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Has Gold Lost its Shine Forever?

Gold has always been a safe bet for investment and a hedge against inflation. But this common belief turned into a nightmare when the prices of gold crashed by almost 13% in mid-April. Historically speaking, prices of gold have always moved inversely to the major benchmarks, but since 2013, investors’ confidence tilted towards equities as seen in the graph below. The Federal Reserve’s monetary stimulus, the U.S. economy, major indices, inflation and the gold prices are all part of one vicious circle. If any one of the factors is adversely affected, a domino effect will be generated affecting all the other factors.

In the last one year, the negative correlation between the Dow Jones Industrial Average (DJI) and the SPDR Gold Shares (GLD - ETF report) has been around 46% and almost 82% since the start of 2013. In the graph given below we see that in the past one year, till 2012-end, the Dow and the Gold ETF has been rallying almost hand in hand but since the start of 2013, they take different and opposite paths. Share price of iShares Gold Trust ETF (IAU - ETF report) have fallen almost 17%. While shares of ProShares Ultra Gold ETF (UGL - ETF report) lost 31%, shares of Sprott Physical Gold Trust (PHYS - ETF report) have decreased 18.5%. Even if we consider the price of gold before the huge sell-off which took place in mid-April, the negative correlation is consistent.

What happened is not a bigger question than what is going to happen in the long run. Investor optimism has played a major role in the market rally since the start of 2013. The Federal Reserve, which purchases $85-billion worth of bonds ultimately showed results during the first quarter in the form of encouraging economic numbers. Since 2013, major indices have gained more than 16% while the price of gold has fallen by 15%. These factors cumulatively encrypted confidence towards equities rather than gold.

The only reason why markets are doing so well is that investor optimism is high and economic indicators are encouraging is because of the monetary stimulus by the Federal Reserve. The Fed indicated in April that if the labor markets continue to improve, the monetary stimulus might be slowed. The Feds cannot continue the stimulus on forever. What will happen after the Feds remove the stimulus? Curbing the monetary stimulus will affect the markets and price of gold indirectly.

Fundamentally, curbing the monetary stimulus, irrespective of it being reduced in parts or as a whole, will adversely affect the economy. Not only will the removal of monetary stimulus affect the markets, but the sequestration cuts will also change the corporate scenario. The second quarter, unlike the first quarter, has witnessed a bump on the road. The effect of sequestration cuts is likely be vivid from the second quarter. The corporate results will probably take a beating. Hence, in order to increase the profitability, companies might take cost cutting steps, which in turn will affect the employment rate in a small way. Profitably of the company might go below expectations. The whole scenario of corporate earnings and economic data will change the markets.

Adding to the investors’ woes, the sequestration cuts along with slowing or shutting down the Fed’s monetary stimulus will rattle investor confidence, thus increasing skepticism towards the markets. Whenever fear towards markets has risen, investors have mostly turned towards gold to park their investments. But, by the time the Feds lift the monetary stimulus, if the inflation rate is not around 2%, it can create an adverse effect.

Inflation, unlike the markets, is not controlled by the investors’ sentiments. Materially speaking cost of products has gone up but the global inflation rate has gone down, triggering the fall of gold prices. Apart from controlling the unemployment rate, bringing the inflation rate to 2% was also a reason for the Fed to introduce the monetary stimulus. As of now, inflation is just half way and hovering around 1%. At this stage if the Fed’s slows the monetary stimulus, it can possibly create panic in the short run. Low inflation rates will keep pressure on the gold prices, at the same time investors will lose confidence in the markets, triggering panic in the market.

In a scenario where the inflation rate is 2% and the Feds slow down the monetary stimulus, owing to sequestration and lack of monetary stimulus support, the markets will still be affected, but in this case, the prices of gold will tend to move higher. Investors will start accumulating funds in gold due to lack of confidence in markets.

The next possible trigger which will probably impact the market is the outcome of the Fed’s meeting due in mid-June. The outcome will likely decide the direction of markets and gold prices.

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