How gold will react if US Fed tapers stimulus package

With less than a week to go for the September 17-18 US Federal Open Market Committee (FOMC) meeting, there is an air of heightened expectancy in the global commodity markets.

There is widespread anticipation that the Federal Reserve will announce the beginning of the tapering of bond purchase at the meeting.

Conditions conducive to such a decision are in place — especially the unemployment number, which has declined to 7.3 per cent, according to data released last week.

Most vulnerable

Of all the commodities widely traded globally, gold appears to be the most vulnerable to any decision of the Fed on tapering.

No wonder, those with large exposure to the yellow metal appear somewhat nervous. At the moment, one can only conjecture the extent of tapering. No one believes there will be a significant reduction.

However, it is possible to build three alternative scenarios. The extent of tapering or reduction in bond purchase may be small — from $85 billion to $70 billion a month. It is also possible that the reduction may be a sharp one too, say $60 billion. Also, there is still an outside chance that the Fed will postpone the decision to taper to a future date, maybe December. These scenarios are not equally likely, though. A smaller reduction of about $15 billion seems highly probable at the upcoming meeting.

It is widely expected that the tapering will be positive for the dollar as a rise in demand will make it stronger vis-à-vis other major currencies such as the euro.

Again, tapering will not only impact the dollar but also gold prices, as it will suck out liquidity. Based on the above, three alternative scenarios can be constructed for gold prices.

At the same time, the rupee is also likely to be vulnerable to sustained dollar strength; and the rate of exchange (USD/INR) will have a bearing on domestic gold prices.

The table shows three scenarios for gold price in dollar terms and three scenarios for the USD:INR exchange rate. It offers a sensitivity analysis of gold prices in India under the three scenarios.

Gold in dollar terms is quoted for one troy ounce which is 31.1 grams and the dollar price is converted to 10 grams as traded in the Indian market. The Department of Revenue notifies a tariff value for imported gold every fortnight and it is assumed that the tariff value will reflect the market price.

Also, the government imposes 10 per cent customs duty on imports, while expenses relating to import (freight, insurance, storage, interest, etc) are roughly 1 per cent. So, there is a 11 per cent cost burden on imported gold.

From an exchange rate perspective, scenario I and III appear to be somewhat extreme cases.

It is possible to calculate the rupee price of gold by assuming any dollar value of gold and exchange rate (USD/INR). At the current price and exchange rate, the thumb rule is that for every $1 change in gold price per ounce, the rupee price (per 10 g) will change by approximately Rs 22.

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