Indian Restrictions Hit Gold; Dollar Strengthens

Raj K Raj | Hindustan Times | Getty Images

Customer tries on a gold necklace in New Delhi.

Gold slumped 1 percent Tuesday as new worries about demand drove prices back below $1,400 an ounce.

The metal closed well off its lows as stocks fell in the U.S. session but still finished off about 1 percent, at $1,397.20 per troy ounce.

Sellers came in after the Reserve Bank of India extended the import restrictions placed on banks last month to all trading houses and nominated agencies. The world's largest gold consumer made the move after fresh data showed that its gold imports had surged to about 162 tons in May from 142.5 tons in April, as prices fell.

"Gold became India's largest dollar import last year, superseding oil for the first time," said James Steel, chief metals analyst at HSBC. "As the current account balances deteriorated and the deficit became greater, I think the finance ministry has targeted gold, and earlier in the year they raised import taxes in an effort to limit the amount of gold coming into the country."

(Read More: Gold Ends at $1,397 on India Demand Concern)

Steel said the Indian wedding season, which ends in July, has been strong and that China will now provide some of the demand for gold that might have gone to India.

"It won't reduce the imports to zero, but we have to gauge what impact this is going to have," he said. "The drop in prices had a big impact in India in April. The rupee was enormously weak last year, so even though gold was down from its highs in dollar terms, it reached its all-time high in rupee terms last year."

The actively trade August contract for gold hit a low of $1,388 on Tuesday before recovering.

Kevin Grady, president of Phoenix Futures and Options, said gold's decline is not just about lower demand. "It's the gyrations in the dollar every day, and gold is not breaking any technical levels on the upside," he said. "I just can't get psyched about gold until we break those levels—$1,535 is where I start getting bullish on gold again."

Steel remains cautiously bullish and thinks gold has probably seen its lows, and he doesn't expect it to rally without more evidence that the U.S. economy is weakening—guaranteeing that the Fed will continue its monetary easing.

"Gold has run into some headwinds with higher yields and stronger equities," he said. "If those things were to reverse, and we were simply to see a cessation of the outflows from the [exchange-traded funds," gold would have a chance to rally, he said.

(Watch More: Can India Save Gold?)

According to Index Universe, SPDR Gold ETF GLD saw $3 billion in outflows last month, ending May with $45.4 billion, 11 percent less than at the end of April.

Steel still projects a double-digit pickup in demand this year. "If we still get a 10 to 15 increase in physical demand ... mostly from the emerging world, mostly Asia, that's why in our view it grinds higher," he said.