Chart traders were exponents of the wedge long before it was discovered by Australian politicians.  With markets having tentatively decided that the Grexit risk has diminished, gold has retreated from its recent peak this week. This move looks consistent with the final decline to a major low in a wedge pattern.

 

Gold Demand

 

Investment demand for gold has fallen over the past couple of years. The latest World Gold Council report reveals that investment accounted for only 26% of world demand in the March quarter. However despite its diminished levels, investment demand is usually the main swing factor in gold’s demand/supply balance and tends to have the greatest impact on price changes in the short term.

If Grexit is off the agenda, it will presumably see reduced demand from investors looking to gold as a hedge against risk in the European banking system.

Possibly more significantly though, reduced concerns about Greece have allowed markets to get back to the job of adjusting for a world of gradually rising interest rates, led by the US Federal Reserve Board. Higher US interest rates have negative implications for gold. Firstly they will increase the funding and opportunity costs of owning gold which pays no dividends. Secondly, higher US rates are likely to see $US rise over time. All things equal, this results in a compensating decline in the gold price which is quoted in $US.

This scenario comes against a background of relatively soft demand for gold jewellery. According to the World Gold Council, jewellery accounted for 56% of total demand in the March quarter. Total jewellery demand was down 3% year on year, led by a 10% reduction from Chinese customers in response to weaker consumer sentiment.

 

Buying when everybody thinks inflation is under control.

 

 One of the core underpinnings of investment in gold is to hedge against inflation. It’s effectiveness in this role depends crucially on a couple of things. For investors outside the US, currency movements have a big impact. An increase in the exchange rate of your home currency v the $US might largely offset the benefit of a rising $US gold price.

For all investors though, timing is also crucial. In the long run buying gold at cyclical lows turns out to be the best hedge against inflation. This means buying when most people think there is little risk of inflation. Those who bought gold at its peak in 1980 when inflation was rampant took 26 years to recover their money. Those who bought in the late 1990’s when the consensus view was that Alan Greenspan and the central banks had inflation worked out, had a great result as inflation turned out to edge relentlessly higher in the years leading up to the GFC.

 

Gold Wedge

 

How might the chart outlook fit with this scenario?

My hunch is that the decline in gold from its $1920 peak is taking an Elliot, 5 wave formation. I’ve labelled this on the monthly gold chart below.

Elliot wave theory says that an overall move in a market takes 5 waves, 3 in the direction of the trend with 2 corrections in between. A few simple rules need to apply to these 5 waves. In a downtrend:

 

 

 

 

 

 

 

 

 

  • The correction up to “2” must not move above the beginning point of the 5 waves.
  • The correction up to “4” must not move above the low at “1” and
  • The wave down from “2” to “3” must not be the shortest of the three waves in the direction of the trend i.e. it must at least be longer than either Wave 1 or Wave 5. Often it’s longer than both.

 

If this scenario is true for gold, we are now in the 5th and final wave of the current major downtrend. When this ends, a significant upward correction could occur.

This is where the wedge comes in. The 5th wave sometimes takes the form of a wedge formation as I’ve drawn on the chart. According to the text book there will be 5 touches of the wedge boundary. The final one will be a swing down to the bottom support line of the wedge, although sometimes price can spike briefly through the lower boundary in a false break.

Right now then, we could be in the final move down in the wedge. The potential end point of this will depend on how quickly price gets there and whether there is a spike below the support line. As a minimum though, it looks likely to be somewhere below $1100 and possibly down towards $1000.

However, when the low point of the wedge is rejected it could signal the end of the 5th wave. That might be interesting given consensus views that inflation risks remain very low due to the extent of spare capacity and unemployment in most developed economies.

 

Monthly Gold Chart

 

Gold cash CFD Monthly Click to Enlarge Gold cash CFD Monthly
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