High global uncertainty demands some holding in gold

Posted On Monday, Jul 27, 2015

Gold prices fell sharply recently, hitting a five-year low. Gold’s losses were intensified by frantic selling in China (one of the world’s biggest gold consumers) 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 Eurozone`s terms. However, gold has not reacted much to this event as a bailout was expected as an eventual and that did happen. Although the structural problem has not been resolved, the situation in Greece will only deteriorate with the possibility of Greece exit becoming a reality. In that event, we may 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 may 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 that 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 US Fed may not want to run risk of a 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 that 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 may 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 slack season, and the demand for gold may pick up from the upcoming festive season. Moreover, the demand for gold or the price of gold will also be impacted because of the monsoons. Rural spending on most items - from television sets to gold - goes up or down depending on the monsoon as rains are crucial for the kharif crop. Nearly 60 per cent of 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 that the main reason to own gold is just the sheer fact that it is a portfolio diversification tool and thereby helping you to reduce overall portfolio risk.

This article was published in Business Standard.

Data Source: Bloomberg, World Gold Council

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