Q3, 2011: BULLION OUTLOOK

Karvy comtrade Research Desk

Synopsis

Friday, beginning of a new quarter is likely to be a crucial one for bullions. At the facet of
decelerate global economic growth, gold may possibly remain the safest bet among the
asset classes. Both Europe and USA economies are not out of the doldrums which could
come to the surface in the July to September quarter. If the Fed hints of infusing liquidity,
then precious metals will zoom or the vice versa. The “Liquidity trap” being the main
perpetrator, is apt to prop the yellow metal. However, silver’s industrial demand part may
get a shock after global slump of manufacturing and industrial activities along with
descending investment demand. Our Statistical Analysis is also suggesting silver to take
a brief correction till $31 while gold may have a room to tick new high in the quarter
ahead.

In a nutshell, “Gold to radiate at silver’s dooms day”

Strategy

 Buying gold and selling silver would be the strategy to reap the benefit of likely
improving ratio for the quarter ahead

Technical Recommendation

1
 BULLION QUARTERLY

Economic Backdrop
Last quarter the global economic conditions have perturbed investors’ sentiments. Sometimes there was a glimpse of
certain recovery while most of the time it remained under suspicion. From the United States to Europe, followed by
the Asia, most of the economies stumbled from higher inflation, food and commodities prices and a soaring crude
price. More specifically, after the Euro nations’ debt, it was the US which also came under microscope of debt burden.
Even, possibility to the US government shut down was raised concerning the debt ceiling to be breached.

Europe’s lingering debt crisis is still haunting investors’ mind. Starting with Portugal, who was sought to get 75
billion Euros bailout, it was Greece who became the first European country with largest debt burden. The Bank of
England said that the inflation remains uncomfortably high as the officials raised their forecasts for consumer prices
and cut their prediction for economic growth. Besides, S&P cut Greece’s credit rating from B to BB-, renewing concern
that the region’s debt crisis is escalating. Greece was set to sell 1.25 billion Euros in an auction of 182-day bills. A
further credit rating down gradation was likely to take place for Greece as the risk of default rises, would make the
country lowest rated country in Europe. The Greek government therefore endorsed an asset sale plan and 6 billion
Euros budget cuts to win the relief fund and arrest a market slide. However, ECB leaders and policy makers are
clashing over how to prevent the currency’s regional debt with central bankers after floating the prospect of
extending maturities on Greek bonds. This implies the risk associated with bonds and sensitivity to interest rate will
change. However, after accepting the proposal, the EU might had withhold the next tranche of credit to Greece after a
report by an international panel of inspectors concluded that the debt laden country has missed all the fiscal targets
agreed in its rescue plan. However, Greek Prime minister promised he will press ahead with new austerity measures
even as he failed to win backing from opposition parties. Although Fitch ratings saw a chance for Greece to get the
loan to avoid default, ECB opposed to extend Greek bond maturities while filling a hole of about $30 billion Euros
next year. ECB while keeping its interest rate unchanged at 1.25% has signaled a hike in July even as higher
borrowing cost may exacerbate the crisis that’s threatening to push Greece towards a default. ECB has also showed
reluctance of rolling over its own Greek holdings while it has rejected any direct ECB participation in a second bailout
for Greece escalating a clash with government.

A restructuring of Greece’s huge debt seemed to be off the table now, which was viewed as negative for the Euro as it
could prompt a flight away from Euro zone bonds and damage the EU’s credibility. Spain’s regional and municipal
elections that have resulted in a blow to the countries ruling socialist party and could reveal the debt levels in the
nation are above what was previously disclosed which boosted concern of debt. Fitch ratings lowered the outlook on
Belgium’s credit rating to negative following S&P’s announcement that Italy’s debt rating was at risk of downgrade.

