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Gold to Keep Shining Amid Positive Catalysts

 October 16, 2012 10:39 AM


(By Mani) Policy and politics will be the primary deciders of gold's fate as the yellow metal steps into 2013. The open-end nature of QE3, with the potential for QE4 when Operation Twist ends in December and the need for a "sustainable" U.S. recovery, means that there's longevity to a higher gold trade.

The current U.S. debt ceiling is expected to be reached in early December, and the European Central Bank (ECB) and the Bank of Japan (BoJ) are also subscribing to further easing to support gold's upside.

"The recent actions of the Fed, with its implications for fiat currency debasement, inflation expectations, liquidity and money supply have longer-term gold implications; a $2,000 price tag is not overly ambitious," UBS Strategist Edel Tully wrote in a note to clients.

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The UBS view is that politicians will prevent the "fiscal cliff"' from happening next year: the debt ceiling is likely to be extended. This increases the possibility of a ratings agency downgrade, which would hurt the dollar and benefit gold.

The three primary ingredients for a sustainable gold rally are decent speculative buying, sizeable ETF inflows and physical demand. The first two have proven to be very strong sources of gold demand since August.

Comex specs now sit at 91 percent of their record 33 million ounces (moz) long from August last year, while global ETFs have seen inflows of about 6 moz since August. Instead, physical demand has been lagging.

However, some respite has emerged in recent week as European physical buying is returning, although not to the levels seen in 2010 or early 2011, while Indian demand has picked up in response to the stronger rupee.

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"We lift our full-year 2012 forecast to $1,700, from $1,680 previously. For 2013, we now forecast an average gold price of $1,900, from $1,725 previously, and for 2014 we lift our previous $1,400 forecast to $1,700," Tully said.

That gold is trading at or near record highs against a slew of emerging market (EM) currencies, including the rupee, explains much of the subdued physical interest in recent months. The future path of EM currencies versus the dollar will, therefore, be an important factor for returning gold demand.

In India, this relationship has been quite clear-cut of late. In September and so far in October, the rupee strengthened in response to various government initiatives. This currency strength is occurring at the right time for gold, with the wedding season intensifying from late October and Diwali from November 13.

So, as long as the rupee doesn't weaken materially, gold demand should pick up further in the coming weeks, and this will be further helped by low inventory.

"While we don't expect that this can at all make up for the near 40 percent decline in gold imports already seen this year, it will be less of a negative pressure point for gold as it attempts to move higher," Tully wrote.

If the rupee strengthens materially, it could prompt very strong gold buying; this raises the risk that the government reacts by hiking import taxes once again, principally to help combat the current account deficit.

Meanwhile, comex net longs have multiplied by 135 percent since mid-August. While spec positioning is very close to record levels, this is not deemed to be a major obstacle by investors because the recent action of the Fed has materially changed the playing field, which gives spec positioning room to climb materially higher.

In addition, while the perception is that gold is very invested, the reality is quite different. Yes, gold is occupying more media space of late, but the recent buyers have come from the traditional commodity sector rather than a more broad-based push from outsiders.

"The tourist trade in gold is not very apparent, which is greatly at odds with the market makeup of last summer. This is positive insofar as it leaves gold room to attract a lot more investor interest," Tully added.

Moreover, the strong ETF buying helps mitigate some of concern that all gold has seen is a speculative rally. The ETF buying gives much credibility to gold's move, as the types of buyers behind it typically have staying power.

In addition, gold's strong correlation with the euro means that the yellow metal will be vulnerable to any negative surprises out of Europe.

"For those wary of negative Eurozone risks, long XAUEUR is an attractive way to position against this," Tully noted.

In the week to Oct 11, gold ETF holdings increased 0.45moz to 87.17moz. The bulk of the inflows occurred in the SPDR fund, to the tune of 228koz. Also, investors made additions in the Source fund (74koz), GBS (LSE) fund (65koz), ZKB fund (29koz), ETFS (LSE) fund (19koz), iShares trust (15koz) and CSGold fund (24koz). Total inflows in the month of October stand at 1.32moz.

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