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Preiss: Expect Major Gold Correction Post Fed Easing Move

Michael Preiss |CNBC Contributor
Wednesday, 10 Nov 2010 | 4:06 AM ET

The Federal Open Market Committee (FOMC) delivered another round of quantitative easingor "QE2", largely as expected. The size of the program, at $600 billion in total through the end of the second quarter in, may have been a slight disappointment, but the overall tone of supporting growth in the context of excessively low inflation was what investors were looking for.

Cash and gold
Lilli Day | Photodisc | Getty Images
Cash and gold

Moreover, the statement emphasized that the FOMC would continue to review the pace and size of purchases “to best secure maximum employment and price stability.” This wording could potentially suggest a more active approach to varying the monthly program than was seen in 2009.

Overall, many, if not everyone, believe the Federal Reserve’s QE2 announcement will maintain the soft bias to the US dollar for a while.

The Fed is still loosening monetary policy at a time when Asia and emerging markets are tightening. As a result, the widening of interest rate spreads continues to attract fixed income and dedicated foreign exchange flows into emerging markets leading to an asset bubble.

Standard Chartered Global Research expects this broad dollar weakness to continue into mid-to-late November before giving way to more sustained profit-taking and risk-reduction ahead of the year-end. More specifically, we think that euro-area negatives will return as an important focus heading into 2011.

Coordinated Central Bank Intervention?

Since the start of September, foreign exchange and global financial markets have been dominated by FOMC expectations and broad US dollar weakness.

The stage is now set for coordinated central bank intervention to support the dollar, a new Louvre Accord.

The G-20 statement made it clear that the US Treasury can no longer debase the dollar lower without the risk of capital controls, economic conflicts and trade wars. Brazil and Thailand have imposed taxes on foreign speculators who buy their domestic debt and South Africa could be next.

The US Congress wants to slap punitive tariffs on Chinese imports because the yuan is a manipulated currency. So is the dollar, of course.

After the QE2, there is a growing possibility that the Fed and the Bank of Japan will begin to buy dollars and coordinate their intervention. This will be a big deal worldwide. It will signal the new policy shift by the US Treasury.

The old market saying – ‘the trend is your friend until the trend comes to an end’ holds very true. This trend of broad based US dollar weakness will also end.

In order to make money you often have to take on a position that feels rather uncomfortable. If it would feel comfortable, you will most likely not make much money from this trade.

Gold Correction Seen in November

Gold Correction Seen in November

Consensus view is very negative on the US dollar and very positive on gold and high-yielding emerging market currencies.

Gold in particular has been a phenomenal performer in the past decade, rising from $250 in 2002 to above to $1,410 an ounce this week.

Gold
Jose Luis Pelaez | Iconica | Getty Images
Gold

Gold has benefited from macro trends such as the rise of per capita incomes in China, reserve diversification by central banks, the secular fall in the dollar, money printing and zero interest rates, the sheer scale of the gold ETF and the unsettled geopolitics of the Middle East. On an inflation-adjusted basis, gold is at least $800 below its peak in 1980 when Brezhnev’s Red Army invaded Afghanistan and the Shah of Iran lost his Peacock Throne.

Yet there is tangible evidence that a November correction in gold is imminent. Why?

One, the US dollar has bottomed against the euro at 1.40 and the new G-20 accord in South Korea rules out significant long-term dollar devaluation.

Gold has an inverse correlation with the dollar so a stronger greenback hits gold bids.

Two, US interest rates have begun to rise as the financial markets price in inflation risk as the natural end-game of the world central bank’s post-Lehman money-printing spree. The US ten-year Treasury note yieldhas spiked up to almost 2.70 percent and even the front end of the dollar yield curve has begun to tighten. This is bad news for gold.

Three, supply and demand curves respond to price bubbles in all commodities in real time. This is happening in gold. Chinese production has surged in the past three years while jewelry demand has evaporated at current prices. Every commodity bubble contains the seeds of its own nemesis as price hikes boost output and slash real, (not speculative paper) demand. Four, sentiment in gold is at all-time highs. Assets in the gold ETF make it the fifth largest holder of bullion in the world, bigger then most central banks. In speculative markets, extreme one-way sentiment bets always end in tears. Always.

Five, gold has assumed the role of a surrogate reserve currency even though it generates no income and has miniscule industrial value. In fact, the biggest gold bull market since the 1970’s predates the 2008 Wall Street crash and global recession. However, even bull market corrects violently, as gold did in 2006, 2008, and even last summer before Ben Bernanke’s Jackson Hole speech. However, the current gold price is 50 percent above its moving average trend lines and is clearly overbought.

The case for gold still exists in a world where property prices in the West and the Middle East have lost 20-50 percent of their value and could well be in the early stages of a ten-year bear market.

Watching China Inflation

The securitization and credit markets went in meltdown mode in 2008 and mortgage finance in many parts of the world has not recovered yet. If banks cannot securitize home mortgage pools, property prices cannot rise, even if the world’s current glut did not exist.

However, the real trigger and catalyst for a US dollar rally and a sharp drop in gold prices will be inflation and rising interest rates in China.

Inflation in China means the Beijing Politburo must now act and cool down an overheated, overbuilt Chinese economy that sits on too many US dollar reserves that QE2 is now rapidly debasing in value.

This was the message of the last PBOC rate hike. China is now set to increase lending and deposit rates at least five times in the next eight months.

Our Standard Chartered Global Research forecast is that we will see interest rates rising again in China before the end of the year. We believe the motivation by Chinese policymakers for additional hikes is to turn risk off in the property sector – something that investors ignore at their peril. Because of this potential risk, our Standard Chartered GIC (Global Investment Council) has revised the “house-view” on equities to neutral on a three-month view.

Gold above $1,400 an ounce, monetary tightening in China, higher US bond yields and the Fed’s measured QE, will all trigger a major correction in gold and a subsequent surge in a very oversold and unloved US dollar.

In the final analysis and in the words of a Chinese saying: “Fortune favors the brave and prepared mind.”

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Michael Preiss is the Head of Consumer Bank Client Research at Standard Chartered Bank and serves as its Chief Equities Strategist. He appears regularly on CNBC's Asia Pacific network.

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