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 BULLION QUARTERLY
The Fed has kept the interest rate unchanged at the prior level to bolster the economic recovery and the $600 billion
asset purchase program will be ending on June. The Fed also said to continue a separate reinvestment about $17
billion a month in proceeds from its portfolio of mortgage securities to buy treasury debt. This should help keep rates
low on mortgages and other consumer loans housing sector continued to grow. The US treasuries have said Congress
must raise the $13.3 trillion debt ceiling to avoid a government default on loan. Hence monetary policy will be
remaining accommodative for at least the next couple of months. So, interest rate increment seems to be least
probable at present. On an attempt to raise the debt ceiling limit of the US, Obama’s wish had been strongly opposed
by the republicans with out spending cut. Democrats favor spending cut or increase in tax over several years to lower
the deficit while republicans oppose the raising tax as not an option. Hence, Moody’s investors’ service warned US
government to put US credit rating under review for downgrade if there is no progress on increasing the statutory
debt limit in coming days after manufacturing and consumer confidence cooled to point a slowing US recovery. US
jobless rate climbed to the highest level this year from 9 to 9.1% as payrolls increased by much less than projected,
added more evidence to a faltering economic recovery. Fed chairman also urged for another record monetary
stimulus to be needed to boost the growth momentum although reiterated that the increasing inflation is transitory.
As Fed is about to end its bond buying program, the US 10 year treasuries yield fell below 3% as the government
prepared to sell $13 billion worth of 30 years bonds on 9th June.

Aftermath of March temblor, Japan is still struggling. The industrial production dropped put a hindrance on
sustaining debt after S&P downgraded the nation’s outlook and hence BOJ kept their target rate intact. But after that
BOJ elevated their growth forecast betting on reconstruction work and have rejected monetary stimulus confirming
that the supply constraints are the main factors for depressing growth. Japan’s economy shrank more than expected
in the Q1 at an annualized rate of 3.5% while current account surplus plunged 69.5% and also logged a trade deficit
of 417.5 billion Yen in April as imports grew against a fall in exports due mainly to the impact of the worst
earthquake in March. But the Yen got appreciated as China purchases of Japan’s long term debt reached a record.

Peoples’ bank of China raised reserve requirements for the fifth time by 50 bps to a record 21 percent with effective
from May 18, 2011 this year to restrain prices, underscoring the risk that tightening measures will cause a slowdown
in growth momentum, impacted upon commodities prices.

Month of May was dominated by the minutes of the meeting of BOE and FOMC pared with Greece’s debt crisis compel
the dollar to remain volatile. The FOMC meeting minutes on May18 showed no firm decisions rather told to need
more discussions was needed to normalize policy; however, the committee’s asset purchase program and the federal
fund target rate were warranted. It showed the current inflation is transitory and to unwind when commodity prices
increase abated. Fed officials are discussing strategy for how to remove stimulus, with majority favoring ending the

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 BULLION QUARTERLY
policy of reinvesting proceeds from maturing securities first before raising interest rate or selling assets. The minutes
of BOE said a majority of members concluded a rate hike wasn't warranted due to a lack of evidence that higher
inflation expectations were becoming ingrained in wage and price decisions and skepticism over the underlying
strength of the economy. Also, the central bank meant to up the size of its asset-purchase, or quantitative-easing
program from 200 billion pounds to 250 billion pounds.

Last but not the least, the Reserve Bank of India raised policy rates for the 10 th times in 15 months, extending the
longest streak of monetary tightening in a decade. Further tightening of monetary policy was expected as core
inflation has hardened to 8.71 percent. So, there was need to have better price stability for sustaining growth in the
medium term. This rate hike will definitely be having some impact in term of postponing the investments. But if
inflation continues to remain at a high level, it will be having a dampening effect on growth in the medium term.

Precious Metals Price Movement

Bullions had a spectacular move in the last quarter and as what we mentioned in our Q2 report has been achieved.
Spot gold has clocked $1577.57 while the futures in the COMEX division have ticked $1577.70 on May 2, 2011. That
was the time when it was a scenario of “a new
day, a new high” for gold. The same has been
observed for the white metal also. Silver
futures neared $50 to tick its life high of
$49.845 on April 25th, 2011. Silver
overwhelmed gold in April followed by a shock
to shatter by more than 20% within a month.

Reasons behind this price uphill:

This price upsurge of bullions can be

1600 95 attributed to the falling dollar index,
1500 90
1400
which in the month of April lost the
85
1300
80 ground by 3.85% (from 75.86 to 72.93)
1200
1100
75 against the majors. But, after that dollar
70
1000 index revived superbly by more than
900 65
800 60
2.50% (from 72.93 to 74.88) and put
precious metals under stress, due to
which both gold and silver slashed heavily
Gold(LHS) Dollar Index(RHS) The asset purchase program worth $600

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 BULLION QUARTERLY
billion will be ending on June which is nothing but an increase in money flow within the economy to spur the
inflation, which is a supportive factor for the metal as an alternative investment
Traders’ speculation over China would buy precious metals to diversify its three trillion foreign exchange
reserves, impacted upon the dollar and precious metals prices skyrocketed
The S&P credit agency sent shockwaves by downgrading the US medium and long term debt outlook from
“stable” to “negative”. This sent the dollar index lower and commodities prices made new highs

