However, it is unlikely that gold will be able to move much higher from its current price level of around $1310/ounce. US 10 year yields will inevitably rise to 3 percent- 3.25 percent from current levels of 2.5 percent as market participants start factoring in the first rate hike in mid 2015. The only question that remains is how fast US real interest rates rise. The real interest rate captures the opportunity cost of holding gold relative to other risk-free assets which provide a return. Thus, historically, one of the most common reasons to have held gold was low real interest rates. The bull market of the 1970s, early 1980s and the previous decade up to 2013 were all associated with negative US real interest rates. Further, the fall in gold prices from 1982 to 2001 was associated with a prevailing period of rising and high real interest rate environment. Janet Yellen has repeatedly mentioned that the Fed would do all it can to avoid a 1994 like bond crash if interest rates rose too rapidly for the markets liking. Further, she has also promised to use all tools available to curb market volatility as and when US real rates rise. If this is indeed how things play out, equities may not correct and there will be limited scope for gold prices to rally on the back of the fear trade.
One of the major pillars on which the bull market in gold relied on was the weak dollar. For the first time since the financial crisis we are witnessing a stronger dollar leading to a risk on move.As QE commences and major central banks such as the ECB and the BoJ remain dovish, we can expect to see the Dollar index at 83-84 by year end. This again would imply bearish price action in gold.
Another reason to be bearish on gold going forward is that we might be entering a period of commodity underperformance. The 20th century saw three secular bull markets in commodities, each averaging about 17 years- 1906- 1923, 1923-1953 and 1968- 1982. Thus, history suggests the current bull run in commodities, which began in late 1998 with the driving catalyst being physical demand from emerging markets - most notably China, is now nearing its end. Although fears of China's possible "hard landing" have largely been abated, the new normal for Chinese GDP growth is now between 7-8 percent, well below the average 10 percent it clocked the previous decade.
Gold bulls on the other hand argue that after the heavy ETF and hedge fund selling witnessed in 2013, gold has moved from weak to strong hands. According to the World Gold Council, the main feature of gold investment throughout 2013 was the contrast between ETFs, which acted as a source of supply to the market as sizable institutional positions were sold (-880.8 tonnes) and the demand for bars and coins, which surged to an all-time high (1,654.1 tonnes). Lower prices in 2013 were used as a buying opportunity by value investors. Demand for gold in the form of jewellery, bars and coins, which is collectively referred to as consumer demand, hit an all-time high. Further, Chinese consumers of gold set a new annual record while Indian demand was still resilient in the face of import restrictions. The result was annual gold demand of 3,756.1 tonnes, valued at $170 billion.Meanwhile, central banks made net purchases of 368.6 tonnes of gold in 2013, adding a further 61 tonnes in fourth quarter (Q4) -- the twelfth consecutive quarter of net central bank demand.
Gold bugs also point towards time periods when rising real interest rates led to bullish price action in gold. From 1985 to 1987, gold prices rose even though real interest rates were also rising. The most astonishing breakdown of the relationship was during October 2003 to October 2006 when US real interest rates rose from about negative 1 percent to 3 percent, while gold gave investors a return of 60 percent over the same period.
The second half of 2014 will essentially be a year of waiting for market participants looking to take positions in gold. Going forward, the pace of the recovery in US 10 year yields will be the most important factor driving gold prices. For investors in gold the moment of truth will likely come next year in the sense that US monetary policy either normalises successfully or it does not. If the former occurs real interest rates should rise in the US and gold will enter a bear market. But if the attempt to exit prompts market turbulence (like in 1994), the dovish Janet Yellen would reverse course which would clearly imply that gold becomes a hot investment again.