Gold Takes It On the Chin…What’s Next?

There was a strong reaction yesterday to the elevated debt crisis in Europe, with commodities and equities being indiscriminately sold. Gold fell 3 per cent this week, losing its safe haven status as the dollar grew stronger and the 10-year government note headed lower.

The markets generally overreact to negative news, however, investors should keep in mind gold’s normal monthly historical volatility. Throughout the past 20 years of monthly returns, the precious metal generally increased only 0.5 per cent in May, and has historically declined in June and July.

Facts don’t thwart the short-term pain, yet as contrarian investor Baron Rothschild said, “the time to buy is when there’s blood in the streets.” Here are five reasons we believe today’s sell-off sets up a buying opportunity for gold:

  1. It is precisely the debt strangling the eurozone which will drive gold demand over the longer term. The side effect to the abundance of printing by central banks in the U.S., Europe, Japan and England is bloated balance sheets amounting to nearly $8 trillion. This is double the amount that it was only three and a half years ago.
  2. Several developed markets have negative real interest rates and these rates are anticipated to remain negative for years to come. Historically, when the inflationary rate is greater than the current short-term interest rate, gold prices rose.
  3. Emerging market central banks continued their gold buying spree in March. UBS Investment Research says that Mexico bought 16.8 tons, Russia bought 15.6 tons and Turkey added 11.5 tons. Additional small purchases were made by Tajikistan, Kazakhstan and Belarus. We wrote a few months agothat central banks have begun accumulating gold reserves since the Federal Reserve cut interest rates in 2007, and HSBC Global Research expects this buying trend to continue for another five years.
  4. In March, China’s gold shipments grew to 62.9 tons, which is the third largest volume of gold in a decade from Hong Kong to the mainland, according to UBS. With ongoing rising demand, China may overtake India this year as the world’s largest gold buyer.
  5. India’s government abolished the excise duty on gold jewelry. This was one of the reasons for the jewellers’ strike, which drove gold imports to decrease 55 per cent in India a few months back. Getting rid of the tax should encourage the restocking of gold and bring Indian gold buyers back to the market. UBS reported on May 9 that Indian buying on yesterday’s dip was nearly twice the average daily volume and the “strongest since April 17.”

Over the past decade, these Fear Trade and Love Trade drivers have spurred gold higher, even as the yellow metal experienced short-term corrections along the way. Only hindsight could show how these corrections set up buying opportunities.

All opinions expressed and data provided are subject to change without notice. Some of these opinions may not be appropriate to every investor.

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