The violence of the fall in the gold price has taken investors by surprise and has understandably led to questions about whether this is a short-term correction driven by technical and hedge fund-led speculative activity or if it signals the end of the 12-year gold bull market.
Below we highlight some of the factors behind the recent gold price declines and our view of the longer-term outlook.
What triggered the sharp sell-off in April?
There were a number of fundamental, technical and investor behavioural factors that likely drove the most recent correction in the gold price.
Performance of index over 1yr
Source: FE Analytics
In our view it was a classic case of speculative investors taking advantage of gold-negative fundamental news and technical break-points to drive a self-fulfilling downward cascade of the gold price.
Arguably the most important catalyst was that a number of gold price technical support levels were breached – with some saying they were strategically pushed through by well-timed large hedge fund selling – triggering margin calls, momentum and model-based investor selling.
Given the size of short COMEX futures positions, an equally powerful short-covering rally may also occur once markets have stabilised, new technical levels evolve and gold fundamental news improves.
Is the 12-year gold bull market over?
The gold price has been trending down since October 2012. The main reason for the fall in the gold price has been rising global growth expectations, particularly in the US, which has lifted interest rate expectations, ratcheted back quantitative easing expectations and boosted investor appetite for cyclical and risky assets.
Normally this alone wouldn't be enough to knock back the gold price, as during most risk-on moves the US dollar weakens, which often helps support the gold price.
However, because of the dire macro situation in Europe and aggressive quantitative easing by the Bank of Japan, during this risk-on move the US dollar has actually strengthened.
This has added further impetus to the downward move in the gold price.
The gold price will face headwinds as long as US interest rate expectations continue to rise and the US dollar continues to strengthen. However, in our view these are tactical/cyclical factors that are temporary.
The rise in developed economy debt burdens, driven by demographic change and entrenched interests, continues unabated. Interest rates will need to remain structurally low to offset fiscal drag, keep interest rate payments from ballooning and support growth. Quantitative easing expectations will ebb and flow with business cycle developments.
However, until the countries backing the world's major reserve currencies put in place credible policies to control their growing debt burdens, the public will look to gold as one of the few hard currency hedges against the risk these countries continue to try to reduce their real debt burdens through the debasement of the purchasing power of their currencies.
Gold will remain in a bull market until these debt issues are resolved or a credible and liquid alternative to the current fiat reserve currencies emerges.
Is gold in a bubble?
Looking at the past 10-year performance of gold to known historic bubbles in other assets, we can see that price gains in gold have been modest.
Performance of indices over 10yrs
Source: FE Analytics
For example, looking at the 10 years running up to the peak of the NASDAQ bubble of 2000 and the gold bubble of 1980, the rise of the gold price seems far from excessive.
Performance of indices 1990 to 2001
Source: FE Analytics
With gold at a two-year low, this could be perceived as a potential buying opportunity.
The governments backing the world's major reserve currencies are faced with extremely large and growing debt burdens.
Ageing populations and insufficient working populations to support current levels of benefits mean that debt levels will swell significantly further without very substantial and politically painful cuts or tax rises.
These can also be counterproductive to the extent they reduce economic growth and therefore government revenues. This puts government in a particularly tight bind.
Europe faces the added problem of backing a single currency for countries with substantially different economic and social fundamentals.
Until these issues are resolved, there will be a natural demand from the public for alternatives to these fiat currencies.
Gold historically has been the first stop of the public when it loses faith that governments will be able to pay back their debts without resorting to inflation/currency debasement. This time is unlikely to be any different.
What is the outlook for the gold price?
The longer-term fundamentals for gold remain strong and ultimately should re-assert themselves once cyclical and technical factors move again in gold's favour.
The fragility of the US recovery, ongoing eurozone weakness and continued high sovereign debt risks are likely to keep central banks firmly in aggressive stimulus mode.
The growth of gold supply remains limited, with production growing by just over 9 per cent over the past decade and recent disruptions in South Africa threatening miners' productivity.
Emerging market central banks have become large net buyers of gold since 2010, equivalent to around 12 per cent of total supply.
Chinese physical demand is the second largest in the world, after India, with Chinese imports of gold now accounting for nearly 20 per cent of total annual demand, from levels of under 3 per cent 10 years ago.
China's demand for gold has been accelerating in recent months.
Given the technical nature of the recent sell-off, short-term moves in gold are especially difficult to predict – both up and down.
However, at these levels physical buyers – central banks, India and China jewellery demand, long-term strategic investors in gold – will likely start to emerge once the market calms down.
Gold needs a positive impetus such as a reduction in US interest rate increase expectations, signs of deteriorating European sovereign debt fundamentals and a weaker US dollar, to resume its bull market climb.
However, with COMEX speculative short positions at all-time highs, in our view the likelihood of a short-covering rally are now higher than another large downward leg of the price correction.
Nitesh Shah is a research analyst at ETF Securities. The views expressed here are his own.