Precious metals: Liquidity injections from the Fed are supportive for prices

Precious metals prices and gold, in particular, continue to take direction from the dollar. Accordingly, the complex traded somewhat lower at the beginning of the week, when the dollar briefly appreciated.

However, with the new extension and  broadening of the lending program by the Federal Reserve which was announced this week, bullish sentiment returned to precious metals markets. At the moment, gold is trading at USD 995. Silver prices stand at USD 20.60. Platinum and palladium trade at USD 2,150 and USD 500 respectively.

As we have already mentioned in previous issues of the Research Weekly – Commodities, we think that the gold price rally is entering a more mature stage, which means a slowdown of the price gains and an increase in volatility. This is confirmed by the latest price movements in the gold market, as well as in the markets for other precious metals. Volatility has been rising ever since the liquidity problems in the money markets started in August 2007. Since then, gold prices have increased by roughly 45%. The rally is now starting to have negative effects on the physical gold market.

The latest data shows that jewelry demand is being hit hard by the price increase. In the fourth quarter of 2007, global gold jewelry demand declined 17% YoY. The weakening physical market is likely to push volatility to even higher levels in the months ahead and is also our main argument why we believe that the gold rally is likely to slow down somewhat. Apart from the developments on the physical market, financial market conditions are still very supportive for gold. The dollar continues to weaken and we believe that it will depreciate further, particularly versus Asian currencies. Moreover, inflation expectations in the USA as implied by 10 year Treasury Inflation Protected Securities (TIPS) are surging sharply. This is additionally supportive for the gold price.

The recent actions by the Federal Reserve in the USA are also positive for precious metals. The extension of the lending program is designed to bring liquidity to the market. We believe that eventually some of this liquidity will find its way into the commodity markets, as has already been observed since the beginning of the year. Moreover, our economists also expect the Fed to continue cutting interest rates. This will push the real Fed funds rate even more into negative territory. In our view, negative real interest rates in the USA will prevail for the next six months at least. This is significant for precious metals prices. Since gold pays no interest or dividends, negative real yields make an investment in gold attractive.

In a nutshell, we think that the gold price will continue to increase and eventually break the USD 1,000 mark decisively. However, the speed of the price rally will be lower than in the previous months as the rally is becoming more mature. At the same time, volatility is likely to increase further, making temporary price corrections likely from time to time. Overall, we believe that gold prices of USD 900 are buying levels.

source: CS