Market Update: Gold stabilises as the world looks to ‘Super’ Mario

After a bearish break down last week, gold prices have stabilised over the past few days, as the financial and investing world looks to the European Central Bank (ECB) and its president, ‘Super’ Mario Draghi.

Trading in a relatively narrow range the past few days (in and around the USD $1240oz mark), the market could well push lower, although a short term bounce, considering its oversold position, shouldn’t be ruled out, especially if the ECB isn’t as aggressive as the market is expecting.

In terms of what is likely to happen in Europe tonight with the meeting of the ECB and the press conference to follow; it is widely expected that the ECB will cut refinancing, deposit and lending rates, and potentially announce some kind of unsterilized Quantitative Easing (QE) measure.

As per Chris Westons excellent primer on the meeting ahead, the expected actions are included below, with my comments in blue after each point.

1. A cut in the refinancing rate (currently at 25 basis points or 0.25%) – This is the central interest rate and the rate at which European banks borrow funds from the ECB. A cut of 10-15bp is a near certainty and would be a huge surprise if left unchanged. Agree here, the ECB will definitely make it easier for commercial banks to access credit.

2. A cut in the deposit rate (currently at zero) – This is the rate charged to corporations to hold funds with the ECB. A cut here would take this to a negative figure, thus penalising banks to hold funds with the ECB. Money markets are pricing in deposit rates, however many question the merits of such action, as there are many unknown consequences in having negative deposits. A failure to cut this rate however should cause a strong move higher in EUR, while bunds should sell-off given market pricing. This is the real Rubicon as it were, cross this, and there’s no turning back. Punishing a bank for prudently holding reserves at the ECB could be a real game changer. ‘Negative’ rate headlines could have negative consequences as well.

3. A cut in the lending rate (currently 75bp) – This is the benchmark by which banks should use as a guide for lending into the real economy. Cutting this rate will have an impact on the interbank market and should lower EONIA, or the rate banks lend to each other. A cut to this rate is 50/50, although I feel it should materialise. This could happen, but not sure it would make a major difference. The real problem is the lack of private sector credit demand in Europe. To that end, it’s not clear that anything the ECB will change that lack of demand.

4. Expanding the ECB’s balance sheet – Given that the sizeable contraction in the ECB’s balance sheet since mid-2012 has been a major factor in driving EUR/USD to 1.40, announcing measures to expand the balance sheet and increase excess liquidity seem key in driving the EUR lower. The ECB could announce suspending the sterilisation of its 2012 Securities Market Program (a back-door way of achieving modest QE), or announcing a highly targeted three-year long-term refinancing operation (LTRO). Both of these measures are partially priced in, however if the ECB wants to go above market pricing, this is where it should focus. I wouldn’t be surprised if they hold fire on this for another month and just announce changes to interest rates for now. If so, the EUR could rally, as some sort of QE is expected.

The full report is available here

A cut to 3 different interest rates and an expansion of the balance sheet would be quite a lot for the ECB to announce all in one meeting, so there’s a decent chance they’ll announce some, but not all of this tonight, and keep some powder dry for their next set of meetings.

Back to gold, and logic would suggest further weakness in the short term and a likely re-test of at least the USD $1200 range, which may not hold this time.

Market sentiment is now overwhelmingly bearish, with most research and analyst reports suggesting prices will head south from here. The following from ANZ, who have just revised their Q3 and Q4 2014 forecasts down, by a not insignificant 13% and 19% respectively, is a decent representation of the overall mood. According to ANZ; “We have revised our near-term and medium-term gold forecasts lower. China’s demand response to the 10% decline in gold prices since March has been weak in comparison to last year. We estimate that China’s identifiable gold supply in Q1 2014 exceeded identifiable demand by around 100 tonnes, suggesting a substantial onshore stock build. This will take some time to work through and will likely result in a slowing of gold imports for the next few quarters. We have revised our Sep 2014 and Dec 2014 gold forecasts to USD1,220/oz (from USD1,400/oz) and USD1,180/oz (from USD1,450/oz) respectively.

