Gold Prices and the Government Shutdown

During periods of normal, uneventful market conditions, gold slips into its commodity role and simply moves opposite the U.S. dollar, as most commodities priced in USD will.

But in times of market turmoil and uncertainty, gold takes on the role of a safe haven and can move in dramatic spurts regardless of how equities, bonds, or even the USD move.

Gold may already be in just such a period now, with uncertainties over the U.S. government’s budget, credit limit, possible default on its debt payments, continuing expenses in monthly stimulus, and new expenses in Obamacare.

Add the “Closed” sign on federal government offices around the country this morning and we have a potentially explosive mixture that could propel gold sky high.

Fundamentals Favor Flight

All the business headlines these days favor a rising gold price. Since gold is priced in USD, anything affecting the future value of the dollar is worth noting. Four critical events are lined up like dominos that could trigger a significant leg up for the gold price.

• Government shutdown: As of this morning, the federal government has trimmed its operations to the bare essentials. This may not necessarily be bullish for gold in and of itself, since “a government shutdown is very disinflationary by nature and is not a gold driver,” Yves Lamoureux, president of market advisory firm Lamoureux & Co., explained to MarketWatch.

What is bullish for gold, though, is the uncertainty that a government shutdown brings, as the first domino falls into the next.

• Debt ceiling: A continued shutdown puts into doubt the raising of the U.S. government’s credit limit in two weeks. If the limit is not raised in time, the government risks defaulting on its debts.

“The market is complacent about government funding and the debt ceiling,” Jonathan Barratt, chief executive officer of commodity newsletter Barratt’s Bulletin, noted to CNBC. “We are back in the [gold] market at $1,324 as we expect a little safe haven buying. We added to our position on the break of $1,333 and are now targeting $1,350.”

• Downgrade: Any default on government debts risks triggering a third domino to fall – the downgrade of America’s credit rating, which would subject the U.S. to higher interest rates on debt renewals. The last time the U.S. credit rating was downgraded on August 5^th, 2011, gold surged upward $250 in just two weeks. Over the same period, the S&P 500 index fell over 10%.

• Dollar pressure: A lower credit rating and higher interest rates on debt would deliver the fourth and final blow onto the U.S. dollar, sending it reeling. And since gold trades relative to the USD, “a softer dollar should be supportive of [any] gold weakness,” Barratt informed CNBC.

Sean Hyman, editor of Moneynews at Ultimate Wealth Report, confirmed to CNBC the dollar’s importance as a gold driver. “The dollar is playing a huge roll. It’s been dropping since last July and appears to have broken its two-year uptrend line. If that continues, that alone will be very supportive of gold and silver heading higher.”

So far, the first domino has already fallen, as Americans woke up this morning to the first federal government shutdown in 17 years. Will the next three dominos give way also?

After the Confusion

Many economists believe not, placing slim chances on the likelihood of politicians allowing things to get so far out of hand. “It is definitely a short-term phenomenon,” analyst Barnabas Gan at OCBC Bank opined to Reuters. Gan believes any positive boost to the gold price over the coming days and weeks will ultimately wear off, as “the sentiment towards gold is still expected to be bearish for the full year”.

Barclays Plc (NYSE: BCS) forecasts gold to average $1,270 by the last quarter of 2014, while investment banks Goldman Sachs (NYSE: GS), Citigroup (NYSE: C), and Morgan Stanley (NYSE: MS) forecast gold to resume declines in 2014 as the U.S. economy improves and the Fed finally eliminates its monthly bond purchases for good.

“Evidence of an improvement within the global economy as well as financial stability within the credit markets is a negative for the gold investor,” Chad Morganlander, fund manager at Stifel Nicolaus & Co, concurred to Bloomberg. “As the economy and the financial system heals itself, gold will continue to underperform other speculative asset classes.”

But even if the U.S. government closure is brief and the debt ceiling crisis is resolved in the nick of time, avoiding a default and subsequent credit rating downgrade, one lingering worry remains that could push the USD down significantly and lift gold up to new all-time highs… inflation.

Inflation Risk Ahead

Inflation benefits gold, which has long been used to hedge against rising prices. “Longer term, gold buyers want to see inflation start to take hold,” Adam Koos, president at Libertas Wealth Management Group, advised MarketWatch.

Gold buyers may have their wish for inflation granted sooner than later. The core inflation rate continued rising in August to 1.2%. And it’s all thanks to the continuing stimulus provided by the Federal Reserve through its $85 billion monthly bond purchases.

“The Fed has made it clear that the economy is weak, and the stimulus spigot will be open full-bore,” fund manager John Stephenson at First Asset Investment Management Inc. elaborated to Bloomberg. “That means they’re continuing to inject more into the money supply, and that is a bullish argument for gold.”

Even slight reductions to the Fed’s monthly bond buying won’t stop gold over the long term, since the Federal Reserve will not begin to remove stimulus back out of the economy until inflation reaches the 2% to 2.5% range. “We’ve got some time before that happens,” Koos informed MarketWatch.

Commodities Futures Trading Commission reports suggest that this is the consensus view among gold traders, as “bullish gold bets more than doubled since reaching a six-year low in June,” Bloomberg cites CFTC data. The latest data from IG Markets show 77% of its clients holding gold expect prices to climb. Hyman, for his part, predicts that “gold heads to $1,500-$1,575 next”.

Gold’s chart indicates Hyman may be right.

Critical Formation

After bottoming near $1,180 an ounce at the end of June, gold enjoyed a two month upswing that took it to $1,420 for a $240 gain. Since completing a 50% Fibonacci retracement to $1,300 by mid-September, the gold price has been plotting a very critical wedge formation of higher lows and lower highs, as indicated in the chart below. (click to enlarge)

Source: Barchart.com

When daily volatility slows and calms down – with lower highs and higher lows closing-in to form a wedge – the price bounces like a ping-pong ball between two paddles that keep moving closer and closer to each other. When those paddles come to a point, something has to give, shooting the price one way or the other.

When the price shoots, it usually moves toward the longer leg of the wedge, as the price retraces the longer trend. As can be seen in the blue wedges, gold retraced all four blue uptrends back down toward their beginnings. If the price reaches the beginning of the trend and falls through that support level, it usually breaks significantly further down.

But in the latest wedge shown in green, the longer leg of the wedge is above the price, indicating that the price should retrace that trend back up to its beginning at $1,425. If the price breaches that resistance level, it could break significantly further up.

Since retracements have been averaging two weeks or so, gold could find itself at that $1,425 resistance level by mid October, just in time to see what happens with the debt ceiling.

Joseph Cafariello

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