Gold eyes 1175 as USD does it like 2005

Gold’s 10% decline to fresh 8-month lows from its July highs and its 16% drop from its August 2013 highs, and intensified in late August as the end of the Fed’s QE3 became inevitable. The simultaneous rally in bond yields and the US dollar since early September helped accelerate gold’s downward momentum below $1270 to reach a new low for the year at $1208.  Considering the US dollar is rallying in ways not seen since 2005, gold weakness is here to stay.

Dollar “internal” strength unseen since 2005

The current dollar momentum continues to show signs of a rally not seen since 2005. Why 2005? Back then, the US dollar index, as measured by the 6-currency basket of EUR, JPY, GBP, CAD, CHF & SEK, rallied against each of those currencies, particularly the Japanese yen. In each of the USDX rallies of H1 2013, 2011, 2010 or H2 2008, the index was primarily boosted by EUR weakness and/or relative USD strength, but never by a USD rally that included JPY weakness . Today, USDJPY is at 6-year highs, partly reflecting an “organic “ build-up of USD fundamentals, which will witness an important removal of the Fed’s quantitative easing component.

And so the last time the USD witnessed a truly fundamental rally, reflecting USD strength, and not solely weakness from Europe and Asia, or safe haven accumulation, was in 2005, when the Fed was six months into a tightening monetary policy, while Europe and Japan remained in easing mode. In fact, the 2005 USD rally was so strong that even firming gold prices in H2 of that year failed to weigh on the currency.

Shanghai’s gold play 

China’s aspirations to become the leader in gold benchmark price-setting in Asia is on track as Shanghai opened bullion-trading to foreign players for the first time last week. “The launch of the gold contracts will increase China’s influence and improve price discovery” China central bank governor Zhou Xiaochuan said last week.

China consumes over a third of global supply, with gold imports surpassing 1,000 tonnes last year and local production is about 400 tonnes. Gold contracts will be priced and settled in yuan from a vault capable of holding 1,500 metric tons of gold. China is seeking to open up its bullion markets just as domestic demand weakens.

China’s push for an international physical exchange, is likely to strengthen the influence of physical demand on bullion prices as is currently the case from the impact of speculative trading. The contracts on the new Shanghai exchange will be traded between bullion banks, refiners, producers and trading houses. Similar gold exchanges contracts are also due to become operational in Chicago (Chicago Mercantile Exchange), Hong Kong, Singapore and Dubai.

Gold’s next stop

Despite gold’s considerable price decline, speculative net longs at the Comex remain 70% above their 2013 lows. Whether this indicates the bulk of the selling is taking part in the physical market, and/or speculative shorts have further downside ahead, beware of the next short squeeze courtesy of Chinese bottom fishing in Shanghai. This may not happen before see gold hitting $1,175. Once the short squeeze occurs, the bounce is seen capped at $1280.