No one knows where the incorrigible gold bulls who until recently had been screaming about the imminent breach of $2,000 an ounce mark are hiding, but currently many market participants are increasingly coming around to the view that the yellow metal may be readying for a major downward correction.

Three principal factors – central bank purchases from time to time, physical demand from major consumers such as India, and the prospect of further quantitative easing in the US – have been driving gold prices for nearly two years now. Of these, the first two factors have weakened. Since the beginning of this year, central bank purchases and physical demand from emerging markets have dropped considerably.

No wonder, in recent months prices have been hovering around $ 1,600/oz, having fallen from over $ 1,900/oz and struggling to find traction without the support of physical demand. The strength of the US dollar too has contributed to gold’s weakness. Despite geopolitical uncertainties and general macroeconomic weakness, the safe haven status of gold is under challenge because of a strong dollar which itself has become a safe haven.

So, gold market participants with long positions are currently left with nothing to look forward to except the QE3. A third round of quantitative easing would be strongly supportive for precious metals prices as it would weaken the US dollar and undermine its current status as a safe haven asset of choice. It is a matter of conjecture whether QE3 will materialise. On current reckoning, many are sceptical about QE3 because there are no signs of the economy deteriorating despite unflattering macro economic data in the US. Obviously the Fed will look for strong justification before taking any precipitate corrective action.

In sum, the gold market fundamentals are bearish and the forex outlook is bearish. Investor interest is tepid but macroeconomic conditions are bullish. It is under these circumstances that many analysts are revising their gold price forecast for next year sharply down. London-based Natixis Commodity Markets is a case in point. In its third quarter review, the consultancy says the economic outlook for 2013 appears more optimistic because of an anticipated US recovery and concrete European solution to its internal economic woes. Gold prices could be put at significant risk if Chinese growth tempted investors to abandon the metal in favour of more productive investments.

In the event, average cash price of gold will drop to $1,225/oz in 2013 compared with the projected $1,550/oz for 2012.

However, gold prices are most unlikely to be on a one-way street. There are alternative scenarios. If the US fiscal crisis were to worsen and a further QE becomes a reality, then it will have the effect of translating any European default or secession from euro into a potential resurgence in European demand for the metal. Another scenario relates to geopolitical instabilities, especially in West Asia that can reinforce gold’s safe haven status and potentially lift the metal’s prices higher.

However, the more likely scenario is for the physical demand to deteriorate further with poor Indian monsoon and the US dollar to stay relatively firm.

Less committed longs and speculative funds will then exit the market, pushing gold prices lower.

It is, of course, an entirely different story if the benefit of lower dollar prices of gold will be available to Indian consumers. That will depend on the exchange rate. If the current rate were to maintain or improve in favour of the rupee in the coming quarters, some decline in domestic gold prices can be expected.

(This article was published on July 31, 2012)
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