Dynamics behind the XAU sell-off

Forex News and Events:

The broad based USD strength continues weighing on gold markets. XAU/USD extended losses to an eight month low of $1,208.40 in the continuation of steep downtrend channel building since September 2nd. Since the month began, the XAU/USD lost more than 5% and the bearish momentum has not slowed yet. What is the downside potential in gold prices?

XAU at risk as Fed exits QE?

The optimism on US recovery and the hawkish Fed expectations will certainly keep the selling pressures tight in XAU/USD. The significant surge in gold prices has started in 2007-2008 as the Fed launched its first QE program to counter the liquidity crisis post-Lehman default. The inflationary fears due to massive liquidity injection lifted the XAU/USD above $1,000 toward the end-2009. The gold hit $1,920 per ounce on September 2011. As the Fed intervention did not result in irrepressible inflationary pressures, the gold prices are seen stabilized at $1,200-1,500. However as we approach the lower band of past four-year trading band, multiple factors enter the game and the price direction becomes difficult to predict.

Today, the market sentiment improves regarding the US economy. The Fed gently tapers its third QE program and the monthly bond purchases are scheduled to end in October 2014. This will bring us to the new era of policy normalization. The Fed’s 4.5 billion dollar balance sheet will start contracting. Will follow the first Fed fund rate hike. Although the timing remains uncertain, the first Fed hike is estimated by the second half of 2015. From a technical perspective, the Fed normalization could stimulate normalization in gold markets and possibly shift the gold levels toward $680-1000 (2008-2009 trading band) should the critical $1,150-80 support breaks. This said, the markets are not pricing in the coming ECB expansion yet. Should the ECB liquidity partially counter-balance the Fed tightening, the normalization in gold markets will certainly be delayed.

Risk of correlation breakdown

On the opposite side, the geopolitical tensions and the safe-haven demand keep the XAU/USD bid above this critical support. Yet if the US economy is ready for normalization, it should be good news for risk lovers. As the risk appetite improves, the gold allocation in investment portfolios should automatically decrease, thus further weigh on gold prices. Following this reasoning, we can also explain why the SPDR Gold Trust holdings retreated to 774.65 metric tons, the lowest since December 2008.

At this point, we still need the hedging / risk-diversifying characteristic of gold in investment portfolios, simply because the end of cheap liquidity can temporary hit the stock/bond values, increase volatilities and keep the demand in gold sustained before the tighter Fed policy becomes the new standard. However, we see a fresh breakdown in negative correlation between S&P 500 stocks and XAU since September 16-17th Fed meeting. The 40-day correlation between the US stocks and XAU turn positive for the first time this year, fueling doubts that the portfolio managers cannot safely count on gold hedging mechanism. Should this situation persist, the $1,150-80 support will come under higher pressure.

Is the sharp reversal in correlation dynamics temporary?

As the ECB expansion is poorly priced in, a tangible explanation is perhaps the gold demand ex-investment/hedging purposes and the lower gold supply. In fact, the gold prices falling towards $1,200 elicits strong demand in physical gold markets as Asian and Middle East markets are highly price sensitive. The gold demand in China and India, world’s biggest gold buyers, are expected to accelerate in the fourth quarter, while the latest reports show that the scrap supply will drop 17% in 2H. The classical supply-demand mechanisms should thus sustain the gold prices before the year-end as the festive/wedding season is expected to have significant boost in the physical gold markets. This seasonal effect clearly distort the short-term shift in correlation dynamics. Hence it is too early to talk about a long-term impact on gold prices. Walking into 2015, we will be closely monitoring a break below the $1,150/80 support, as the Fed/ECB dynamics concertize.

Today's Key Issues (time in GMT):

2014-09-23T12:30:00 CAD Jul Retail Sales MoM, exp 0.40%, last 1.10%
2014-09-23T12:30:00 CAD Jul Retail Sales Ex Auto MoM, exp -0.20%, last 1.50%
2014-09-23T13:45:00 USD Sep P Markit US Manufacturing PMI, exp 58, last 57.9
2014-09-23T14:00:00 USD Sep Richmond Fed Manufact. Index, exp 10, last 12

The Risk Today:

EURUSD EUR/USD remains thus far unable to hold above its previous lows, indicating persistent selling pressures. Hourly resistances can be found at 1.2930 (18/09/2014 high) and 1.2988. A key support stands at 1.2755. In the longer term, EUR/USD is in a succession of lower highs and lower lows since May 2014. The break of the key support at 1.3105 (06/09/2013 low) opens the way for a decline towards the strong support area between 1.2755 (09/07/2013 low) and 1.2662 (13/11/2012 low). A key resistance lies at 1.3221 (28/08/2014 high).

GBPUSD GBP/USD has made a sharp bearish reversal near the resistance at 1.6497 (see also the 38.2% retracement). A phase of consolidation is likely. Hourly supports can be found at 1.6241 (intraday low) and 1.6162 (16/09/2014 low). A key resistance now lies at 1.6525 (19/09/2014 high). In the longer term, the collapse in prices after having reached 4-year highs has created a strong resistance at 1.7192, which is unlikely to be broken in the coming months. Monitor the recent rebound as it could signal the start of a medium-term consolidation phase. A support lies at 1.6052, while a strong support stands at 1.5855 (12/11/2013 low). Friday's weakness has forced us to close the remaining of our long position.

USDJPY USD/JPY is losing momentum. A break of the initial support at 108.60 would favour a short-term corrective phase. Hourly supports are given by the steep rising trendline (around 108.19) and 107.39. An hourly resistance stands at 109.46 (19/09/2014 high). A long-term bullish bias is favoured as long as the key support 100.76 (04/02/2014 low) holds. The recent new highs confirm a strong underlying bullish trend. Despite a likely pause near the major resistance at 110.66 (15/08/2008 high), an eventual break to the upside is favoured. Another resistance can be found at 114.66 (27/12/2007 high).

USDCHF USD/CHF continues to exhibit a succession of higher lows. However, prices are close to the strong resistance at 0.9456 (06/09/2013 high). An hourly resistance now lies at 0.9433. Hourly supports are given by the steep rising trendline (around 0.9328) and 0.9287. From a longer term perspective, the technical structure calls for the end of the large corrective phase that started in July 2012. A strong resistance stands at 0.9456 (06/09/2013 high). Another key resistance lies at 0.9751 (09/07/2013 high). Supports can be found at 0.9176 (03/09/2014 low) and 0.9104 (22/08/2014 low).

Resistance and Support: