A few weeks ago, we suggested that gold was demonstrating a pattern of uncertainty, and that our expectations were for a break out to the downside. Figure 1 shows an updated chart of gold price with trendline support in orange and trendline resistance in blue. As we can see, the key moment here is that we are still within this triangle of uncertainty. However, instead of converging toward the horizontal support of $1,530, we are now converging with an oblique angle defined by even earlier support levels (bottoms in April and June 2011).
As we can also see on the last candlesticks, we broke to the upside the minor descending trendline resistance, but were stopped by the major trendline resistance. We have closed the week above $1,600 after a risk rally that resulted from positive job numbers on Friday, just in between these two resistance trendlines. The market is still undecided whether gold should go up or should go down. From this pattern, we are inclined to think that time is running out, and that the market will have to come to a decision on gold in the coming days/2-3weeks. In addition, our in-house indicators suggest that next week could be a potential window for a market move out of these compression lines. Such timing could correspond to the digestion by the market of the heavy news flow that happened last week.
Figure 1. Daily chart of Gold futures, with key trend lines indicated.
Last week, the statement of the Fed out of its August meeting suggested that it is closer to engage in some form of additional easing. However, employment numbers released on Wednesday and Friday have beaten expectations (ADP, NFP). Bad employment numbers have been an important support for gold prices since May. With such positive numbers, this support will be weaker for the coming weeks. It does not nullify the chances of a QE3 in September, but it certainly reduces it, at least till the next NFP report comes out in a month from now. As a side note, we should mention here that yields on treasury notes are already extremely low. This means that the effects of another round of QE at this stage are dubious. Not to mention, that given the large volumes of bonds that the Fed purchases, it might be confronted to a lack of sellers on the secondary market. The Japanese Central Bank, with its much smaller QE program, has had weeks where it was unable to buy bonds. Therefore, it appears that further extension of government deficits (a new stimulus program by a newly elected president) is prerequisite. It would allow to increase the supply of treasury notes, increase the yields, and consequently allow a QE program to be effective.
The more important event last week was Mario Draghi's press conference after the ECB board meeting. Basically, Draghi announced that the ECB is now ready for full fledged QE programs (direct bond buying). Theoretically, money printing by the ECB will be positive for the price of gold in euros, but for the price of gold in dollars it should be a negative. The dramatic fall of about $100 that occurred on February 28th when LTRO2 was executed is still in the memory of many gold bugs. If the market accepts the fact that European style quantitative easing is on the way, then we have a strong negative signal for gold and also for the euro. This could be our trigger to exit the indecision pattern. However, we should remark here that the monetary easing that Draghi has announced has many conditions. First, the country must request help. None has done so far. Then, the country will have to execute some reforms and budget cuts in exchange for the help, similarly to what is ongoing in Greece. Only after this does the ECB start buying short term bonds. Here is the original text:
The Governing Council extensively discussed the policy options to address the severe malfunctioning in the price formation process in the bond markets of euro area countries. Exceptionally high risk premia are observed in government bond prices in several countries and financial fragmentation hinders the effective working of monetary policy. Risk premia that are related to fears of the reversibility of the euro are unacceptable, and they need to be addressed in a fundamental manner. The euro is irreversible.
In order to create the fundamental conditions for such risk premia to disappear, policy-makers in the euro area need to push ahead with fiscal consolidation, structural reform and European institution-building with great determination. As implementation takes time and financial markets often only adjust once success becomes clearly visible, governments must stand ready to activate the EFSF/ESM in the bond market when exceptional financial market circumstances and risks to financial stability exist - with strict and effective conditionality in line with the established guidelines.
The adherence of governments to their commitments and the fulfilment by the EFSF/ESM of their role are necessary conditions.
The Governing Council, within its mandate to maintain price stability over the medium term and in observance of its independence in determining monetary policy, may undertake outright open market operations of a size adequate to reach its objective. In this context, the concerns of private investors about seniority will be addressed. Furthermore, the Governing Council may consider undertaking further non-standard monetary policy measures according to what is required to repair monetary policy transmission. Over the coming weeks, we will design the appropriate modalities for such policy measures.
Outside of the impact of last week's news, gold price should continue to be positively impacted by buying from central banks. Also, the second half of the year is historically a positive period for gold. Continually weakening corporate earnings and earnings forecasts are also bullish for gold since they increase the chances of a fed intervention. However, China, one the main consumers of both investment and jewelry gold, has been economically slowing.
There are many indirect indicators that show that the situation in China is worse than the official numbers suggest. One of them is the falling electricity consumption. China GDP and Chinese inflation have been declining month after month. This means that there will be less Chinese savings to invest in gold. This is another negative for gold. The Indian rupee remains also very weak, which also inhibits any gold demand growth from India. Many gold bulls, such as Marc Faber, remain positive on gold and are continuing to buy gold on the basis that sometime in the future, gold will explode to the upside. The fundamentals of the gold bull market remain solid, and investors with a time horizon of 2-3 years or more can continue buying. However, the shorter term dynamics suggest that the gold correction will continue.
We therefore recommend our readers be prepared to enter the market long or short depending on the price action in the comings days or weeks. Gold futures and gold ETFs such as SPDR Gold Trust (GLD) are obvious ways to profit from the new trend that will emerge. The stocks of gold miners should also be impacted if a breakout occurs, probably with a larger magnitude to the upside than to the downside. Gold Miners MV (GDX) is a solid ETF to trade the gold mining sector. Given all of the above, we still do favor shorting gold. However, we should also remain careful of an upside breakout should Bernanke decide to surprise the markets and announce QE3, for instance, during his annual speech in Jackson Hole.
Additional disclosure: I have a small put option on gold futures. I will initiate a larger short or long position based on price action / news flow.