Metals Sell Off: Is the Year's Hottest Trade Breaking Down?

Investors rushing headlong into precious metals likely took pause Wednesday as gold and silver prices plunged sharply, with gold futures losing $30 an ounce and silver plunging 5 percent so far on the day.

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Both metals were blowing through key technical levels; for gold, that marks a sharp reversal from a record high hit just a day earlier.

A big factor in the pronounced sell-off in precious metals has been the rise in real interest rates. For months, the gold trade has been very much about zero or negative real interest rates. Yet as Treasury yields and real interest rates rise, so does the opportunity cost of holding gold.

"The market fears that the increase in Treasury yields will soon push real yields back in positive territory," says MF Global precious metals analyst Tom Pawlicki. "The developing trend of higher stocks, dollar, and yields signals economic growth. That would take away the need for previously bullish drivers like safe-haven or more quantative easing."

Another factor pressuring the market is the fear that China is days away from announcing an interest rate hike, as it is set to release its monthly consumer price inflation on Friday, two days earlier than previously expected. A major concern is that a shift toward tighter monetary policy in China will slow investment demand from one of the world's largest consumers of all commodities, including precious metals.

Also important in Wednesday's sharp slide is the bearish technical levels that have been breached. After hitting an all-time high over $1,430 an ounce on Tuesday, gold has fallen below near-term support at $1,385, the high on November 23.

"We're seeing severe profit-taking after yesterday's highs," says independent trader Anthony Neglia of Tower Trading. "If we break down below $1,375, we could be at $1,350 by the end of the week."

Silver, as it is more highly leveraged, has made a more precipitous drop from the fresh 30-year high above $30 it reached on Tuesday. Silver remains above $28, but came very close to a key technical reversal point earlier in the session.

A steep correction may be in store.

"I would not be surprised if we are on the defensive for the rest of the year," says HSBC precious metals analyst Jim Steel. "The market did reach new highs, has been extremely long and the temptation to take profits before the holidays is extremely compelling."

But traders and analysts say even if the pullback intensifies a bit, the bull market for precious metals should remain firmly in tact in 2011. Gold and silver still "have a long way to go," Neglia says, before they've completely broken down.