Taking an aggressive directional call on gold looks difficult at this point of time

Jul 28 2014, 10:55 IST
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Gold has been in a trading range of $1200/ounce-$1400/ounce so far this year. (Reuters) Gold has been in a trading range of $1200/ounce-$1400/ounce so far this year. (Reuters)
SummaryThe real interest rate captures the opportunity cost of holding gold relative to other risk-free assets which provide a return.

Gold has been in a trading range of $1200/ounce-$1400/ounce so far this year. They yellow metal has managed to trade above the key support of $1200/ounce mainly because US 10 year yields and the US Dollar index have not witnessed an uptick on the back of the US Federal Reserve taper. Further, prices have also been supported by factors such as weak economic data releases in the US early in the year due to the weaker manufacturing activity, corporate bond market fears in China, the Ukraine crisis and the militant insurgency in Iraq. Thus, although the US Federal Reserve has maintained its stance on tapering its monthly purchases of bonds and mortgage backed securities to the extent of $10 billion a month, the "fear trade" has been providing upside to gold prices despite the sucking out of cheap liquidity out of the financial system.

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

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