Gold Price Down: We've Seen It Before, We'll See It Again

 |  Includes: ERO, EU, GDX, GDXJ, GLD, IAU, PHYS, UDN, UUP
by: Gold in Mind

The gold price fell 6% during the past 6 days. Dozens of articles appeared across the Internet trying to make their case for the “bursting of the gold bubble”. A look at the facts reveals that this drop is no bigger than temporary drops that occurred in previous years. Also, there is no substance to support a lasting trend reversal. Rather, the recent price change is a cumulative reaction to a few notable events that took place in a short sequence. It won't hurt to recap them:

  • Chicago Mercantile Exchange (CME) increases margin requirements: On November 9, the day the decline in the gold price started, one of the biggest precious metals spot markets, the Chicago Mercantile Exchange announced it was increasing margin requirements on silver contracts. (Most commodities futures are bought on margin, the investor has to put up only a fraction of the actual value of the contract). This created expectations that CME will do the same for gold, platinum and palladium, which CME in fact did on November 16. The new requirements forced a number of players out of their positions. Despite its unknown timing and big impact, the action by CME is of no fundamental importance. The margins simply needed to be adjusted upwards to reflect the increased price and volatility in precious metals.

  • The dollar rally: The dollar strengthened against most major currencies when the news of further problems in Europe (Ireland's debt) lead traders and investors to convert their euro positions into dollars. The Dollar Index is at its highest point since September 28. This made the dollar attractive to many short-term traders who abandoned gold for the dollar. Measured in euros, however, gold fell only 3.9%.

  • Asian anti-inflation measures: China announced it was considering price controls to curb inflation which rose sharply last month. Also, foreigners should be more restricted in their ability to buy residential and commercial property. South Korea raised its base rate to 2.5% in an attempt to contain inflation. Because gold is perceived as a hedge against inflation, some analysts fear that these measures could have a negative impact on Asian demand for gold.

  • Commodities pullback: Most commodities experienced a significant pullback as speculative capital poured into the dollar. The Reuters/Jefferies CRB Index has plunged 7% since its November 9 high, its steepest decline in two years. Gold, falling 6% over the same period, didn't nearly suffer as much as some commodities. Sugar, for instance, lost 18%.

  • U.S. Consumer Price Index (CPI): Throughout the week, markets were anticipating very low October CPI numbers, which were to be released on November 17. Indeed, the CPI rose only 0.2% from September and Core-CPI didn't change at all. This lead to a widespread belief that the danger of inflation is not eminent for the time being.

Now, given the volume of speculative short-terms trades that today represent a significant fraction of the gold market, it is no surprise that these events combined created a powerful and fast drop and reinforced each other's effects. However, one should not forget that the strategic, mid- to long-term component has dominated the gold price over the past 10+ years, providing strong support levels for further growth after each significant drop. In December 2009, the gold price dropped 11.3% from $1.218 to $1.080. In October 2008, it dropped almost 23% from $897 to $693. And look where we are today.

Numbers mean nothing, because they mean nothing to the man at the printing press. In the olden days before 2007, groups of economists in favor of 2% annual expansion of the monetary base would be fighting those who demanded 4%. Today, the Fed pours 20%, 30%, 50% into the system without blinking an eye. Don't expect stability. Speculators were given a lot of money to play with and you can bet they will shuffle it around fast to make their quarterly bonuses as handsome as possible. Add low and high frequency trading robots and you have all the ingredients for a high volatility cocktail. Jerky markets on steroids are the new normal. (By the way, have you ever wondered if the real, physical commodities and stock certificates can keep up with these trades?)

The bottom line: the only thing that somewhat makes sense is the big picture and the general direction. The gold price has so far gained 20% in 2010, even after the current drop. All primary, long-term reasons for gold's continuous rise such as exorbitant government debt and unfunded liabilities, Quantitative Easing, high volatility and uncertainty in all markets, fear of commodity inflation (to be followed by imported domestic inflation), and many more, remain in place. There is no obvious reason for a lasting trend reversal in the gold price. Unfortunately, very obvious are the reasons for a further decline of the value of the dollar and possibly also the pound and the euro.

So, strategic investors and savers, don't lose your nerves. Wherever we are headed, it will be a bumpy ride that may end up in a complete off-road trip. Don't forget where the north is, think about what you'll need should we arrive in the wilderness. Nothing is safe there. Diversify, buy gradually, avoid paper promises. Keep your economic seat belt buckled, keep your eyes open, keep gold in mind.

Disclosure: Long gold