In the medium-term, exchange-traded fund selling is likely to continue pressuring prices. Tensions between Ukraine and Russia sparked 'safe-haven' gold demand earlier this year, providing a brief respite from the heavy selling in 2013. But a resumption of the downward trend has seen net holdings in gold ETFs decline by 39 metric tonnes in the year-to-date. We expect steady net redemptions of ETF gold to become the norm for at least the next 12 months, though the threat of geo-political risk remains ever present.”

For a US view, this article, which appeared in Bloomberg earlier in the week, which can be accessed here, also sums up sentiment and the mainstream outlook toward the metal too. Low inflation, rising equity markets, a US dollar rally and economic stability. Whilst I don’t believe any of these factors will be permanent, this is overwhelmingly how most market participants are looking at the world now (more on this below), so in that sense, the article is a decent representation of the consensus outlook towards the precious metal complex.

How about other markets

Not surprisingly, whilst sentiment toward gold is overwhelmingly bearish, and a fear of further price declines, it is the opposite picture when it comes to equities.

Indeed, just this morning a note appeared in SMSF adviser online which cautioned trustees against complacency, as the VIX (volatility) index hit a new low in May of this.

A good representation of investor ‘fear’, a low VIX highlights complacency in the market, something that Goldman Sachs Research covered in a research note this week, where they stated; “Almost all (institutional) clients have the same outlook: 3% economic growth, rising earnings, rising bond yields, and a rising equity market.”

With that in mind, its perhaps not surprising the ratio of bulls to bear is as skewed to the bullish side as it is now, with the following chart highlighting how strong the belief is that the all will be well in the economy and with asset markets.

Commenting on the chart below, Charlie Bilello, Pension Partners director of Research stated; "Last week's poll showed 58.3% Bulls and only 17.3% Bears. The spread between Bulls and Bears of 41% is higher than 94% of historical readings and at a level from which further equity gains were much harder to come by."

Whatever is giving investors such confidence, it can’t be the economy itself, what with US GDP printing at -1% for Q1 (yes, we know it was just weather related) and overnight data lukewarm at best.

Whilst the ISM non-manufacturing data did improve, the ADP Employment figure released overnight showed that just 179,000 jobs were added in the US economy in May.

This was well below market expectations, which were suggesting closer to 210,000 job creations, and came off the back off lower revisions to prior readings too.

MBA mortgage applications also fell again, down just over 3% for the week, in a sign that there is no real sign of life in the housing market right now, even with rates falling for the majority of the year.

The disappointing news didn’t end there, with the April US trade deficit widening by some 7%, to over $47 billion dollars. This has already led to forecasters reducing their estimates of US GDP growth in the second quarter, while the fact that Q1 monthly deficits were revised higher (by over $5bn in total) suggests that the Q1 GDP print of -1% may end up being revised even lower.

On that note, for those who have a little more free time, there is an article I suggest you read which highlights what is going on under the surface in the US economy, specifically the retail space, which is particularly important to the US economy. Titled the “Retail Death Rattle Grows Louder”, it is authored by James Quinn, and can be found here.

Finishing off the week

Apart from the ECB meeting tonight, we’ve also got a raft of other data out, including the European retail sales, and the Bank of England is also meeting re monetary policy, though that will be a snooze fest relative to what the market is expecting from the ECB.

To finish off the week, we’ve got the all important US Non Farm payroll report, as well as average hourly earnings and the labour force participation rate.

Until next week.

Disclaimer

This publication is for education purposes only and should not be considered either general of personal advice. It does not consider any particular person’s investment objectives, financial situation or needs. Accordingly, no recommendation (expressed or implied) or other information contained in this report should be acted upon without the appropriateness of that information having regard to those factors. You should assess whether or not the information contained herein is appropriate to your individual financial circumstances and goals before making an investment decision, or seek the help the of a licensed financial adviser. Performance is historical, performance may vary, past performance is not necessarily indicative of future performance. Any prices, quotes or statistics included have been obtained from sources deemed to be reliable, but we do not guarantee their accuracy or completeness.