Gold's shine has faded a bit, is QE3 talk to blame?

Well, you can’t say you were not warned. The dizzying pace at which gold prices have climbed recently made it almost certain that they would take a tumble sooner or later.

[caption id=“attachment_69258” align=“alignleft” width=“380” caption=“Gold has gained 23 percent this year as snowballing global debt crises and turbulence in equity markets enhanced the appeal of the precious metal as an alternative asset. AFP”] [/caption]

The yellow metal extended losses on Thursday to fall as much as $200 from Tuesday’s record high, as investors favoured assets seen as higher risk and after the CME Group hiked trading margins for the precious metal for a second time this month.

Prices have eased primarily on growing speculation that the US Federal Reserve chairman Ben Bernanke will announce a further easing of monetary policy when he attends a meeting in Jackson Hole, Wyoming, on August 26.

The hope of further economic stimulus - the merits of which are highly debatable - has dimmed some of the shine of gold as a safe haven asset and boosted equity markets.

Gold has gained 23 percent this year as snowballing global debt crises and turbulence in equity markets enhanced the appeal of the precious metal as an alternative asset.In recent times, gold’s gains have been spectacular: in the past few days, prices were climbing by nearly $50 an ounce each day. In July alone, the price of gold surged by $400 an ounce.

The breathless pace of gold’s advance even put exchanges on which the metal is traded on alert: on Wednesday, US exchange operator CME Group (CME) raised collateral requirements for trading gold futures for the second time this month. It said gold margins would be raised 27 percent effective close of trading Thursday. By asking traders to provide more collateral, the exchange is trying to curb excessive speculation in the market. In China also, regulators raised collateral requirements for traders borrowing money to buy gold.

Investors typically put down a small deposit, known as a margin to trade gold futures. When there is a large sell-off, exchanges increase margin requirements to make up for the loss in the value of the collateral/assets. If traders cannot pay the higher margins, they have to liquidate their positions, which accelerates the selling.

In other signs of investor wariness, investors have been selling shares in the largest bullion-backed exchange-traded fund (ETF), SPDR Gold Shares, in the US. That, in turn, has forced the ETF to offload some of its store of bullion.

With the shiny metal’s sudden and hefty drop, the bears are starting to growl. Is this the end of gold’s super winning streak?

To be sure, the metal’s rally has extended too far, too fast: even the most die-hard gold enthusiast would find it hard to disagree with that. “You have a commodity that retail investors, hedge funds and everybody were long, and the technical indicators showed it was overbought. It was just a matter of time before the market starts cracking,” Mihir Dange, a gold options trader in Chicago told Reuters.

Last week, Wells Fargo and Co said in a report that rising speculative demand from investors had pushed the market into a “bubble that is poised to burst.”

Unlike stocks or bonds, gold does not pay any dividend or interest. Its value is tied to what investors are willing to pay for it. And that’s the problem, according to some experts. “When you have something so subjected to investor psychology, you can see extreme reactions,” Cetin Ciner, a professor of finance at the University of North Carolina-Washington told Associated Press .

With gold prices rising so rapidly, there’s little doubt it was time for a correction. “I think it was overbought, yes. I think the rally was too quick during a short amount of timespan,” CPM Group analyst Carlos Sanchez said. Some of weakness in prices might also be due to traders opting to book profits.

So where does gold go from here? It’s most likely that a further sharp correction in gold is possible in the short term. Prices might fall back to $1,650 an ounce. “Nothing goes up in a straight line! I suspect that there is one hell of a correction to this most recent surge in the not-too-distant future,” Martin Murenbeeld, chief economist for Dundee Wealth, wrote in his weekly “Gold Monitor.”

The correction that analysts expect in the short term has more to do with the pace at which prices have gained, not the prices themselves. Gains accrued in a slow and steady manner are more likely to be sustainable than those of the kind that recently turned the metal into an overnight star.

In the medium term, the drivers for gold’s rise remain unchanged: the sovereign debt crisis engulfing Europe is still far from being resolved, the flagging US economy seems in danger of slipping into another recession and inflation worries continue to plague nations such as China and India. Gold is typically bought as a hedge against inflation. Plus, central banks around the world continue to repose their faith in the precious metal by steadily increasing their holdings.

More importantly, India, the world’s biggest consumer of gold, continues to be a fan: both jewellery demand (up 17 percent from a year ago) and investment demand (up more than 200 percent, judging by the increase in investments in gold ETFs) continue to be robust, according to a Citigroup report. The Citigroup analysts, like several other experts, predict that gold could jump to $2,000 an ounce in the short term. However, unlike other analysts, they also expect gold prices to plunge back to $1,000 levels in the long term, once the global financial uncertainty dissipates. At this point, that view seems a bit extreme, given that the “financial uncertainty” they talk about seems a long way off from dissipating, even in the long term.

In the medium term, it would be prudent to remember that gold prices fell when equities nosedived as the 2008 global financial crisis erupted, before going on to hit new highs.In 2010 too, gold prices advanced 30 percent, as rising inflation and the impact of central bankers’ actions on the value of paper currencies occupied investors’ minds.

History tells us that gold prices have a habit of making sharp pullbacks that ultimately prove temporary.So, don’t dismiss gold just yet.