Gold Could Lose A Crucial Support Level

by: Alpha World


Gold prices have fallen sharply since February, driven mainly by a stronger dollar.

Physical demand for gold could also remain lackluster.

Gold could lose $1,100 an ounce support level in the current slump.

After finishing nearly flat in 2014, gold prices have fallen nearly 4% so far this year. This however doesn't show how bearish market sentiment has become on gold. Gold actually kicked off the year on a solid note, climbing to above $1,300 an ounce level. However, since February, the precious metal has seen a sharp pullback and is now trading at $1,159 an ounce level. The losses have been mainly driven by a stronger dollar. The dollar of course is strengthening due to speculation that the Federal Reserve might hike interest rates sometime this year.

Among all factors that tend to influence gold prices, none is as central as the U.S. monetary policy. Indeed, gold prices--- which climbed to a historic high of $1,920 an ounce back in September 2012 as the U.S. Congress bickered over the debt-ceiling issue and euro zone battled with its debt-crisis--- started to feel the heat after the Federal Reserve began talks of tapering its multi-billion dollar asset purchase program in 2013.

Following a slump in 2013, gold prices stabilized somewhat in 2014. Following a very subdued 2014, gold prices momentarily climbed to $1,300 an ounce on January 22--- a five-month-high level--- after the European Central Bank (ECB) announced its own quantitative easing program. But these gains were short-lived. Prices pulled-back sharply last week, falling to their lowest level since November 12, as attention shifted once again towards the Fed.

The concern is that after a strong jobs report for the month of February, the Fed would now feel inclined to hike rates sooner rather than later. While earlier there were expectations that the Fed would hike interest rates no sooner than 2016, market participants now fear it could be as early as mid-year.

Higher interest rates on bonds and Treasuries tend to dissuade investors from non-interest bearing assets such as gold. Gold benefited from near zero interest rates since December 2008 as the Fed set out an ultra-loose monetary policy in order to spur the economy following the financial crisis.

Of course, speculation of an interest rate hike in the U.S. has meant that global investors are now flocking to buy the greenback, taking the currency to its multi-year highs.

On March 10, the dollar index, a gauge on greenback's performance vis-à-vis a basket of rival currencies, rose to a new 12-year high. A stronger dollar will badly hurt the commodity market, especially gold. A stronger dollar makes commodities--- which are internationally priced in dollar--- more expensive for buyers who trade in domestic currencies.

Apart from a stronger dollar and U.S. monetary policy, there are other factors as well that have led to the current slump in gold prices.

In January, the ECB announced its monthly bond purchase program worth €60 billion, in order to spur the sagging euro zone economy. Ideally, an ultra-loose monetary policy should boost gold's inflation-hedge appeal. However, the speculation over the Fed's possible rate hike has offset investors' sentiment on gold. Moreover, the euro zone's economy is at a risk of falling under deflation. Key economic indicators such as consumer spending, prices and wages have been showing declining trend. In this backdrop, it is highly unlikely that investors will look at inflation-hedge.

In 2013, when gold prices slumped to below $1,200 an ounce level, a pickup in physical demand provided strong support to prices. Most of that physical demand came from China, which in that year took over India as the world's biggest consumer of physical gold. However, the demand from China, as well as India, may not arrive this time.

Over the years, China's huge appetite for metals, fuel and soft-commodities led to a boom in commodity markets, which also included gold. However, the demand for the precious metal has been waning lately as China's economy is slowing down. In 2014, China's GDP grew by 7.4%, the slowest pace of growth since 1990. And this year, the growth rate will be weaker as the economy is expected to grow by 7%.

In this backdrop, China's massive middle-class population is likely to spend less on luxury items and jewelry as disposable incomes are likely to decline. This is evident by dwindling gold imports.

According to data compiled by Bloomberg, mainland China's gold imports from Hong Kong dropped 32% to 750 tons in 2014 from 1,108.8 tons in 2013. And during the same period, China's total gold imports fell 38% to 813.6 tons, according to the World Gold Council.

Further, imports have also been hurt by an ongoing anti-graft drive in China, aimed at bringing down rampant corruption prevailing among government officials. According to the World Gold Council, purchase of luxury items, gold bars and coins have declined significantly due to a clampdown on corruption.

India overtook China as the world's biggest gold buyer in 2014, regaining the top position it wrested in 2013. In 2014, India imported 842.7 tons of gold. But imports were 14% lower compared to the previous year. Imports fell as buyers continued to feel the heat due to duties on gold. In order to curtail India's burgeoning trade deficit, India's former finance minister, PC Chidambaram had imposed 10% import duties on gold, back in 2013. Over the course of time, however, India's trade balance has contracted thanks mainly to cheaper oil imports. This was the reason why the jewelry industry was anticipating a cut in import duty ahead of the latest annual budget announcement. However, much to the dismay of the jewelry industry, the import duty on gold wasn't lifted, and this could keep a lid on imports ahead.

In December, I had noted that gold prices will have support at around $1,100 an ounce level as physical demand in Asia tends to pick up at this level as we saw in 2013. But the prevailing conditions in China and India, the two main markets for physical gold, coupled with a stronger dollar, means that physical demand might not pick-up as expected at the $1,100 an ounce level. It must also be noted that this is not the peak gold buying season in India. Indeed, I expect gold to lose the crucial support level in the current downturn.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.