Weekly Fundamentals - Recent Developments Support Gold's Outlook

  on November 06 2011 5:34 AM

The G-20 summit ended Friday mainly focused on the sovereign debt crisis in the Eurozone. Two critical developments we observed were Italy's acceptance of surveillance and monitor by the IMF, as well as the failure to agree on the use of IMF resources. Both are expected to affect market sentiment towards the 17-nation region.

In the IMF program to monitor Italy's progress of the reforms, the world lender will provide independent and frequent assessments of the economic and financial conditions of Italy. It will also review on the Italian government's implementation of the fiscal policy such that credibility will be built up in the government regarding policy implementation.

The G-20 communiqué stated that G-20 countries 'stand ready to ensure additional resources could be mobilised in a timely manner'. The various channels that countries can contribute to the IMF include bilateral contributions, SDRs, and voluntary contributions to an IMF special structure such as an administered account.

AS happened last week was Greece's announcement and cancellation of the referendum of the EU agreement, FOMC meeting as well as ECB meeting. We will discuss in the precious metal section on these issues and their impacts on gold price.

Energies: While macroeconomic developments have inevitably dominated new headlines and oil price movements, the DOE/EIA report offered some interesting points for discussion. Recent demand data has told a tale of 2 petroleum products, highlighting the strength on distillate and the weakness on gasoline. As the following chart shows, US distillate demand has been rising while gasoline demand dropping. The 4-week average of distillate demand has been climbing higher over the past week and reached 4.22M bpd for the week ended October 28. On the other hand, gasoline demand has dropped quite sharply over the past few weeks, reaching the lowest level in a year last week.

Seasonally, distillate balances tend to tighten during winter time as heating demand ramps up. We expect to see consumption in the oil product to remain strong.

The DOE/EIA reported that gas inventory increased +78 bcf to 3 797 bcf in the week ended October 28. Stocks were -17 bcf below the same period last year but -201 bcf, or +5.6%, above the 5-year average of 3 593 bcf.

Separately, Baker Hughes reported that the number of gas rigs plunged -27 units to 907 in the week ended November 4. Oil rigs soared +34 units to 1112 and miscellaneous rigs dipped -2 units to 7, sending the total number of rigs to 2026 units. Directionally oriented combined oil, gas, and miscellaneous rigs stayed unchanged at 243 units while horizontal rigs added +2 units to 1157 and vertical climbed +3units to 626 during the week.

Precious Metals: Gold gained for a second week. We concluded there were 3 key factors driving gold higher last week. First, while the Fed announced no change in interest rates and stimulus measures, it's clear that policymakers were seriously considering additional easing measures such as large-scale purchases of mortgage-backed securities. Interestingly, 3 members (Minneapolis Fed President Kocherlakota, Philadelphia Fed President Plosser and Dallas Fed President Fisher) who dissented implementation of operation twist at the last meeting dropped their dissent while Chicago Fed President Evans voted against the decision to stay on hold as he favored additional policy accommodation. This indicated that the economic condition has deteriorated so rapidly that more Fed members believed in the need of easing. Gold bulls found a reason for accumulating the yellow metal as the Fed funds rate will remain at exceptionally levels for at least until mid-2013 and the eventual implementation of 'QE3' will weaken the US dollar.

Second, the ECB surprisingly cut the main refinancing rate by -25 bps to 1.25% at the November meeting. It's unveiled in the accompanying statement that 'some of the downside risks have been materialising, which makes a significant revision to forecasts and projections for average real GDP growth in 2012 very likely'. Moreover, despite the ECB's stress on credibility and urge for governments to deal with fiscal issues, it appears that the central bank will be a main body in bailing out debt-ridden countries. We will probably see the ECB buying Spanish and Italian bonds later. Similar to the case of the Fed, gold benefits as the ECB keeps interest rates low.

Third, ups and downs of market sentiment were driven by Greece which had called for a referendum of the EU bailout plan agreed in late October but then cancelled. The acts raised questions about whether the Greek Prime Minister should step down and whether the country should stay in the Eurozone. These questions raised uncertainty in the sovereign debt crisis in the region and euro's outlook. Although gold and euro moves in line traditionally, the yellow metal does rally during economic turmoil despite euro's decline. That's what we had experienced over the past 2 years when problems in European debts and banking systems triggered strong demand for safe-haven investments.

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