inflation Hedge or Protection Against Quantitative Easing and Devaluing Currencies?

Gold, while being used as a traditional hedge against inflation, this past year has climbing higher on another factor and that is the undermining of confidence in fiat currencies. That is of course because of the response by central banks to flood the markets with liquidity and to expand central bank balance sheets to buy up government bonds – what’s known as quantitative easing. The largest quantitative easing program is being run by the Fed, which purchased $1.5 trillion of bonds in the “QE1″ starting which began in March 2009. The Fed has embarked on QE2 – a plan to buy another $600 billion, which it is conducting now.

It was the speculation around and unveiling of Quantitative Easing 2 between August and October of 2010 that gold moved from around 1,200 an ounce to 1,385 an ounce. This run-up to the QE2 decision put heavy pressure on the USD until the most recent outbreak of Euro-zone sovereign debt woes in early November helped to stop outflows from USD. Since gold is priced in USD, we see that the recent bout of USD strength has caused more volatile, choppy condition in gold markets, and what looks like an attempt to form a top.

Can US Recovery Drive A Stronger USD and Hence Weaker or Flat Gold?

Worries over Europe along with better-than-expected US data driving expectations around US economic growth, has caused a sharp swing in EUR/USD and the USD Index. This trend could continue if the focus remains on the stronger US economy – supported by better data – and markets continue to remain spooked by European sovereign debt woes.

If we have that scenario the USD, which would be benefiting from a firmer recovery, may again become the preferred destination for safe haven demand, and gold may be unable to extend its recent gains. A US recovery gaining momentum that helps to push up the USD, would be a gold negative development. But, having said that, in an environment where things are uncertain in Europe and growth is slow in other areas of the global recovery, gold will still be in strong demand.

Higher US Yields, Gold, and Money Flows

With yields rising in the US, to 6-7 month highs in 10-year Treasury yields (near 3.5%) for instance, investors have a little bit more incentive to buy Treasuries during time of risk aversion, as it will pay out more. Higher interest rates would push investors away from gold, which bears no interest, pays no dividends and thus carries an opportunity cost. However, higher long-term yields that reflect rising inflation expectations and diminishing confidence in the U.S. dollar are bullish for gold.

The story with US yields will be important to monitor to start 2011. If longer-term yields are rising because of expectations about higher economic growth, which would lead to higher inflation and higher interest rates, and not just worries about the US fiscal health and credit worthiness, then the USD would benefit. Let’s remember that QE is around to help battle back deflation, and get inflation into the economy again. The government is helping in passing tax cuts and other stimulus measures that should goose up the US economy in the first half of next year. That however, puts more strain on the fiscal side of things for the US. Which sentiment wins out will have an important impact on where money flows the first half of next year.

Other Factors to Consider – Supply?

If you are interested in the supply side of gold, The Economist has a good article on that here:

Gold – Store of Value.

Here’s an excerpt: “On the supply side (chart 2, bottom panel), the main source of new gold—what is dug out of the world’s goldmines—has been flat or declining. Mine production peaked in 2001 at 2,646 tonnes and has been a little less than that ever since. A combination of rising production and exploration costs, dwindling output from long-established mines in North America and South Africa, and political and economic instability in other parts of Africa means that mine supplies cannot be ramped up at will.

Another potential source of supply is sitting in the vaults of central banks. In June national central banks, the ECB and the IMF held more than 30,000 tonnes in all. On average, they sold 520 tonnes a year between 2000 and 2007. Last year the flow of central-bank gold almost dried up, even as the price soared. Only 41 tonnes made it to market.”

The note here is that supply can not be ramped up to meet the rising demand that fast, and therefore these elevated prices can continue from the supply side of things. Still, there are many of these other factors that are overshadowing regular supply side dynamics.

Fundamental Outlook:

The fundamental outlook boils down to which main theme emerges to start 2011. If concerns over quantitative easing are the main story going forward  or if we have a return to weaker US economic data then the USD will be on the backfoot and gold should be a major benefactor.

Quantitative Easing can even overshadow the US recovery but we can look at the recent rise in yields and data in the US as an indicator that one of our core fundamental factors – a weak USD because of a weak economy that needs more QE – is being undercut. How the US labor market fares may be the key ingredient here.

If concerns emanating from the Euro-zone regarding sovereign debt escalate, and the US economy is faring well, then both the USD and gold could benefit from safe haven demand, but gains in the USD would temper gains in gold.

Based on the improving fundamental data in the US, the tax deal, and QE2, my outlook is that the US recovery will gain momentum in the 1st and 2nd quarters of 2011. That will help the USD Index, as will any safe-haven demand from further convulsions in the Euro-zone bond markets in January when many governments and companies go to market to re-finance. At these valuations gold seems too heavy. While we may not see a sharp sell-off, a more volatile sideways trading similar to what we have seen the since November may be the order of the day. That kind of price action could be a precursor to a correction.

And with that let’s take a look at the technical set-up for Gold.

Technical Setup (12/19/2010)

We may have a correction to start the year. The trend is still bullish no question, with continuing higher peaks, and higher lows. The pattern of the rally since mid-October however displays a possible diagonal triangle, which could be a topping pattern. Gold still has potential to continue higher, but the market may want to retest the 2010 -mid-year highs near 1265. A less aggressive target for this correction is to the 1315 level, which appears to be the origin point of the current diagonal triangle. Candlestick analysis notes the strength of bearish daily candles since October. These type of bearish candles were not seen since the summer where gold consolidated, also after a break below a diagonal triangle.

Gold in Summer of 2010:

The market was showing extended bearish divergence throughout the formation of the pattern, similar to what’s going on today. In June, the market broke below the topping pattern, and a retracement of 61.8% materialized. The uptrend resumed in August. At the end, this was basically an extended flat correction. What will the result of the current topping action be?

We would love to hear your opinion on Gold.

Subscribe and become a member to share your views and join live discussions as well as webinars about the markets.

Information and opinions contained in this report are for educational purposes only and do not constitute an investment advice. While the information contained herein was obtained from sources believed to be reliable, author does not guarantee its accuracy or completeness. FXTimes will not accept liability for any loss of profit or damage which may arise directly, indirectly or consequently from use of or reliance on the trading set-ups or any accompanying chart analysis.