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Gold spot price to retain lustre through 2014? CIBC asks the question

US real rates vs bullion

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iNVEZZ.com, Tuesday 3 December:

Although 2013 is shaping as the year in which the gold spot price posted its first calendar year drop since 2001, market players are likely to remember primarily how the price slipped below its two-year support back in April. The precious metal plunged by more than $200 per troy ounce, some 12 percent, in a cascading two-day sell-off that started on 12 April.

And whilst the reasons for this dive may be debated for years, “the root cause can be traced back to shifting investor expectations for rising interest rates (vis-à-vis Fed tapering), a stronger US dollar, and persistent low inflation”, opines Alec Kodatsky, a mining analyst at the Canadian Imperial Bank of Commerce (CIBC). Simply put, bullion’s sell-off was amplified by profit-taking in gold ETFs, which swiftly pushed a hefty supply onto an unenthusiastic market.

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However, Kodatsky sees light in the tunnel for gold bulls in 2014 because he believes that “a significant amount of ‘bad news’ has already been factored into the price”. CIBC is currently predicting an average 2014 gold price of $1350 per troy ounce, despite the entrenched headwinds for precious metals.

“Should inflationary pressures begin to emerge, or ‘safe haven’ buying of US treasuries once again pushes yields lower, we see upside potential for gold”, writes Kodatsky. “Long-term [CIBC] remain constructive on gold as deteriorating reserve bases, rising production costs and continued physical demand present a positive fundamental dynamic for prices.”

What’s really driving gold?

The spot price of gold is typically assumed to have a strong negative correlation with US real rates – the difference between interest rates and inflation – so buttressing the view of gold as an inflationary hedge. The traditional view is that high real rates lead to lower gold prices because those yields lead to a diminished appeal for non-yield investment products like precious metals.

Notably though, the World Gold Council highlighted in its Q2 analysis this year that “the influence of the US real rate on gold has receded over the last couple of decades,” as inflation and physical demand in emerging markets take on greater importance.

The chart above illustrates the relationship between the spot price of gold and US real rates since onset of the global financial crisis. US real rates are calculated by CIBC as the difference between 10-year T-bond yields and US CPI. Thus, the Canadian investment bank suggests that “if you have a view on US 10-year rates and US inflation, you can formulate a view on gold prices”.

Except in periods of financial instability, like in 2009, bullion tends “to struggle in a rising real rate environment, but can gain positive traction when real rates stabilize or decline”, according to CIBC’s Kodatsky. For US real rates to continue climbing higher and gold to sustain its downtrend, the analyst believes yields have to rise and/or inflation needs to ease further.

The dilemma is the “limited scope for a material rise in 10-year yields”, as the Fed’s tapering-is-not-tightening message and an arrested fall in US inflation keep borrowing costs low for an extended period of time.

The CIBC analysis concludes with the warning that “downside risks remain should US yields rise more aggressively than expected or US dollar strength emerges”.

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