Tired of all the trite mean­ing­less pro­pa­ganda from Eco­nomic PhDs who crawl out of the wood­work every time there is a downtick in gold, pro­claim­ing in big bold let­ters that the Gold "bub­ble" has burst, only to crawl right back in when gold soars $100/oz in the days fol­low­ing their lat­est ter­mi­nally wrong procla­ma­tion? Or, alter­an­tively, won­der­ing what will hap­pen to gold from this point on? Then the fol­low­ing report from Nomura is for you. As Saeed Amen ana­lyzes: "In this arti­cle we explain why the price of gold has fallen in recent weeks. Notably, price action dur­ing Asian hours has become very bear­ish, which had not been the case in pre­vi­ous unwinds ear­lier in the year. In addi­tion, it is likely that losses in risky assets such as equi­ties helped pre­cip­i­tate unwind­ing of very heav­ily extended long gold posi­tions. How­ever, the key rea­sons for being bull­ish gold remain; namely, a very low inter­est rate envi­ron­ment and the poten­tial for long-term demand from Asia. Also, the poten­tial for gold’s sta­tus as a safe-haven hedge to tail risks aris­ing from var­i­ous uncer­tain­ties due to the Euro­pean debt cri­sis is likely to be enhanced, espe­cially now that short-term spec­u­la­tive posi­tion­ing is rel­a­tively light. Also on a short-term basis, we have begun to see some rever­sal in gold  back upwards dur­ing Asian hours, after the unwind." Over­all, infor­ma­tive but noth­ing new to reg­u­lar read­ers: gold liq­ui­da­tions on mar­ket plunge (con­firm­ing iron­i­cally that gold is now among the most liq­uid types of invest­ments in the mar­ket) as had been pre­dicted months ago, and the same long-term fun­da­men­tals for the metal once the cur­rent stock down­turn shakes out all the weak hands.

Full note:

Why Did Gold Go Down:

Intro­duc­tion

In recent weeks the gold price has fallen sig­nif­i­cantly from around $1900 to $1535 (intra­day). Gold is now trad­ing near our Q3 tar­get of $1650. The size of the move was far more sig­nif­i­cant com­pared to other recent unwinds, like those in May or August. One of the key fac­tors for our long-term bull­ish view on gold is Asian demand. As dis­cussed in FX Insights – Gold, gold, 6 July 2011, the major­ity of end-user demand for gold is from Asia. From an Asian val­u­a­tion per­spec­tive, gold is also rel­a­tively cheap (

Gold has not been sup­ported dur­ing Asian hours

One way to proxy Asian demand for gold is to look at how gold per­forms dur­ing Asian trade. Over the past few years, gold has gen­er­ally appre­ci­ated dur­ing Asian hours, reflect­ing strong demand for the metal. How­ever, recent weeks have shown weak­ness in Asian hours (Fig­ure 1). On pre­vi­ous occa­sions when gold traded poorly, such as in May and August, it remained rel­a­tively robust dur­ing Asian hours, with any sell-off tend­ing to come in Lon­don and New York hours, sug­gest­ing that Asian investors were sup­port­ing an unwind of West­ern investors’ long gold positions.

This con­trasts with the recent fall, which has been notice­able across mul­ti­ple time zones. In the very short term, we believe a rever­sal would need to be led by appre­ci­a­tion in Asia. Although a few data points do not con­sti­tute a trend, on Tues­day and Thurs­day gold rose by 2%, its largest moves higher dur­ing Asian hours since Octo­ber 2008 and per­haps a sig­nal that it could be turn­ing back up.

Gold has declined more than would be sug­gested by moves in rates

The last FOMC meet­ing did not expand the Fed’s bal­ance sheet (i.e. QE3), which would have been bull­ish for gold (see Give Gold Some Credit, 19 August 2011 for some dis­cus­sion about the rela­tion­ship between QE and gold). How­ever, the Fed has com­mit­ted to keep­ing rates low until mid-2013, as well as embark­ing on Oper­a­tion Twist, which should be gold-supportive. Indeed, in Fig­ure 2 we plot inverted real rates against gold and find that the price action has been detached in recent weeks. This sug­gests that it is dif­fi­cult to attribute the fall in gold purely to the lack of QE3.

Gold sold off at the same time as equities

Although gold can trade like a tail-risk hedge, it often trades like a risky asset. This has been evi­dent in recent weeks where we have seen a strong pos­i­tive cor­re­la­tion between gold and the S&P500 (Fig­ure 3), which we use as a proxy for risky assets. The ratio­nale is that heavy losses in risky assets forces investors to unwind other posi­tions to free up cash. As a liq­uid asset and also with heav­ily extended net long spec­u­la­tive posi­tion­ing head­ing into this episode, gold has suf­fered (Fig­ure 4).

