3 Charts Explaining Why Gold Could Recover

The gold market has cooled down in the past several weeks mainly after the FOMC decided to taper its asset purchase program back in March 19th. The FOMC’s revised  monetary policy may have softened the demand for gold — an investment considered a hedge against the depreciation of the US dollar including a sudden rise in inflation. But will gold bounce back? Here are three charts that show the recent developments in the financial markets, and present why gold could rally.

The price of gold dropped by 6% during the past couple of weeks after it had slowly rallied in previous months. The table below demonstrates the shift in financial markets during March.

gold silver and USD March 2014Source: Bloomberg

As you can see, gold rallied at the first half of March and added nearly 4% to its value until March 17th. But since then, gold plummeted. Leading gold ETFs including SPDR Gold  (NYSEMKT: GLD) and iShares Gold Trust (NYSEMKT: IAU) also changed course in recent weeks and shed 5.4% since March 17th; iShares Gold Trust fell by a similar rate. Despite the recent fall in the price of gold, these ETFs demand are still up for March: iShares Gold’s holdings increased by 1% during the month; SPDR Gold’s gold holdings rose by 1.7%. This brings me to the first chart that could encourage bullion investors:

GLD holdings March 2014Source: SPDR website

The chart shows the progress of the gold hoards in GLD’s chart during 2013-2014. Even thought SPDR’s gold hoards plummeted during 2013, they have rallied in 2014. Even when the price of gold declined in recent weeks, the demand for SPDR Gold kept slowly rising. If this ETF’s gold holdings continue to rise, this could signal the demand for gold as an investment will increase further.

Gold prices started to fall close to the FOMC’s policy meeting, which was held between March 18th and 19th. In the meeting, the FOMC tapered its asset purchase program or QE3 by $10 billion so that the current asset program is set at $55 billion a month. If the FOMC continues to taper QE3 in the coming months, it won’t have a long term negative effect on the price of gold. The chart below explains why.

gold money base March 2014Source: Federal Reserve site and Bloomberg

The FOMC’s QE3 program didn’t have a positive effect on the price of gold during 2013, albeit it did expand the U.S money base. Therefore, if the FOMC tapers again QE3, this decision might not have a long term negative effect on gold. The chart also shows that since the FOMC started to taper QE3 at the end of 2013, the price of gold rallied.

So what could be behind the recent fall in the price of gold?

In last meeting, the FOMC also addressed the timing of raising its cash rate. In the past, the FOMC announced it will raise the rate, when the U.S unemployment rate falls below 6.5%. Since then, however, the FOMC shifted that goalpost. Janet Yellen, Chair of the FOMC, said in a press conference that when the U.S economic condition improve, the FOMC is likely to raise its rate – very ambiguous. But it was enough to drag down gold, even for a short while. The current assessments are that around mid-2015 the FOMC might raise the cash rate. Once the FOMC raises its cash rate, the price of gold is likely to fall: The risk of the US dollar devaluating will diminish, and thus the demand for gold, a potential hedge for the U.S dollar, will drop. Until then, gold is likely to slowly recover. Moreover, the economic conditions could still deteriorate, which will push further into the future the timing of raising the cash rate. The recent FOMC decision and the speculation around the rate hike have also pulled up the U.S dollar.

In the chart below are the developments in the USD/ Japanese yen during 2014.

Yen goldSource: Bloomberg

The chart shows that the US dollar depreciated against the yen during January and February. The US dollar had a similar trend against other leading currencies such as Aussie dollar and Canadian dollar. But during March, the U.S dollar slightly appreciated against the Japanese yen.  This may have been another short term reaction to the FOMC’s decision to taper QE3. In previous months, however, the FOMC’s tapering decisions didn’t curb down the depreciation of the US dollar. Further, the recent recovery of the U.S dollar may have also contributed to the decline of gold.

Therefore, once the hype over the rate hike discussion wears off, the U.S dollar could resume its downward trend; in such a case, this could pull back up the price of gold.

Final note

The gold market has cooled down in the recent weeks. But over the coming months, gold could bounce back even if the FOMC tapers again QE3 and especially if the US dollar resumes its downward trend.

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Disclaimer: The author holds no positions in stocks mentioned and does not plan to initiate positions within 120 hours of the posting of this article. This article is to be used for educational, research and informational purposes only and does not constitute investment advice. There are no guarantees, expressed or implied, of future positive returns in regards to the subject matter contained herein. Understand the risks inherent in investing before making the decision to invest or consult an investment professional for more information. Reasonable due diligence has been performed in regards to the information in this article. However, the author expressly disclaims any liability for accidental omissions of information or errors in fact.