Has the Gold Bubble Burst?

During the past two months gold has rallied by a mind blowing 30 percent as an increased number of investors have been seeking refuge in the yellow metal as worries about the health of banks, government debt and slowing global activity have taken their toll on other asset classes. A 400 dollar rally in such a short period of time became increasingly unsustainable but was spurred on by some forecasts of 3,500 dollars or even 5,000 within a foreseeable future had short term speculators piling in.

Over the last two weeks however we have begun to see hedge funds and large investors reducing their exposure. The weekly data from the U.S. Commodity Futures and Trade Commission shows that since 2 August they reduced long futures exposure by 20 percent to 622 metric tonnes. During the same time however exposure to exchange traded products continued to rise with investors adding 40 tonnes to a total of 2,200 tonnes before the sell-off began Tuesday.

What triggered the sell-off was probably a combination of a market that had become over-extended combined with a 55 percent margin increase by the CME which handles the global benchmark gold futures contract. With daily price swings above three percent CME felt that the cost of holding a contract worth 170,000 dollars had to increase. This has brought back memories and fears of a collapse similar to the one that hit silver back in May which also occurred after a steep rally was followed by an aggressive margin hike.

The question everyone asks today is whether the gold bubble has finally burst after a 200 dollar tumble from the 1,913.50 high reached on Tuesday. The severity of the sell-off has primarily been due to the amount of speculative positions having been built up over the last month and with much of that now out of the way many will have a look at the fundamental picture once again. The factors that have been driving gold higher over the last year have not gone away but after having over extended to the upside the near-term risk is one of an overextension to the downside. The Jackson Hole speech by Ben Bernanke of the U.S. Federal Reserve tomorrow at 16:00 CET could easily set the tone for the coming months, just like it did last year with the announcement of QE2. High expectations, especially for another round of quantitative easing, have been dwindling over the last couple of days. Given that gold would be the main beneficiary of QE3 the lack hereof could add to the downward pressure. 

Support in the market is now centered on 1,697 dollars which represents a 50 percent correction of the recent rally followed by moving average supports at 1,570 and 1,480. The uptrend is still firmly in place above 1,450 so even a major drop would not ruin the long-term prospect for gold.

Investors who want to benefit from the gold “bubble” need to show discipline and use trailing stops in order to avoid being burnt by corrections similar to the one we have just experienced.