Contagion risks put gold in acceleration mode

Last August in an interview with the Business Standard, I outlined why gold was very attractive at prices near Rs 2,500 a gram and its potential to rise 35 per cent (excluding customs duty) within five years. The market, however, has proved me to be a pessimist, with a stellar rally of 27 per cent in the first half of the current year. The GFMS team at Thomson Reuters expects this rally to continue (although likely with a correction first), with potential for gold prices to test Rs 3,320 by the end of 2016. This will be supported, in our view, by a rupee that is likely to have depreciated 2.5 per cent by this year-end.

Since the beginning of the year, there is one clear trend that has stood out - the long tenor bonds of Switzerland, Japan, Germany, Austria, Finland, France, and Belgium have been fetching negative yields. In other words, investors pay the government to hold their wealth. That said, in many cases it has been the central banks themselves that are printing money to purchase their own bonds rather than being driven higher by safe-haven buyers.

How long can this last? As long as the contagion risks do not get out of control. One such risk event that has just unfolded was the vote in the recent referendum, for the Britain to exit from the European Union (EU). There has been a flight to safety towards the US treasuries and gold since then. An interest rate hike this year by the US Federal Reserve is a low probability event.

Investor activity has been at its highest since early this year, dominated by demand from the western world. Globally, total gold ETF (exchange-traded fund) holdings are estimated to have crossed 2,000 tonnes as of the end of June, the highest level since September 2013.

Interestingly, the shift of bullion flows from East to West is getting more visible with increasing imports of gold into Zurich from some of the major consumption markets, which is then refined into good delivery bars and moved to allocated accounts of investors. The Asian physical markets subsequently showed mixed responses to the sharp rise in the gold price following the British referendum, with trades initially dominated by sell-side activity. Demand in the region has been subdued though there are reports that flows to China have picked up in recent days.

A recent report by the Commodity Futures Trading Commission showed that total managed net long position as of June 21 was 799 tonnes, the highest level since May 2007. This could have increased further last week following the surge in price, which was also almost certainly accelerated by short covering.

That said, there is a growing risk of profit-taking in the short term, with these liquidations potentially dragging prices lower. Additionally, there is an increasing chance that miners may look to lock in prices at current levels. However, with a growing consensus that this rally will be sustained, it is possible that any opportunistic hedging may be postponed until next year.

Given the current global economic backdrop, the prospect of further intervention to monetary policy by the US Federal Reserve this year is increasingly unlikely. As a result, this is likely to fuel increased demand for safe haven assets, with gold an obvious beneficiary.
The author is lead analyst - precious metals, South Asia and UAE, GFMS Thomson Reuters