Gold About To Break Out Toward $2,000

Includes: GLD
by: Convex Strategies

As a result of the recent barrage of aggressive central banking action, October gold futures are not only making new 2012 highs, but are also approaching a key technical level:

Click to enlarge images.

While not a technical top, the $1,790-$1,800 region has acted as an area of strong resistance since November. After bottoming around $1,530, gold moved in a sideways pattern in which a series of higher lows were made before the commodity broke out above $1,600 on QE3 speculation. Over the past three weeks, gold has been in another consolidation pattern between $1,760 and $1,780.

Fundamentally, gold has a lot of catalysts to send it well above the year-to-date highs.


While not a unique position, some investment theses are simpler than others. By now, the mechanics of QE3 are well understood. $40 billion in monthly liquidity will be pumped into the U.S. financial system until the employment picture improves markedly; this language has major significance for the price of gold.

Unlike Operation Twist, QE3 will be a "flow" program. Flow programs add incremental liquidity to the system, whereas OT merely altered the stock of the Fed's balance sheet by shifting the duration of the securities. Expansion of the Fed's balance sheet has a directly positive effect on M2, and, in theory, should lower interest rates even further and light a fire under assets that are beneficiaries of inflation.

Though gold already made a swift move from $1,600 to the recent year-to-date highs of $1,780, the key here is the open-endedness of the operation. Annually, at least $480 billion in liquidity will used to purchase MBS; this compares to a total of $600 billion in QE2. Gold prices will continue to trend upward over time in order to reflect the expansion of the balance sheet.

Clearly, the Fed's LSAP programs have not caused the hyperinflation that many have predicted. A definite argument can be made that the commodities complex has been the beneficiary of speculative funds, but the overall effect on real consumer prices has been decidedly muted; private sector deleveraging has made sure of that. However, forward inflation expectations are far more relevant to gold prices than trailing CPI figures, and the Fed's language indicates that inflation is going to be of much less concern going forward than unemployment.

The key takeaway here is that as real interest rates remain negative, gold prices will have a major tailwind as, one, the opportunity cost of holding gold is limited and, two, perceived inflationary risks are elevated.

Safe Haven

In regard to the safe haven debate, gold's actual price action has been inconsistent. In the midst of 2011's debt ceiling debate and downgrade, nervous investors flocked to gold en masse, driving it into a short-term bubble.

In 2012's European flareup, gold was treated as a risk asset and was sold along with equities. This took many by surprise, and speculation grew that the bull market in gold was over.

The difference: the price action prior to the macro event. When gold is acting well, major macro events tend to draw investors into gold in a flight to safety. As illustrated in the above chart, gold made a very strong run in the beginning of 2011, and economic concerns exacerbated demand for perceived "riskless" assets. Of major significance is the fact that gold rallied in the face of a major USD and UST rally.

Despite a strong start to 2012, gold prices stalled out at the end of March. Gold traders are funny; when prices are acting well, gold is a safe haven. When they're not, gold is treated as a risk asset and falls prey to the risk on/risk off dynamic.

With Europe seemingly "fixed" as a result of the potential for ECB bond buying and a full-scale Spanish bailout, it appears that we are at the "champagne party" segment of the Einhorn cycle:

If and when European worries begin to permeate the market again, gold is highly likely to act as a safe haven for two main reasons:

  1. Given the shockingly aggressive developments in central banking policy, any economic turmoil will be perceived by the market as a catalyst for more action. Further easing is an obvious plus for gold prices.
  2. Since gold is already performing well, it will likely be perceived as a hedge against tail risk during a major macro event.

Extended Slow Growth Environment

On a longer-term basis, the Fed's clarity regarding ultra-low rates until 2015 further enhances the bull case for gold. As previously mentioned, low rates reduce the opportunity cost of holding gold and also convey to the market a period of weak economic growth.

When growth expectations are mediocre, productive assets like equities and risky sovereign bonds become far less attractive relative to gold. Additionally, painfully slow growth keeps expectations for inflationary measures prevalent in the marketplace.

Conclusion: Gold Toward $2,000, But With One Warning

Gold is in a sweet spot right now. If equities continue to rally, they will have done so on the back of open-ended liquidity injections in the midst of a sub 2% GDP economy. The combination of several hundred billion in additions to the Fed balance sheet, the prospect of open-ended sovereign bond buying on behalf of the ECB, further easing from the PBOC, and low-economic growth is exceptionally bullish for gold.

If equities roll over the next few quarters, the catalyst will likely have been a poor earnings season, a flareup in the euro debt crisis, an unexpectedly rapid downturn in China, or a combination of all three. These three factors all have the following result: hopes for extended easing policies, and a move away from growth assets into safe havens. As a result, I recommend an investment in either December gold futures or the Gold ETF (NYSEARCA:GLD).

These dynamics, along with gold's technicals, make a strong case for a breakout in gold with the next target being $2,000/oz. That being said, investors in gold should always keep their emotions in check and steer clear of the doomsday thesis. Gold's fundamentals changed when QE3 was announced, and they will continue to change with the policy and economic landscape. Adapting to these changes and applying them to your investment thesis in gold is a necessity.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. A joint account I co-manage owns December gold futures. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.