Gold: Only half way to the bottom?

How low can gold go? Down by another 25%, when it will be priced at less than $US1000 an ounce, is the answer to that question because gold has lost its appeal as an asset of last resort in a world pregnant with the expectation of rising interest rates.

Gold’s Achilles' heel has always been its status as a negative asset caused by the fact that in its physical state, or as an exchange-traded product, it generates no yield for its owner, and can incur a cost to be held.

As shares in a gold mining company it is even worse with asset-value write-downs compounding losses incurred as production costs have risen into a falling gold price.

Investors in Newcrest Mining, easily Australia’s biggest gold miner, have suffered heavy losses over the past few years as the company has struggled to produce gold profitably and then been forced to write down the value of its assets.

Over the past four years, a period that incorporates gold’s peak price and recent fall in value, Newcrest’s share price plunged by 83.7%, dropping from a high of $42.63 in November, 2010, to a low of $6.96 last December.

Newcrest shares have recovered from that low to be trading around $10.48, but the company continues to receive mixed reviews with investment bank price tips over the next 12 months ranging from a high of $12.50 from Merrill Lynch to a low of $7.50 from UBS.

The problem with gold, an asset which I once found appealing, is that times have changed. Gold is for troubled times as a safe haven investment and as a counterweight to inflation.

Despite Ukraine’s civil war and non-stop fighting in the Middle East the world is not in crisis and inflation is so benign that some governments are trying to kick-start their economies by creating inflation to avoid an even more fearful economic bogeyman, deflation.

Seven years ago it was different and gold was undoubtedly the place to be. The world was on the brink of a catastrophic economic meltdown with massive doses of government monetary stimulus triggering fears of an outbreak of rapid inflation.

Back in 2007 gold was just starting a spectacular upward drive. It opened the year at $US640 an ounce and closed at $US836 an ounce, and that was just the start of its journey to an all-time high of $US1,895 an ounce in September, 2011.

Since that peak, and largely because of fading fears that the world is on the brink of disaster, gold has been in retreat, leading to a warning in a story I filed from London for Eureka Report just under two years ago (Gold warning bells chime) that started with these words: “Gold is in trouble”.

On that day in 2012 gold was trading at $US1,712 an ounce but sentiment was turning against the metal which generates no yield but performs a useful task as a sheet-anchor, or an insurance policy against catastrophe, in an investment portfolio.

Today, gold is trading at around $US1,235 an ounce, a fall of 28% in US dollar terms. However, it has fallen less in Australian dollars after allowing for the drop in the exchange rate which was $US1.04 in December, 2012, to around US90 cents today.

A guide to the future direction of gold will come tonight when the chair of the US central bank, Janet Yellen, speaks publicly after a two-day meeting of the Federal Open Market Committee, the Federal Reserve System’s primary policy setting group.

Most interest in what she will say during a web-broadcast on Wednesday evening (Washington time) will focus on the timing of changes to the banks stimulus policies and comments on interest rates.

The consensus view of economists surveyed over the past few days by the Bloomberg news service is that the first upward move in official US interest rates will not take place until the middle of next year, and even then be a modest move up.

Another problem for gold is that even a modest increase in interest rates will cause investors to rethink their strategies and compare an asset class yielding zero with other safe havens such as 10-year US Treasury bonds which currently yield 2.57% and are highly likely to rise steadily in future years.

There is no debate among economists that a rate rise is coming. The only unknowns are when, and the pace of the increase as the US creeps closer to the Federal Reserve’s targets of full employment and stable inflation.

Full employment is defined broadly as 5% unemployment. A year ago US unemployment stood at 7.2%. Today it is 6.1%. The annual rate of inflation is less than 2%.

As the US economy recovers so does the country’s currency which is rising strongly against key rivals such as the euro and lesser currencies such as the Australian dollar.

A strong US dollar is the ultimate enemy of gold with the prospect of higher US interest rates adding to the attraction of holding US dollar denominated assets.

It’s with this background, and with events such as the current meeting of the US central bank’s supreme policy setting committee underway now, that the gold price appears poised to take another step down.

Most investment banks are cautious about the outlook for gold but one is particularly pessimistic.

Goldman Sachs, the bank which correctly tipped a big fall in the price of iron ore to around $US80 a tonne two years ago, is the big bear in the room with a gold price tip of $US1,050 an ounce.

Arch-rivals, JP Morgan and UBS, reckon the long-term gold price will sit around $US1,300 an ounce.

Given its success in forecasting the iron ore slump it would be unwise to ignore the view of Goldman Sachs which is why its $US1,050 an ounce should be seen as the next target price for gold, and perhaps below the $US1,000 an ounce barrier if it overshoots that target.

There are two other reasons for being pessimistic about the outlook for gold. Firstly, because volatility in the price has dropped to its lowest since October, 2010, and secondly, because it is only five years since gold passed the $US1,000 an ounce mark on its way up.

The fall back to $US1,000 an ounce could be achieved just as quickly and if that’s true we’re about half-way through the price correction period with the $US1,000 an ounce mark likely to be breached in 2017 – about the same time US interest rates are expected to have returned to a normal setting.

As an investment, gold is losing its speculative appeal and is returning to its role as an insurance policy against economic turmoil.