Global uncertainty demands some holding in gold

Gold prices fell sharply recently, hitting a five-year low. Losses were intensified by frantic selling in China (one of the world's biggest consumers of the yellow metal) amidst low liquidity. The sell-off was sparked by a report from China's central bank on its gold holdings. This was just after the Greece delivered a landslide 'No' vote to the euro zone's terms. However, gold has not reacted much to this event, as a bailout was expected eventually and that did happen. Though, the structural problem has not been resolved and the situation in Greece will deteriorate with the possibility of Greece exit becoming a reality. We might see panic in asset markets and bids under gold, as markets would suddenly become risk-averse.

From a fundamental perspective, movements in gold prices will largely depend on the US' interest rate decision. The markets will continue to oscillate in a range unless the view for US rates becomes clearer. The major development for gold over the coming months is likely to be the formation of a broader market consensus on the Fed's timing of rate increases. If we do not see a major shock in economic numbers, it's likely that interest rates will be raised by the end of this year and markets seem to be pricing that scenario as of now. Fed would likely raise rates by 0.25 per cent. The token rate increase may be to preserve their credibility after all. If they don't hike rates the markets will completely lose face with them but below the surface the Fed knows the economy is not in a good shape and, hence, may hold rates there.

As we approach the rate hike, there could be panic selling in gold on the prospects of further hikes and talks of real rates moving higher. After the initial rate normalisation jitters, the environment will likely be far more positive for gold. It is thereafter markets would shift focus from timing the rate hike to the likely nature and extent of rate hikes. The Fed might not want to run the risk of too divergent monetary policy than its global counterparts, as that would lead to a significant further appreciation in the dollar. Even the current dollar strength seems to be hurting the US economy rather than helping it. Also, the Fed has been openly saying the rate hike would be gradual, so it's no point shooting in the dark and expecting an aggressive tightening cycle. We reiterate our view that as the market figures out that Fed will stay behind the curve and do only little and keep real rates negative for much longer, gold should start moving northwards.

Until a clearer picture emerges, gold prices will likely continue its correction/consolidation phase. Cost of production and demand from traditional consuming centres will act as a support for prices, limiting the downside risks.

On the domestic front, we are already at the end of a slack season. Demand for gold might pick up from the coming festive season. Moreover, the demand or price of gold will also be impacted because of the monsoons. Rural spending on most items - from televisions to gold - goes up or down depending on the monsoon, crucial for kharif crop. Nearly 60 per cent of the total gold demand in India comes from rural areas.

To conclude, as global uncertainty remains high, gold remains an important asset to hold in such turbulent times when perceived risks can suddenly change. I reiterate the main reason to own gold is the sheer fact that it is a portfolio diversification tool, helping you to reduce overall risk.

The author is senior fund manager - alternative investments, Quantum AMC