Gold Remains Relatively Cheap, Here’s Why

It's increasingly looking like gold bulls will not be taking back this market any time soon. After a bright start that saw gold prices touch all-time highs amid the Ukraine crisis and a commodity supercycle, gold prices have pulled back sharply over the past four months. Over the past 30 days, gold prices have slipped 7% to trade at $1,720 per ounce in Wednesday's intraday session, with rising interest rates reducing the appeal of non-yielding gold. Even a weakening dollar and a slightly less hawkish Fed have not helped ease selling pressure on the yellow metal.

After briefly touching a 20-year high, the dollar has been weakening against major world currencies. Gains by the euro, which sent it further away from the sub-parity with gold levels of last week, as well as falling expectations for an aggressive 100 basis point hike from the Federal Reserve this month knocked the dollar from its recent 20-year high. The dollar, gaining strength recently, has been chipping away at gold prices, with the greenback maintaining its status as the world's premier safe haven during times of global upset.

The markets in general have seen choppy trading after the latest inflation data suggested the Fed could get even more aggressive with its rate hikes. However, they have lately switched back to a baseline of a 75-basis-point hike, with the odds at 69% vs. 31% for 100 basis points, according to CME FedWatch. Last month, inflation in the United States hit a torrid 9.1% clip, the highest reading since 1981, once again exceeding expectations and raising the odds the Fed will continue its aggressive rate-hike regime in a bid to tame spiraling prices. Investors remain on edge as they wait for another rate hike during the FOMC meeting scheduled for July 26-27.

"We think 100 bps will be on the table on July 27, but data on real economic activity in June that were released after we published our forecast make the case for a supersized rate hike less compelling. These data reinforced previously published data that point in the direction of economic deceleration," Wells Fargo has said.

Others have said that a 75-basis-point hike would be reasonably aggressive.

"We don't want to make snap policy decisions based on some knee-jerk reaction to what happened in the CPI report," Fed Governor Christopher Waller said in a Thursday press conference.

Selling pressure remains heavy. According to commodity analysts at Standard Chartered:

"Tactical investors have scaled back exposure for the fourth straight week, taking net fund length into negative territory for the first time since April 2019. Speculative interest was largely scaled back on fresh short positions being established in excess of 10 thousand (k) lots for the fourth consecutive week. Net fund length as a percentage of open interest has fallen to -1.9% and is consistent with positioning typically held during a hiking cycle. It is possible that short positions could be covered over the coming sessions if the Fed indicates hiking could pause before year-end. Gold ETF investors have followed a similar path, with net outflows for 19 straight sessions. Net redemptions have reached 88 tonnes (t) already in July and are on track to mark the largest net outflows since March last year (-133t). The acceleration in net redemptions also suggests only around 100t of metal held in trust accumulated in 2022 is now loss-making.'

Some experts, however, believe that the bulls could get a temporary reprieve if the Fed goes for a 75-bps bump in rates instead of the higher number.

According to StanChart:

"If the FOMC hikes by 75bps as expected, market focus will turn to whether the next hike will be 75bps or 50bps - we expect Fed Chair Powell to reiterate that a 75bps move is not the norm.

Given how quickly tactical and ETF positioning has been scaled back in recent sessions, we believe gold prices could edge higher if the Fed hikes by 75bps as expected. A steeper hike or a more hawkish tone could, however, pressure prices below the key support level of USD 1,690/oz."

Source: TradingView

Long-term bearish

That said, the medium and longer-term gold outlook tilts bearish due to a couple of negative catalysts.

First off, the dollar's weakness is not expected to last for long. Indeed, analysts are reluctant to turn bullish on the euro given ongoing concerns about how hawkish the ECB can really be, the ongoing natural gas and energy crisis as well as anemic economic growth amid high inflation.

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"In our view, this bounce is likely to prove short-lived and should provide better entry levels for short euro positions. Even if the ECB does deliver a 50bp hike, the positive follow through for the euro may be limited," Dominic Bunning, head of European FX Research at HSBC has said. Bunning also notes that ECB's 50 basis points "no longer looks so hawkish" against bigger hikes from the likes of the Fed and the Bank of Canada and that close to 150 bps of ECB hikes in 2022 were already priced in. 

U.S. 10 Year Treasury

Source: CNBC

Unfortunately, a Eurozone recession is now looking more likely than ever after Russia's Gazprom cut in half the amount of natural gas flowing through a major pipeline from Russia to Europe, with gas flows falling to just 20% of capacity.

Further, demand trends by the world's biggest gold markets remain mixed.

According to StanChart, gold's downside support is primarily driven by the physical market. China--the world's largest gold market--has been showing signs of robust appetite for precious metals. China's gold imports climbed 57% y/y in June and almost trebled m/m to 106t, up 29% for the YTD to 392t.

In sharp contrast, India--the world's second-largest gold buyer after China--has just entered a seasonally slow period for consumption and hiked import duties for gold and silver. India's gold imports were already on the decline even before the hike.

That said, Standard Chartered has argued that high production costs put a floor on how low gold prices can fall.

According to the experts, the average all-in sustaining cost of production (AISC) for gold has climbed to USD 1,600/oz from around USD 1,300/oz four years ago, marking the highest level since 2013. In effect, this means that ~10% of current gold production is selling at a loss. StanChart says that historically, gold trades at approx. one-third above the average AISC, which puts the floor for gold around USD 1,600/oz.

By Alex Kimani for Oilprice.com

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