Game remains the same for gold in 2014

After a tumultuous 2013, gold has started the new year a little stronger, although this doesn't look like much to be too excited about.  Given the investment thesis for gold continues to be mostly about the same things that drive real interest rates and the USD, the pressure on the yellow metal appears to be down.

It will, however, be important to keep an eye on the shifting composition of the drivers of physical demand, as this may ultimately change the way gold behaves.  There isn't any clear evidence this has happened yet, but there continues to be some interesting tensions building in the gold market.

Gold prices have risen a little while real interest rates have remained stable as shown in the first chart, although this is nothing like the big diversions seen earlier in the year.

Gold is also in the recent trading range against the USD TWI, suggesting there is nothing particularly out of line between gold and FX markets.

When combining these two factors into a simple regression model, recent movements in gold are not particularly far way from where we might have thought given well established relationships between these variables in the last 5 or so years. Again, this is distinctly different to April and September of 2013.

This simple model over the last 5 or so years has a pretty high R-squared of ~0.8.  The way I like to interpret this is that 80% of the movements in the gold price are explained by the same things that drives bonds and currencies, namely general macroeconomic factors like growth, inflation and monetary policy.

The other 20% of movements in gold price are factors which are more specific to gold, like conditions in physical markets or abnormal positioning in futures markets.  So understanding these factors are important, but are secondary to the bigger macroeconomic picture.

Physical ETFs have continued to see significant outflows over the past month or so, suggesting western investors continue to believe there are better opportunities in an environment of rising interest rates.

Futures positioning also shows a tilt towards weaker prices, with net speculative positioning likely to be negative when accounting for passive long positioning by index funds.

One critical factor to keep in mind is that it is rising real interest rates that have undermined gold, not nominal rates.  Stronger real rates have been a function of higher nominal rates and somewhat lower inflation expectations, which are ~25bps lower than what would be ideal for policy makers.

Many investors and analysts might see the potential for rising inflation expectations as bullish for gold.  But importantly this will only be the case if nominal interest rates remain stable, or don't rise as much.  At the moment, this seems unlikely given we are still along way from the point where inflation is problematic and policy makers are behind the curve.

While western investor interest has waned as tapering by the FOMC has begun, this has been offset to some degree by better interest in China. Lower prices has lifted turnover and premiums into China, although this impulse remains subdued compared to the boom periods seen earlier in the year.  Another sign of this bull in physical demand are negative GOFO rates, which have again drifted below zero.

So 80% of the picture looks negative for gold, while the remaining 20% is looking somewhat balanced.  That leaves the total picture as negative.