GOLD – THE NEXT MOVE, a period of consolidation

As per expectation gold prices have rallied sharply over the last three months before cooling off by around 8-9% over the last few days. As I had written in September, gold had made a very strong technical move as it moved above the USD 970 per ounce level and my view was that this will lead to a rally upto 1200-1300 levels. This level of gold prices infact has got achieved much earlier than I expected.

The key now is to evaluate whether gold prices will continue to rally significantly or will they give much more subdued returns going forward. I believe the dynamics of gold price movement from here on will largely be dependant on the following factors –

– The pace of recovery in the US and other Western economies and a confidence among investors that we are not going into a double dip recession

-The extent of gold buying by central bankers and flow into gold ETF’s

– The increase in gold consumption in China, where the consumption has gone up as it has declined in most other large consumption sectors. Gold demand from traditional consumption centre’s like India, Middle East, US etc. is expected to remain subdued in the near term

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With increasing signs of an economic recovery in the US we have seen a sharp bounce back in the US Dollar over the last few weeks. The rise has been helped by the Greek and Dubai crises’s. The US Dollar Index has moved up from a level of 74 to 78. This has also created pressure on Gold prices. The Reserve Bank of India‘s decision to buy gold from IMF triggered a sharp up move in an already bullish market a couple of months ago. I believe that although in the long run many central bankers would like to increase their gold holdings as a part of overall reserves, in the near term given the price action where gold prices moved up from a level of USD 680 TO USD 1230 per ounce the pace of this up move will slow down significantly.

The US dollar after taking a sharp beating over the last 9 months is also likely to consolidate in a range over the next few months before continuing its downward journey. As such given the correlation of gold prices and USD movements gold prices are also likely to move sideways rather than move up. Even historically we have seen that gold prices tend to consolidate after sharp moves over a prolonged period of time.

The inflow into Gold ETF’s has largely followed the price movement of gold and was also prompted by the fear factor that gripped the markets last year and in the early part of the current year. As fear recedes there is an increased likelihood that these funds will see some redemptions or at the least slowing inflows.

China is the only major country where consumption of gold has moved up. Frankly the consumption pattern of this country is difficult to call. However the current price levels of gold is likely to have at least some impact on consumption. Given the fact that the drop in consumption in other major consuming centres is over 50% just Chinese consumption is unlikely to hold prices up.

Gold investing has also become much fancied among retail investors and a disproportionate share of money is going towards investment demand for gold. Unlike equity mutual funds where the rally has led to net redemptions over the last six months the corpus of gold funds has kept on increasing. One reason for this also is that gold has given positive returns even from the top of early 2008 whereas equity investors who invested at the top of the markets in end 2007 are still in losses. As such, from a behavioral pattern point of view also as gold prices languish or move down we are likely to see reduced investment demand.

As such on an overall basis I do not expect gold to give any significant returns to investors over the next six month to an year. Although I continue to be bullish on gold in the long run and would still give some allocation to gold mainly because the impact of the extreme monetary easing and huge fiscal stimulus’s on inflation is still unclear the near term price outlook seems to be capped.