Gold has dropped sharply over the past month, from c.$1,350/oz to c.$1,250/oz, with the majority of the move lower occurring on Tuesday of this week, following hawkish comments by Fed officials (Lacker in particular) and a subsequent break of the psychologically and technically important $1,300/oz level (N.B. the next important technical level is $1,248/oz – a 1.618 extension target from the Aug. 2 high).
The recent move lower has been broadly in line with our bearish base-case price forecast path, which was predicated on our US economists’ forecast of a rate hike by year-end (on the balance of probabilities), and rising US real interest rates into year-end (please see Exhibits 1 and 2). Importantly, the substantial move lower in gold closes the divergence between real rates and gold that opened up during July and August. Also notable is that the move lower does not appear to be driven by physical gold ETF liquidation (Exhibit 3) – physical gold ETFs have actually built over the past week, and as such we expect that Friday’s CFTC report (which will include data through Tuesday October 4, the day the major sell-off occurred) will show a substantial decrease in net speculative short positions (Exhibit 4).
With prices having corrected sharply, we are broadly neutral on the outlook for gold through year-end, with our forecast of the probability of US rate hikes through year-end roughly in line with market expectations (GS 65% vs. market pricing 62%). Our expectations for US non-farm payrolls tomorrow is also in line with consensus, at 175,000. Having said this, the reaction of gold prices has been larger than we had anticipated, and as such this leaves the risks surrounding our year-end forecast of $1,280/oz as moderately skewed to the downside (a key data point to watch will be the degree to which Comex speculative positioning has corrected over the past week).
Though the GS rates team do continue to see US real rates rising into year-end, which would likely place downward pressure on gold, the drivers of strong physical ETF and bar demand for gold during 2016 are likely to remain intact, including continued strong physical demand for gold as a strategic hedge, limiting any downside. Indeed, we would view a gold sell-off substantially below $1,250/oz as a strategic buying opportunity, given substantial downside risks to global growth remain, and given that the market is likely to remain concerned about the ability of monetary policy to respond to any potential shocks to growth.
On top of those strategic factors mentioned above, there is also reason to believe that Chinese investment demand for gold may pick up following the recent sell-off, particularly from medium-long term asset allocators. The potential drivers of increased Chinese physical buying, include purchasing gold as a way to hedge for potential currency depreciation in the face of capital controls, and purchasing gold as a way of diversifying away from the property market, which has this year to date had a remarkable rally (with the government moving to rein in speculation and price growth).
Finally, while cost support is not provided by miners in the short term, and certainly prices can and often do trade in to the cost structure of the industry for sustained periods, the latest move lower does bring gold down to a level in line with the marginal cost of production (90%ile of the fully allocated costs).
Max Layton, Mikhail Sprogis, Jeffrey Currie – Goldman Sachs International