3 Charts Explaining Why Gold Could Recover

The gold market has cooled down in the past several weeks, mainly after the Federal Open Market Committee, or FOMC, decided to taper its asset purchase program back on March 19. The FOMC's revised monetary policy may have softened the demand for gold -- an investment considered a hedge against the depreciation of the U.S. dollar, including a sudden rise in inflation. But will gold bounce back? Here are three charts that show the recent developments in the financial markets and why gold could rally. 

The price of gold dropped by 6% during the past couple of weeks, after it had slowly rallied in previous months. The following table demonstrates the shift in financial markets during March.

Data from Bloomberg.

As you can see, gold rallied in the first half of March and added nearly 4% to its value until March 17. But since then, gold has plummeted. Leading gold ETFs including SPDR Gold (NYSEMKT: GLD  ) and iShares Gold Trust (NYSEMKT: IAU  ) have also changed course in recent weeks and shed 5.4% since March 17; iShares Gold Trust fell by a similar rate. Despite the recent fall in the price of gold, these ETFs' demand is still up for March: iShares Gold's holdings increased by 1% during the month, and SPDR Gold's gold holdings rose by 1.7%. This brings me to the first chart that could encourage bullion investors: 

Source: SPDR website.

The chart shows the progress of the gold hoards in GLD's chart during 2013-2014. Even though SPDR's gold hoards plummeted during 2013, they have rallied in 2014. And even when the price of gold declined in recent weeks, the demand for SPDR Gold kept slowly rising. If this ETF's gold holdings continue to rise, this could signal that the demand for gold as an investment will increase further. 

Gold prices started to fall close to the FOMC's policy meeting on March 18 and 19. In the meeting, the FOMC tapered its QE3 asset purchase program by $10 billion, moving it down to $55 billion a month. If the FOMC continues to taper QE3 in the coming months, it won't have a long-term negative effect on the price of gold. The following chart explains why. 

Sources: Federal Reserve and Bloomberg.

The FOMC's QE3 program didn't have a positive effect on the price of gold during 2013, although it did expand the U.S money base. Therefore, if the FOMC tapers again on QE3, this decision might not have a long-term negative effect on gold. The chart also shows that since the FOMC started to taper QE3 at the end of 2013, the price of gold rallied. 

So what could be behind the recent fall in the price of gold? 

In its last meeting, the FOMC also addressed the timing of raising its cash rate. In the past, the FOMC announced that it would raise the rate when the unemployment rate falls below 6.5%. Since then, however, the FOMC has shifted that goalpost. Janet Yellen, chair of the FOMC, said in a press conference that when the U.S. economic condition improves, the FOMC is likely to raise its rate -- which is a pretty ambiguous thing to say. But it was enough to drag down gold, even for a short while.

The current assessments are that around mid-2015 the FOMC might raise the cash rate. Once the FOMC does, the price of gold is likely to fall: The risk of a devaluation in the U.S. dollar will diminish, and thus the demand for gold, a potential hedge for the U.S. dollar, will drop. Until then, gold is likely to slowly recover. Moreover, the economic conditions could still deteriorate, which will push further into the future the timing of raising the cash rate. The recent FOMC decision and the speculation around the rate increase have also pulled up the U.S. dollar. 

Finally, in the following chart are the developments in the USD/Japanese yen relationship so far in 2014. 

Data from Bloomberg.

The chart shows that the U.S. dollar depreciated against the yen in January and February. The dollar had a similar trend against other leading currencies, such as the Australian and Canadian dollars. But in March, the U.S dollar slightly appreciated against the Japanese yen. This may have been another short-term reaction to the FOMC's decision to taper QE3. In previous months, however, the FOMC's tapering decisions didn't curb the depreciation of the U.S. dollar. Further, the recent recovery of the dollar may have also contributed to the decline of gold. 

Therefore, once the hype over the rate-increase discussion wears off, the U.S. dollar could resume its downward trend; in such a case, this could pull the price of gold back up. 

Final note
The gold market has cooled down in recent weeks. But over the coming months, gold could bounce back even if the FOMC again tapers QE3, and especially if the U.S. dollar resumes its downward trend. 

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Lior Cohen

Lior has been a contributor for the Fool since 2012. His main interests are in commodities, and energy and materials companies.You can follow him on Twitter to stay up to date with his industry analysis. @tradingnrg

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