Spec­u­la­tive posi­tion­ing is lighter in gold – back to tail-risk hedge?

How­ever, with posi­tion­ing now at rel­a­tively low lev­els, it is likely that gold will trade more in line with the fun­da­men­tal fac­tors we have dis­cussed, namely low real rates and the poten­tial for con­tin­ued Asian demand, which are broadly pos­i­tive. The lack of posi­tion­ing could also enhance gold’s sta­tus as a tail-risk hedge in the con­tin­ued uncer­tainty around the Euro­pean debt situation.

Tail risks in Europe

Devel­op­ments in Europe have become the main mar­ket dri­ver recently. In recent pub­li­ca­tions we have analysed both our base case, which involves no Greek default and the tail risk of a Greek default (see EURUSD: Our Cen­tral Case, 5 Sep­tem­ber 2011 and EUR/USD – The Greek tail risk, 7 Sep­tem­ber 2011). In short, we think that both our cen­tral case and the tail-risk sce­nario are likely to be neg­a­tive for risk sentiment.

Even if Greece con­tin­ues to meet its oblig­a­tions and avoids a dis­or­derly out­come, there are seri­ous doubts regard­ing the EFSF’s capac­ity to inter­vene cred­i­bly in the sov­er­eign debt mar­kets of Italy and Spain once it takes over this role from the ECB with­out sig­nif­i­cant lever­age (for a dis­cus­sion on how this may be achieved see EFSF 2.0, 3.0 and beyond, 30 Sep­tem­ber 2011). Despite  the bar­rage of pol­i­cy­maker meet­ings next week and the fact that the var­i­ous options regard­ing EFSF lever­age are on the agenda, we do not expect any deci­sions to be made any time soon (see also G10 FX Insights — The Miss­ing Bazooka, 30 Sep­tem­ber 2011). Until we have bet­ter vis­i­bil­ity on this issue, how­ever, we believe mar­kets are likely to exert renewed pres­sure on Italy and Spain as we approach the takeover date. Fur­ther­more, the Greek saga con­tin­ues with Troika inspec­tors’ delayed return to Athens caus­ing fur­ther delay in the dis­burse­ment of the sixth instal­ment, EFSF 2.0 rat­i­fi­ca­tion pend­ing in many EMU coun­tries and var­i­ous head­lines regard­ing the pos­si­bil­ity of a change in the terms of the 21 July agreement.

The bot­tom line is that both our cen­tral case and Greek tail risk are likely to cause a new round of risk aver­sion in global mar­kets in the next few weeks and exert fur­ther down­side pres­sure on EUR. We have been trad­ing EUR/USD from the short side since 25 August (see Sell EUR/USD spot) and have recently restruc­tured our shorts (see Posi­tion­ing for the euro break, 22 Sep­tem­ber 2011).

Bar the unlikely event of a major break­through by Euro­pean pol­i­cy­mak­ers in the next few weeks, we expect gold to ben­e­fit from a new bout of risk aver­sion as the mar­ket re-assesses yet again the chances of a new sys­temic cri­sis. This point is fur­ther enhanced by not­ing that the cor­re­la­tion between gold and EUR/USD has turned neg­a­tive recently. A sim­i­lar, albeit greater, cor­re­la­tion shift occurred dur­ing the first phase of the Greece cri­sis in May 2010 (Fig­ure 3). This lends fur­ther sup­port to the idea that gold tends to func­tion as a safe-haven hedge in cases of Euro­pean risk events that have a sys­temic impact.

Con­clu­sion

We have seen that gold’s recent fall has been accom­pa­nied by heavy dep­re­ca­tion in Asian hours. This con­trasts with rel­a­tively robust Asian price action dur­ing ear­lier peri­ods of gold weak­ness in May and August. We think that a rever­sal of this trend back to gold appre­ci­a­tion in Asian hours is the key to a short term rever­sal and we have begun to see this in recent days. We also find that the cor­re­la­tion between risky assets and gold has been higher than usual in recent weeks. Hence, we sug­gest that heav­ily extended spec­u­la­tive net long gold posi­tions have unwound to free up cash for other losses in risky assets, like equi­ties. With short-term spec­u­la­tive posi­tion­ing net longs at rel­a­tively low lev­els, it is likely that fun­da­men­tals, as opposed to posi­tion­ing, are likely to drive the price of gold again.

We con­tinue to view long-term fun­da­men­tals, such as low real rates and the rel­a­tive cheap­ness of gold when viewed from an Asian per­spec­tive, as bull­ish for gold. At the same time, gold’s attrac­tive­ness as a tail-risk hedge against the con­tin­ued uncer­tainty in Europe is likely to be another fac­tor that should sup­port the price of gold in the short term.

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