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Earlier this week, I posted an article outlining the reasons behind my bearish outlook for gold (NYSEARCA:GLD). Gold finished the week 0.64 % gain underperforming S&P500's (NYSEARCA:SPY) 0.85 % weekly gain. Gold notched weekly gains despite major banks downgrading its year-end outlook. Banks cited acceleration in the US economy, fewer tail risks and lack of inflationary pressures as the main reasons for the downgrade. Remarkably, gold analysts have turned the most bullish on speculation that near record bearish bets in gold are dropping.

During 2013, investors endured unparalleled volatility in the gold prices. Increased volatility in the gold prices raised the option premiums (through higher implied volatility levels), as shown in Figure 1.

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Figure 1 30- Day Implied Volatility in Gold since 2012. (Chart Source: Livevol)

Historically implied volatility in S&P500 options has closely tracked gold's volatility. This relationship diverged from its historical pattern in April last year, as shown in Figure 2. The Cyprus crisis and hint of tapering from QE by the Fed chairman forced this divergence. The market reacted to this divergence by pushing the interest rates higher, and causing a steep decline in gold price. Figure 3 confirms my assertion that interest rate volatility led the volatility in gold prices.

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Figure 2 Gold (red) and S&P500 (NASDAQ:BLUE) 30-day implied volatility (Chart Source: TOS)

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Figure 3 10 year interest Rate (green) and gold realized Volatility

In my last post, we discussed the existence of strong relationship between gold prices and economic growth. Expanding on this premise, analyzing emerging markets (NYSEARCA:EEM) and gold presents a strong narrative supporting the theory. The conclusion originating from Figure 4 is the cyclical correlation between emerging markets (representing economic growth) and gold prices. Overlaying the historical volatility of gold, emerging markets and S&P500 presents a novel insight to the investors. Investors can capitalize on this relationship in volatility levels to hedge their exposure in gold markets as shown in Figure 5.

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Figure 4 Gold and Emerging markets equities (Chart Source: StockCharts.com)

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Figure 5 Realized volatility levels for Gold , S&P500 (red), EEM (green)

Realized volatility comparisons

Table 1 highlights the volatility differential between gold, S&P500 and emerging markets. Single digit realized volatility levels in S&P500 suggests muted moves in the index. Earnings season will bring the volatility back into the markets, when investors adjust to the revised profit margins. Investors will use the performance from the earnings season to discover the path forward for profit margins. A slow down in emerging market growth coupled with the direction of profit margins will serve as a strong catalyst for gold prices in future. This economic catalyst can likely cause gold to make news lows.

20 day realized volatility

Present

1 week ago

1 month ago

EEM

21.15%

21.18%

19.18%

GLD

17.81%

19.08%

18.62%

SPY

8.38%

10.20%

8.39%

Table 1 Realized volatility for GLD, EEM, SPY

20 day expected volatility

EEM

22.50%

GLD

17.80%

SPY

11.57%

Table 2 Expected volatility for next 20 days

Source: Gold Volatility Review