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.