A False Break-out of Gold

The break-out of gold above the resistance at 1,355$/oz turned out to be just a false break-out. Gold did not only fall back below this resistance level, but also finished the week below the close of two weeks ago. Normally, technical analysts expect a stronger move in the opposite direction after a false break-out. In the case of gold, this would imply further weakness. However, in the short run, gold might be torn between geo-political developments and negative medium-term economic fundamental factors.

The rise of gold above the resistance at around 1,355$/oz, corresponding to the high made in October last year, was driven mainly by geo-political developments. Financial and commodity markets feared that the referendum held at the Crimea peninsula about whether to become an independent republic or to join the Russian Federation would lead to increased political and military tensions. However, after votes were counted, financial markets already in Asian trading shrugged off the result of a vast majority for joining Russia. Many analysts predicted that this result would lead to further turmoil in financial markets, with gold being a beneficiary due to its safe haven status. However, traders acted according the old market adage to buy the rumor and to sell the fact. Also the statement of Russian president Putin, which he made on Tuesday, that the rest of the Ukraine should remain intact and that Russia would not be interested in other territory than the Crimea contributed to further selling of gold as well as other precious metals and recovery of stock markets.

But does this imply that the political tensions would subside? While one would hope that they ease indeed, unfortunately the risk remains that they might flare up again. The USA and the EU reacted with sanctions, which were partly retaliated by Russia. There are more and more demonstrations in the Eastern part of the Ukraine also demanding a referendum about joining Russia. Transnistria is another autonomous region in Moldova and along the border to Ukraine, which has a Russian majority of its population. NATO now fears that tensions in this region would lead to another military intervention by Russia. Also demands by some politicians to deploy more NATO troops in member states being neighbors of Russia would increase the tensions. Thus, it could not be ruled out that any escalation of geo-political tensions in the Black Sea region lead to a renewed flight into the safe haven of gold and other precious metals.

The second factor, which drove gold lower last week was the first press conference of the new Fed chair, Mrs. Yellen. The FOMC kept the Fed Funds target rate unchanged at 0.25% or less and also continued to reduce the volume of monthly bond purchases by a total of $10bn. This had been widely expected. However, the markets were surprised by a half-sentence of Mrs. Yellen during the press conference that the first hike of the Fed Funds target rate might occur about 6 months after the termination of the bond buying program, which is also known as QE3. Stock and bond markets sold off and the US dollar firmed against the major currencies, which then also send precious metals lower.

But this market reaction on a so-called “surprising statement” demonstrates again that the academic theory about efficient and rational financial markets is flawed. Even under Fed chairman Bernanke, the FOMC told for more than one year that the first rate hike is expected to take place in the middle of 2015. So far, the FOMC has reduced the volume of bond purchases by $5bn for the US Treasury paper and mortgage bonds respectively at each FOMC meeting starting in December. This decision became effective with the start of the month following the meeting. Thus, for the month of April, the volume of Treasury purchases has been reduced from $35bn to $30bn and of mortgage bond purchases to $25bn. If the FOMC keeps that pace of cutting the buying volume, which appears to be a plausible assumption given the current FOMC projections for US economic growth, inflation and unemployment development, then there would remain six more FOMC meetings until the purchases of US Treasury paper will be terminated. Given the calendar of FOMC meetings in 2014, this implies that the final cut of US Treasury buying will be made at the December FOMC meeting. And six months later will be well in the middle of 2015, which is exactly what the FOMC indicated for quite some time as the most likely time for the first rate hike.

Furthermore, starting to hike the Fed Funds target rate in the middle of next year does not imply that the FOMC would then embark on an aggressive restrictive monetary policy. The majority of the FOMC members still expect that the Fed Funds rate would be at 1.0% or lower by the end of 2015. Given the projection of the core PCE inflation, this would still imply that the real Fed Funds target rate is negative between -0.7 and -1.0%. However, this could hardly be called a tightening. As long as the nominal Fed Funds target rate remains below the core PCE inflation rate, the monetary policy of the Fed is accommodative. This should be supportive for stock markets. While the short-term interest rate could remain at the current level for some time, the forward rates would have to price in rate hikes in 2015 and beyond. The close the first rate hike gets, the more it will have an impact on money market rates and on yields of US Treasury notes. Thus, opportunity costs of holding gold are poised to rise and this will have eventually a negative impact on gold.

Therefore, the medium-term outlook for the major fundamental factors of the gold price indicates that gold is likely to weaken. However, gold has profited so far this year from an increased uncertainty about the development of stock markets and geo-political tensions. This uncertainty could even lead to a new rise of gold towards 1,400$/oz or even above. But once the uncertainty subsides and investors have again stronger convictions about the outlook for other asset returns, then flows out of the safe haven could send gold to new lows.