Correction at the gold market appears to be looming

Gold might be heading towards a correction after rising for more than four weeks. The fundamental arguments for buying gold have not been convincing lately. With a slow-down of the US economic growth, there is no risk the economy would overheat and lead to inflation. As many economists even predict or fear a double-dip recession, the risk seems to be biased more towards deflation than inflation. However, gold is not a perfect hedge against deflation, contrary to the pretentions of many gold bugs. Hedge Funds and other asset managers were heavily invested in gold and are now looking for the bigger fool to sell their gold. One should always be very careful when fund managers appear on tv stations and praise an investment vehicle. This is often the best selling opportunity, not only in gold but also in US Treasuries.

Last Friday, gold started to react on the stronger US dollar, while the firmer US dollar against the euro had been ignored for about one week. The trigger was an interview of Bundesbank chief Weber with Bloomberg TV. He indicated that an exit from quantitative easing should not take place before the end of this year and might start as soon as Q1 2011, depending on the financial stability. This should not come as a surprise, even as Mr. Weber is considered to be a hawk within the ECB council. As long as the money market of the eurozone is not functioning and banks of some regions have no access to the interbank market, the ECB is unlikely to embark on exit strategies. In addition, the Euribor futures have not priced in that the 3mth Euribor would be above the ECB refinancing rate by December 2010. Thus, the renewed pressure on the euro versus the US dollar appears to be overdone; nevertheless, the impact on gold was negative.

Unlike gold, the other precious metals traded sideways in July and August. Recently, silver and the PGMs even declined while gold moved temporarily above 1230$/oz. Within the precious metals complex, gold got overvalued. If valuations get overstretched, traders will sooner or later start to sell gold and buy the other precious metals.

We have pointed out the unusual positive correlation between gold and the 10yr US T-Note future. Last Friday, this correlation was another negative factor for gold. Since the beginning of April, the price of the T-Note future gained more than 10 full percentage points. The yield on 10yr T-Notes has fallen by 1.5 percentage points to 2.5% and traded even below the level recorded after the collapse of Lehman Brothers in September 2008. Even with a CPI inflation rate of 1.2%, the real yield is unusually low and not in line with the US economic situation. The past week, the 10yr US T-Note future showed first signs that the rally is coming to an end. The market traded sideways after reaching a new high at the start of the week. In a week over week comparison, the market even closed slightly lower. A new high but lower close is regarded as a key reversal pattern by chart technicians. Also other technical indicators point to a potential reversal. The ADX in the daily chart reached the 60 mark and has declined already slightly. Readings above 50 are a harbinger that the trend is going to exhaust and to reverse soon. Also the MACD and the stochastics are close to trigger sell signals. A correction in the US Treasury market would then have probably also a negative impact on gold.

But not only the intermarket relationships of gold turn negative, also the gold chart sends warning signals that the rally might come to an end. The candlestick pattern of a hanging man has emerged last Friday. This pattern has a high probability to indicate a trend reversal. The ADX is declining, which points to a weakening of the trend strength. In this environment, more emphasis should be put on oscillators like the stochastics instead of trend following indicators. The two lines of the stochastic have already crossed in the overbought zone. However, to trigger a sell signal, a return back into the neutral zone is required.

All in all, the odds are increasing that the rally in the gold market is coming to an end and that a reversal might be around the corner. However, before selling gold short, the technical indicators should provide more confirmation for a reversal.  

The tail wagging the dog and metal prices fall thereafter

The correction in precious metals prices might be approaching its end, because in the previous week panic has engulfed the financial markets and this is often a sign of a speedy turnaround. The trigger for this panic is the development of credit default swaps (CDS) with which investors can hedge against a possible insolvency of an issuer. The 5yr CDS rate for Greek government bonds climbed in the previous week, according to data from Markit to 425.18 bp, which is 20.84 bp higher than the level of the previous week and this, although, the EU imposed tight controlling measures on the budget of the Hellenic Republic, to reduce the deficit in relation to GDP and to push it back under the limit of 3% by 2012. Also the CDS rates on government bonds have increased significantly in Spain and Portugal, after Portugal at an auction, has not accepted the buyer demands and reduced the volume of emissions below the level intended originally.

Rising CDS rates on government bonds are supposed to be positive for precious metals as a safe haven, because they reflect that the financial markets priced in a higher probability of failure of a sovereign debtor. But things are not so simple, unfortunately. The yield spreads between government bonds of different countries in the euro zone and German Bunds as a benchmark are based on the development of CDS rates. If the CDS rates for Greece, Spain and Portugal desend, it also widens the corresponding yield spread over Bunds. This relationship is now providing for hedge funds and proprietary trading desks of investment banks, a very attractive playground. The market for CDS is in fact much narrower and less liquid than that for government bonds. Hedge funds can therefore already pushing CDS rates upwards with a low risk. At the same time they sell their bonds, so for example, from Greece, and buy in return German Bunds with approximately the same maturity. Rising CDS rates can therefore lead other investors to the assessment that the affected country really is heading for bankruptcy. These investors will be compelled either to sell their holdings in these bonds, or secure the holdings by buying CDS. They will, however, reinforce moves in the CDS induced by hedge funds, which in turn has an impact on the yield spread. The tail wags so successfully with the dog.



On the foreign exchange markets, the interest rate difference plays a major role. For the exchange rate of the euro against the U.S. Dollar, this is at the short end of the term curve, the difference between the 3M or 12M USD Libor and the Euribor. At the long end of the curve, the foreign exchange market has so far mostly focused on the yield spread between the 10yr U.S. Treasury and the 10yr German Bunds. With the outbreak of the crisis over the deficit in the Greek state budget late last year, this is pushed into the background and focus on the foreign exchange market is also directed to the CDS rates. Quite a few foreign exchange strategist and professor of Doom, Nouriel Roubini, predicted an end to the euro. With rising CDS rates for Greece, Spain and Portugal, the euro exchange rate against the U.S. dollar got more and more under pressure. Since the high of 1.514 at the beginning of December 2009, the euro has fallen by over 10% until 1.358 against the U.S. dollar.

Rising CDS rates for southern European countries in the euro area not only lead to an exodus of investors from the euro, but because of the stronger U.S. dollar also out of gold. But as pointed out above, a market panic indicates often that a movement is nearing an end. The technical picture of EUR/USD and gold indicates that the sell-off could be petering out. The recommendation might be, then, buyer beware, because unlike in the opera and theatre, there will not be a bell ringing for the entry.