With gold dropping over 10% from its recent peak, many investors may wonder if this makes for a good opportunity to purchase the precious metal. While there are many factors that historically contribute to the increase in gold, it seems that these factors have changed in the short term. In light of the European crisis and the Fed implementing Operation Twist, one would think that gold would be the only real safe haven asset at this point, several factors will determine gold’s price move from this point forward.
Many articles have been written about the liquidity of gold and how the recent price run up makes it the asset of choice to shore up cash and avoid margin calls from declining equities, or gold itself. Looking at the run up in the price since the begging of the year (some 30% ) I have no doubt that there is a degree of speculation in the asset, making the price at these levels behave more as a profit making tool than a preservation of wealth. This hot (and often leveraged) money usually pushes assets into bubble territory and is the first to make an exit at the sign of trouble.
Interest rates in the U.S. are at record lows and with the introduction of Operation Twist by the Fed, are bound to go lower. This would normally be a boon for holders of gold as there is less opportunity costs associated with holding it. The nature of Operation Twist does not constitute as a plain vanilla drop in interest rates however, with the Fed using the short end of the curve as financing for the purchases of the longer term securities this will make the amount of interest on shorter term deposits increase making bank deposits more attractive than gold. The decline in global growth prospects and commodities as a result will ease inflation prospects, keeping the threat of negative real interest rates at bay. Inflation figures should be watched closely for developments in either direction.
Flight to Safety
With the turmoil in Europe growing by the week, it is getting harder to find a safe haven asset with limited downside potential. The Swiss franc has effectively been pegged to the euro and the Japanese Yen has strengthened to the point that intervention talks are a discussion when, rather than if, one will occur. In light of this, the dollar is bound to have more inflows as the only currency with the liquidity and relative upside potential to be a safe haven currency. This will weigh on gold (as well as other commodities) without any strong support in the opposite direction.
Whether the recent drop in gold is a bear or bull trap in the bubble cycle is yet to be seen, but the recent price has definitely set the stage for volatility in the near term and in my opinion more downside. Longer term movements in the price of gold would need to take into consideration factors such as whether central banks are going to continue to be net providers of demand or providers of supply, the Chinese economy and their demand for commodities, and the U.S. fiscal issues.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.