Daryl Guppy

Is the long-surging price of gold a bubble about to burst?

By Daryl Guppy (China Daily)
Updated: 2011-04-25 12:22

What do you do when the biggest borrower is threatened with a downgrade by the Standard and Poor's rating agency? This is not a small problem when the borrower is the United States.

True, the threatened downgrade is a single notch, but it comes immediately after acrimonious budget debates and the promise of further bitter hearings about lifting the United States' debt ceiling. This is a profligate spender arguing for yet another increase on their credit card limit. It highlights a pattern of behavior and a growing concern about the ultimate sustainability of US deficits at current, or even growing, levels.

US Treasury Secretary Tim Geithner's comments that there was "no chance of a downgrade" ignores the effect of this wake-up call. The fact the possibility has been canvassed by a rating agency as respected as Standard and Poor's means the damage is done. Ratings agencies came under fire for their role in the global financial crisis during which they were slow to recognize the extent of the problem. Some argue they helped cause the problem by assigning inappropriate ratings to the derivative instruments at the very core of the meltdown. If Standard and Poor's move is too late, then the situation is probably worse than it appears. If the Standard and Poor's move is more timely then it reveals a problem that is further advanced than many analysts acknowledge.

This combination of factors has accelerated the rise in the price of gold. It's a volatile mixture of fear, greed and speculation. The rise on the price chart is impressive but it takes place against a background of rising regulatory concern.

There are limited ways to buy gold. Many people buy small gold taels, or medallions, or gold jewelry as a store of value. This provides physical gold, but it soon becomes a problem with safe storage. Increasingly people buy gold through futures contracts and through Exchange Traded Commodity Funds. These are similar to Exchange Traded Funds (ETF). Some of the gold funds buy physical gold, but many funds use the COMEX futures contract as a basis for their fund.

In Europe regulators are taking a closer look at the ETF industry. The Financial Stability Board is asking questions about the systemic risks surrounding the funding and collateralization of ETFs. The chairman of the Financial Stability Board, Mario Draghi, said ETFs had all the hallmarks of a bubble waiting to burst and this needs close monitoring. Analysis by the Bank for International Settlements highlighted the derivative structure that potentially contains the same elements of contagion risks that contributed to the global financial crisis. This is the creation of derivatives from derivatives in the form of collateralized debt obligations. This is a $1.3 trillion ETF industry and accounts for about 20 percent of the US fund market, so the risks are a genuine concern.

This is not far removed from the gold price that reacts to investor speculation transferred through ETF buying. The rise of the price of gold has been underpinned by ETFs. When we look at the gold price analysis it is useful to remember this has many of the characteristics of a speculative bubble. Despite the genuine foundations underpinning the price rise, the structure of speculation suggests a pull back is inevitable. It means gold is a good trading instrument and that continued upside carries a risk of trend correction. These types of bubbles face their greatest risk from regulatory change that prevents some trading methods.

The challenge from a technical perspective is to identify the conditions that would suggest a collapse of the bubble, or a continuation of the bubble activity. The trend breakout above the resistance level near $1,420 to $1,440 has been powerful. The upside target is near $1,530. This is calculated by measuring the trading band between support at $1,320 and resistance near $1,420 and projecting this value upward. Once this level is achieved there is a high probability of a new resistance level developing with a consolidation band near $1,530.

The author is a well-known international financial technical analysis expert.