Gold’s drop only an accident?

Gold reached a new record high at 1,900$/oz last week and then dropped by almost 200$ within three trading days. Many market commentators have identified the hike of margin requirements for gold futures as the cause for the abrupt u-turn of gold. However, we doubt that lifting margin requirements were the only reason triggering the plunge to 1,706$/oz.

From our point of view, the – at least temporary – recovery of stock markets also played a crucial role. The sentiment in stock markets changed as the Fed seminar in Jackson Hole, Wyoming, approached. Last year, Fed Chairman Bernanke presented the plan for QE2 and this year, there was speculation in the markets that he would now present the plan for QE3. Gold headed south as investors cautiously increased their risk appetite and stock markets traded higher. It is also striking that gold recovered on Thursday after the German DAX future plunged within a few minutes by 200 points or more than 4% without any obvious reason. This plunge dragged also US stock indices lower, which was supportive for gold.

In our quantitative models, the VIX volatility index has normally not a significant impact on gold. Only if the VIX is above a certain level, the impact of stock market moves on gold is increasing and gold is sought as a safe haven. While the VIX had been above this crucial level several times this month, the index ended last Friday far below the threshold level. Nevertheless, the VIX also serves at this lower level as a good indication for the risk aversion of investors. A further decline of the VIX would signal the investors reduce their risk aversion, which could have a negative impact on gold.

It is ridiculous to postulate that financial markets are rational as academic theory does. Expectations in financial markets concerning the Fed seminar in Jackson Hole provide the proof that sometimes expectations are irrational. From our point of view, it came as no surprise that Fed chairman Bernanke did not announce QE3. The recent FOMC meeting took place on August 9 when stock markets were already in turmoil on fears of a global recession. The Fed clearly underlined in the statement that the slow GDP growth is not only the result of temporary factors like the rise of energy prices following the unrest in the MENA region and the earthquake in Japan. The decision to keep the Fed Funds target rate at the current level for another two years found stronger opposition among the voting members. This already indicated it would be rather unlikely that Ben Bernanke would announce QE3 in a seminar speech.

However, the financial markets have overlooked another phrase in the statement. The Fed is monitoring the development closely and is ready to act when needed. This implies that QE3 is still an arrow in the quiver of the Fed. The speech given by Ben Bernanke was along the lines of the recent FOMC statement. The US stock market traded higher on the option that QE3 is still possible. The US Treasury market also traded higher, despite the 10yr T-Note future pared gains, as QE3 is less likely to be implemented at the next FOMC meeting. Gold rallied later in the US trading session also on expectations the Fed might ease monetary policy further. However, as traders headed home earlier due to the hurricane warnings in New York, a less liquid market might have contributed to the late rally on Friday.

All in all, we expect that a recovery of stock markets would reduce the appeal to invest in gold. This would indicate that gold might be in for a consolidation. However, the debt crisis in the eurozone is far from being solved. The decisions taken by the head of states at the July 21 summit have to be approved by national parliaments. German Chancellor Merkel is facing growing opposition in her own coalition parties and it is not a done deal that the German parliament will pass the bill. Also the question of Greece collateral for financial aid demanded by Finland could lead to a set-back. Therefore, even in the case that gold might consolidate, it appears to remain well supported.