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Market tears up golden rule book; bullion faces further pressure

The collapse in the price of gold has been accompanied by the realization that none of the normal rules for valuing gold is working, which could spell more weakness ahead for the yellow metal.

After a slide on Friday, gold experienced its largest daily decline in more than 33 years on Monday, dropping 9.7% on the day and hitting a low of $1,336 an ounce. That was its biggest daily percentage and absolute drop since March 1980 and took the price of bullion to its weakest level since February 2011.

The price action has spooked some investors, who see it as a potential canary in the coal mine for financial stability. Indeed, the price of gold in dollar terms has now lost almost 30% of its value since the peak recorded in September 2011, bringing it close to the scale of the sell-off experienced during the peak of the global financial crisis in 2008.

 Gold price slumps to lowest level in more than two years

It is hard to pin the collapse in gold prices on one factor, with prices already under pressure as news of gold sales from Cyprus to fund its bailout prompted fears of heavy supply from other European central banks.

Gareth Berry, strategist at UBS, says weak first-quarter growth data from China might have been the “straw that broke the camel’s back” for gold prices.

He says with China faltering – news that came after recent data showing the pace of recovery in the US was slowing – the idea that none of the world’s economic engines will generate any economic growth this year might have put paid to expectations for the end of disinflation in G10 economies and higher inflation in emerging markets, all of which could have weighed on demand for gold.

Others put the slide down to a more simple explanation.

“The trigger for slump in the price of gold since Friday appears to have been aggressive selling by speculative traders, rather than a change in the long-term or fundamental drivers,” says Julian Jessop at Capital Economics.

He says gold has also been caught up in the broad-based weakness in commodity markets, including oil and industrial metals, due to softer US and Chinese economic data.

“Once trading clams down, we expect gold to stage at least a partial recovery,” adds Jessop.

Some remain unconvinced, however, over the ability of gold to recover.

Simon Smith, chief economist at FxPro, says even before the tumble in the gold price, things were not looking good for bullion.

He says before this year, the multi-year bull market – gold has risen in dollar terms every year from 2001 to 2012 – defied the credit crisis and the subsequent patchy recovery and quantitative easing from the world’s largest central banks.

“This increased the perception that gold could survive anything and the good times would continue,” says Smith.

“But it also created a false sense of security for gold bulls and that’s now increased, because the old rules have broken down and, as yet, there’s nothing new to replace them.”

He points out there have been many justifications for the rising price of gold between 2001 and 2012.

During the early part of gold’s rally, it was seen as a dollar story, with rising gold prices the flipside of a weaker dollar. During that time, gold’s correlation with the dollar was -0.55 – now it is in positive territory.

There has also been a change in gold’s relationship with global real interest rates – a simple representation of the opportunity cost of the real return of holding a non-yielding asset such as bullion.

If inflation-adjusted returns are high in general, then it is a bigger hurdle for investors to give up in favour of holding gold, with larger capital appreciation needed to overcome the real return lost.

During the credit crisis between 2008 and 2012, that relationship held up well with an inverse correlation of 0.5 between real interest rates and gold. Again, that relationship has disappeared, with a positive correlation of 0.65 now holding.

Even the advocates of rising gold prices being a reflection of money debasement via the expansion of central bank balance sheets are having a hard time of late.

Indeed, during the past six months, global G4 central bank balance sheets have expanded by more than 12%, whilst the gold price has fallen by 16%.

“The upshot is that the golden rules for gold, as much as there can be rules for such an asset, have floundered,” says Smith.

“For now, nothing has emerged to take their place.”

As such, he expects gold bulls to push a return to the old world order, but warns that while the global gold price peaked 19 months ago, global holdings of gold in exchange traded funds peaked just four months ago.

“From this perspective, the lack of a rule book could mean that there is more liquidation to come before any recovery can take place,” says Smith.

Gold might face further pressure in the weeks ahead.

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