I wrote in a previous article in September 2013, that because all-in-all, costs of gold production are estimated at $1,250 per ounce, this level is a very strong support for the yellow metal.
Exhibit 1: Gold prices will retest their June lows
Last week, this strong support was broken (Exhibit 1), suggesting a very bearish development for the precious metals complex. From a technical point of view, it is likely that gold will retest its June low of $1,180 per ounce in the very short term (let's say before the end of the year). Let me explain why later.
The $1,180 level is a solid support, as it has been tested a few times, so private investors will consider the yellow metal as a good-buying opportunity. Let's examine downside risks:
Investors need to understand that market participants have priced an increasing probability of Fed Taper, according to the latest FOMC Minutes.
Ben Kramer-Miller wrote in 'The Taper Caper' that 'the notion of 'tapering' doesn't come from the Fed' and that:
.... anybody who has actually read these minutes, Fed minutes do not say anything about what the Fed is going to do in the future.
I am sorry Mr Kramer-Miller, but Fed participants in the minutes of the October FOMC indicated that:
1- 'They generally expected that the data would prove consistent with the Committee's outlook for on-going improvement in labor market conditions and would thus warrant trimming the pace of purchases in coming months.'
2- 'They also considered scenarios under which it might, at some stage, be appropriate to begin to wind down the program before an unambiguous further improvement in the outlook was apparent.'
From these minutes, market participants have assumed that the Fed has left open the possibility of tapering in December. This is consistent with what Fed participants indicated in their discussion. Consequently, we have seen gold prices pushing down while Treasury yields are up.
In the current environment, some investors may be confused by the evolution of gold prices. Why has Fed Taper talking had such a strong influence on gold prices? It is all about real interest rates.
A theoretical approach is necessary to understand to what extent real interest rates have such a strong influence on gold prices. In fact, , the historical behavior of supply suggests that real gold prices tend to be low when world gold production is approaching a peak, while they tend to be high when world gold production is bottoming. According to the economics of gold supply, world gold mine production is positively correlated to real interest rates. Mine production grows at a faster pace in a high interest rate environment and grows at a slower pace in a low interest environment. Consequently, a rise in real interest rates leads to a faster rate of world gold mine production, resulting in lower prices
As seen in Exhibit 2, US real interest rates and gold prices are negatively correlated, suggesting that higher real interest rates have a strong negative influence on gold prices. In the current environment where the Fed is manipulating interest rates through large-scale asset purchases (Quantitative Easing 1, 2, 3), market participants expect that the Fed will inevitably begin pulling back on the pace of asset purchases because both Fed participants and market participants are aware that the longer the Fed waits to normalize rates, the more difficult it will become to control the bond market.
Gold prices have been under hard pressure this year mainly because market participants have started to prepare for a rise in real interest rates. Real interest rates are likely to be higher next year, pushing more pressure on the precious metals complex.
This is also the reason why recent data from GFMS showed that world gold mine production is expected to increase by 2% from 2,861 tonnes in 2012 to 2,920 tonnes in 2013, and Metal Focus (world's leading precious metals consultancies of which the Director is Philip Newman, former Director at GFMS) expects gold mine output to rise by roughly 5% from 2012 to 3,000 tonnes in 2014.
The rational economic consequence of tapering is obviously that U.S. inflation fears will decline in the future as the expansion of the Fed's balance sheet is coming to an end.
As the timing of Tapering is discussed, investors have become less worried about U.S. inflation in the future. Interestingly, legendary hedge Fund Manager John Paulson told clients at his firm's annual meeting on November 20 that he wouldn't personally invest more money in his gold fund because it is not clear when inflation will accelerate, according to a person familiar with the matter. John Paulson, who has been betting that the yellow metal would rally as a hedge against inflation, has lost 63% year-to-date in the PFR Gold Fund. Thankfully, his Gold Fund represents the firm's smallest portfolio, with only 2% of assets.
In sum, even though gold is a good long-term bet, investors need to be very careful in the short-term, as sentiment is the primary driver and downside risks predominate. Gold will likely retest its June low of $1,180 per ounce before private investors consider the yellow metal as a buying opportunity and react accordingly. If the $1,180 mark holds, investors should build their long term positions. Investors need to remember that even though it is tempting to forecast gold prices by monitoring only the monetary demand, over long periods of time, real gold prices are driven more than changes in supply rather than demand.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.