Gold’s false break-out not necessarily a positive indication

Until last Friday, it looked like most precious metals would trade sideways for the second week in a row. But the wave of physical buying, which set in after the plunge in mid-April, appeared to peter out as reports of some bullion trading houses indicated. At the same time, large speculators continued to sell gold. On the one hand, they reduced gold futures holdings and increased short positions according to the recent CFTC report on the “Commitment of Traders”. The net long position declined further by 7,629 to 89,423 contracts. The SPDR Gold Trust ETF recorded on Thursday the first increase in gold holdings since March 19. However, it was only the one swallow, which does not make a summer. Therefore, the question appeared to be only when and not if precious metals would break out to the downside.

Last Friday, then the unavoidable appeared to happen. Gold and silver traded below the low of the preceding week. Normally, one would expect technical oriented selling to set in and thus, driving prices further down. In addition, on a break-out day one would expect the close to be near the lowest price of the day. However, at the time of the London PM fixing, the spot market turned around and gold as well as silver pared most of the losses. Both metals closed again inside the sideways trading range, which prevailed until Thursday. Thus, the break-out would be characterized as a false one by chart analysts.

In technical analysis, one of the rules is that a false break-out often leads to a strong move in the opposite direction. However, we have some doubts for several reasons that the trading pattern of last Friday sets the stage for another strong move upwards and that gold as well as silver would complete a flag formation. The first reason is that some quantitative technical indicators indicate the two precious metals are overbought. Especially the stochastics indicator returned back into the neutral zone, which is often a good indication for further weakness to follow. In addition, the difference between the MACD and its signal line narrows, which is also a harbinger that gold and silver might head further down.

The second reason is of course the fundamental factor which led to the break-out of gold and silver. Crude oil was on balance positive for the price development of gold and silver, but showed a similar trading pattern last Friday because it reacted on the same factor, which also pulled the precious metals lower. Also the stock market was positive for the precious metals, but gold and silver have decoupled from the co-movement with the S&P 500 index since November last year. We pointed out several times, that the reason for this decoupling is the change in Japanese policy following the election of a new government. Prime Minister Abe is determined to end the period of deflation and to reach a CPI inflation rate of 2% within a time frame of two years. Also the Bank of Japan has changed its course and got more expansionary. The BoJ embarked on another round of quantitative easing too.

This leads directly to the argument that quantitative easing would be positive for gold and other precious metals. If QE were a necessary condition for a rally in gold, then the program of the BoJ to extend its balance sheet would have to be also positive for gold. Especially, as the BoJ targets a higher CPI inflation rate. There should be no difference whether QE is followed by the Federal Reserve in the US, the Bank of England or the Bank of Japan or any other major central bank. Also the argument that the discussion within the FOMC about the timing of scaling down or even stopping the bond buying program would be the major reason for the decline of gold and silver prices since last November is not convincing. First, this discussion had been made public after gold already traded lower. Second, the Fed policy remains accommodative until 2015.

Therefore, QE is per se not a necessary condition for a bull market in gold and silver. However, this does not imply that QE would not matter at all. Quite the opposite! However, it is the impact of QE on foreign exchange rates, which matters for the precious metals.  This also explains why quantitative easing measures of the Fed have the opposite impact than bond buying by the BoJ. The expansionary monetary policy of the Fed is having a negative impact on the US dollar exchange rate (if not compensated by other factors like the eurozone debt crisis), while balance sheet expansion of the BoJ weakens the yen against the US dollar and other currencies. A stronger US dollar is usually a negative factor for precious metals or other commodity prices.

The trigger for the false break-out of gold and silver was the movement of USD/JPY. Ahead of the G7 finance minister meeting in London on Friday, USD/JPY surpassed the 100 mark on late Thursday afternoon (GMT) and the Yen weakened further in Asian and European trading on Friday to 102 against the US dollar. The QE measures of the BoJ are likely to contribute to further yen weakness. Therefore, we remain sceptical that the false break-out of gold and silver would set the stage for a strong upward move.