Over the first quarter of the year, gold prices benefited primarily from unexpected weakness in the US economy. Abnormally cold winters dampened economic activity, causing 10-year yields to drop 33 basis points to 2.75 per cent, reducing the opportunity cost of holding gold. At the same time, the dollar lost around one per cent, further contributing to higher dollar-denominated gold prices.
Geopolitical events have also been positive for gold prices. The crisis in Ukraine caused investors to seek a safe-haven store of value in case the annexation of Crimea led to military conflict in the region.
For the second quarter of the year, despite a wide range of potential geopolitical risks, events in the US are expected to remain the most important determinant of international gold prices. As the US economic situation improves, gold prices are likely to fall. Were US interest rates to rise, the opportunity cost of holding gold would increase. With the potential for a stronger dollar, the need for an alternative safe-haven could also diminish.
On the positive side, Chinese gold consumption is expected to remain strong during the second quarter of the year. As Chinese authorities allow the price mechanism to play a more active role in resource allocation, the risks of corporate default, weak economic growth and a possible currency depreciation increase. In the first two months of the year, net imports of gold into China from Hong Kong rose to 195 tonnes, compared with only 80 tonnes in the same period in 2013, and any further concerns about the their economy could result in additional strength in Chinese demand for gold.
In the recent past, Indian demand for gold has fallen significantly, dampened first by the weakness of the economy and the rupee, and subsequently by the government's draconian efforts to curb the current account deficit by restricting imports of precious metals. According to Natixis figures, Indian gold imports dropped by 27 per cent in 2013 to 718 tonnes. In January and February 2014, Indian gold imports were only 40 tonnes.
As India goes to the polls to elect a new government, these negative factors are beginning to turn around. The rupee is close to a nine-month high at around 60 versus the dollar, lowering the rupee price of gold. A new government might usher in a period of stronger economic growth, which would be expected to boost Indian demand for gold. But these factors are unlikely to have a major impact unless the new government reduces the 10 per cent gold import tariffs.
For Indian investors, domestic developments are likely to have the most significant impact upon local gold prices in the near term. Any further strengthening of the rupee, particularly if accompanied by a post-election loosening of import tariffs, would reduce the local price of gold, potentially offering an attractive long-term entry point.
Mainly because of an improvement in the US economy, we expect the price of gold will continue to drop in the near term, averaging $1,250/oz in the second quarter (April to June) and $1,240/oz for the year as a whole. Over the medium term, dollar-denominated gold prices could be approaching a low point, as rising costs of production will soon begin to eat into the top end of the global supply curve. As the global economy recovers, however, any increase in gold prices is likely to be a slow process as higher interest rates, combined with a stronger dollar to reduce the appeal of holding gold.
Take a look at prices on May 15 and assume a five per cent move in either direction by May 29. Then, strangle with long puts and calls