The Hindu Business Line : Overheated gold in correction mode

NOT unexpectedly, the overheated gold market has gone into a correction mode with prices sliding from the 25-year high recorded earlier this week. It seemed to be a case of "irrational exuberance" with too much money chasing the commodity without adequate support either from fundamentals or other factors such as inflation or geo-political concerns.

The strong interest of speculative investors in gold was reflected in the latest CFTC report, which showed that net non-commercial long positions rose to a high level of 520.7 tonnes last week from 494.3 tonnes, although the highest level was recorded on October 14 with 551.8 tonnes.

The yellow metal used to be in perfect harmony with inflation as it is perceived to be a good hedge against inflation. In the past, inflation in the US was often a significant driver of gold prices. The last time when gold prices headed towards $800 an ounce, it was accompanied by inflationary pressures.

However, this time, despite strong increase in energy prices, inflation has been a bit of a non-event in the current cycle, both in the US and in Europe.

This, obviously, is a reflection of the current macro-economic environment.

Inflation has remained low. Interestingly, however, oil, which is generally seen as a proxy for inflation, and gold have shown good correlation. Other variables are seen to be driving gold prices, the most notable one being liquidity.

Experts believe low inflation has been greatly influenced by the credibility of the monetary policy implemented by central banks around the world. The success of monetary policy is also reflected in the divergence of the US headline and core inflation rates, according to Macquarie Research Commodities.

Headline inflation included all price items and has been boosted by energy prices; but this did not feed through into the general economy, with core inflation (i.e. headline inflation excluding food and energy) remaining relatively stable during the current cycle. The restrained transmission of inflation, to a large extent, is seen to have resulted from the Fed repeatedly talking about busting or managing inflation and assuring the public that upward price pressure will be muted.

Also, China's role in world trade as a supplier of low priced goods (apparel, for instance) is also seen contributing to inflation control in addition to productivity increases through wider adoption of technology.

Clearly, too much money is chasing gold in the international market with support from technical analysts who predict further upside to prices.

Producers are having a wonderful time they would like to continue forever.

Usually, there is propensity for mine production to rise with sustained high prices.

With the rise in speculative length to near record levels, the downside risk increases. No wonder, the market has got into a correction mode, with profit taking. It will continue to do so until another reason is discovered for reversing the trend.