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Cheer up, gold bugs: HSBC predicts a year-end recovery

The precipitous downturn in gold has taken the market to levels not seen since March 2009 but low prices may contain the seeds of the next rally, according to HSBC.

The bank projects prices will end the year as much as 10 percent higher than current levels; gold closed at $1,114 an ounce on Friday.

Gold has struggled to regain its allure this year, down 6 percent since January, as investors continue to shun the precious metal in favor of higher yielding assets such as equities.

But there could be some light at the end of the tunnel, with HSBC offering food for thought on the possibility of a gold resurgence. In a report on Friday, the bank set out five reasons its experts believe gold prices could recover to $1,200 per ounce to $1,225 towards the end of the year.

1. Fed tightening is already priced into gold

With a shift in the Federal Reserve's policy having been anticipated in the financial markets since as early as 2013, some of the declines based on a rate rise have already occurred, the bank said.

Therefore, gold's reaction to the rate hike – whenever it comes – may not be as negative as feared.

2. Actual Fed hikes could see gold prices rise

History suggests that the U.S. dollar tends to weaken after the Fed raises rates, which bodes well for gold, which is inversely correlated to the greenback. One reason for this inverse correlation, according to analysts, is that a weaker dollar makes gold less expensive for holders of other currencies, raising its appeal.

A look at the previous four Fed previous tightening cycles that have happened over the past 30 years, the dollar has fallen for the 100 days immediately after the first rate rise.

"This pattern has important ramifications for gold. History shows that gold prices…generally rise, though sometimes with a lag, after the first rate hike," the bank said.

3. There's scope for a short-covering rally

Short positions in gold are historically high while long positions, though high aren't exceptional by historical standards. This leaves the market open to a sharp short covering rally if investment sentiment reverse, the bank said.

Gross short positions on the Comex touched an all-time peak on July 7 and remain close to that level, while gross long positions are at their highest since December 2009.

4. Low prices will, ultimately, spur demand

While emerging market consumers have so far failed to react to the drop in prices with increasing purchases, low prices will eventually spur greater demand, the bank said.

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"In important gold consuming nations, such as China, India, Indonesia, and Vietnam, as well as other EMs, consumers may have fewer tools at their disposal with which to protect savings and household wealth against rising prices or low or negative real interest rates."

Annual per capita consumption of gold in India and China is relatively low at one gram, leaving significant room for growth as income grows in these nations, it noted.

5. Central bank buying will remain supportive

The People's Bank of China's higher gold reserve holdings are bullish for the market in the longer-term, the bank said. The central bank recently revealed its gold reserves stood at 1,658 tons at the end of June, up 57 percent since the last time it reported holdings in 2009.

"The PBoC is an important central bank with significant influence. The mere fact that they have accumulated gold may lead other EM central banks to examine purchasing bullion," it said.

"Also many central banks hold quite low levels of gold reserves in relation to their forex holdings, leaving room for further accumulation."