The staggering rise of silver price then waned as the CME has raised initial margin for silver within a quick
succession from $16200 to
1600 50
$21600 (with effective from
45
1400 40 May 9, 2011). Speculators
35 were bound to unwind their
1200 30 positions after this combative
CME
margin 25
decision has been announced;
1000 raised, 20
silver silver got a big hit to start the
15
800 10 month of May. Billionaire
investor Paul Touradji sold all
of its shares (173000) in the
SPDR gold trust, valued at $24
Gold(LHS) Silver(RHS)
million as per the filing to the
US Securities and Exchange
Commission led gold to retreat. However, the Central banks of Mexico, Russia and Thailand have increased their gold
reserves valued at $6 billion after the dollar plunged to its two years lowest.

Gold & Silver in Different Currencies

Strong gold and silver prices were seen sustaining their gains across key currencies. Normally, currency appreciation
leads the metals to retreat, i.e. Prices move inversely to currency appreciation. But, the past quarter has seen the rule
to be diverged. Although silver followed the stated hypothesis, gold did not. There are however economic reasons for
the rule to contradict. Since economic disruptions and a seeming weakness lead the manufacturing industries to stall,
metals related to it are also faltered, silver being one of them. Majorly, silver plunged in each currency as the CME
raised margin for speculators compelled them to liquidate their positions. Besides, the Greek dilemma remained
under concern which made the Euro to swing. Gold in such ambiguity remained a strong buy to keep protect
investors’ wealth, broke the conventional relationship.

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 BULLION QUARTERLY
It has been observed that year till date gold has been increasing in every currency. The dollar index depreciated by
more than 5 percent on the back of which gold lifted its price. But other currencies like, Euro, GBP, Canadian dollar,
Swedish Kroner and Frank which all have
20%
appreciated against the benchmark, gold prices in
15%

10% those currencies have actually improved. This

5% might be the impact of geo political turmoil from
0%
Libya, rise in crude prices and inflation concern all
-5%
over the globe drove the prices. To keep wealth
-10% Dollar EURUSD GBPUSD USDJPY USDCAD USDSEK USDCHF
-15%
Index protect from the attrition, safe haven buying came
-20% to lead the prices up despite respective currencies
YTD Currency YTD Gold YTD Silver appreciated against the dollar.

Q2 FY11 however has seen the different thing. The Euro, GBP and Japanese Yen all have appreciated against the
dollar but gold in all those currencies have
10%
gained modestly. Euro zone debt crisis may
be one of the reasons to take the Euro 5%

denominated gold at higher side. While 0%

Japan’s tsunami and earthquake stalled the -5%

Dollar EURUSD GBPUSD USDJPY USDCAD USDSEK USDCHF
economic growth, people might have shifted Index
-10%
to safer side like gold. Speculative Margin
-15% raised: silver plunged

However, Q2 was not fare for the white -20%

Q2 Currency Q2 Gold Q2 Silver
metal. After a fabulous start with the month
of April, it slashed more than 20 percent in the month of May as the CME raised speculative margin within quick
succession. Besides, manufacturing industries all over the globe from US to Germany, Euro Zone, China, Japan
faltered, waning the industrial demand part of the metal, which is another major reason for silver to retreat. So, with
currencies appreciation and due to fundamental reasons silver fell drastically.

Exchange operator CME Group Inc. (CME) cut the amount of collateral required to trade gold futures in a move that
may invite greater speculation in gold. As of close of business on June 20, 2011, speculators in the benchmark gold
contract must put up an initial margin of $6,075 per contract, down from $6,751. To keep the contract overnight,
these traders must maintain $4,500 of the initial margin, down from $5,001. CME also lowered the initial and
maintenance margin requirements for hedgers and exchange members, to $4,500 from $5,001 previously. When
price movement becomes less volatile, margins typically go down because the risk of the position also decreases. This
is the case with the decrease in gold margin requirements yesterday, CME said. The lower margins therefore, are a
boon for gold speculators, who can buy or sell more contracts with less cash.

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 BULLION QUARTERLY

Investment Demand
Gold
SPDR Gold Trust, the world’s largest gold backed exchange traded funds is one of the major indicators of the metal’s
investment demand. Originally listed on the New York Stock Exchange in November of 2004, and traded on NYSE
Area since December 13, 2007, SPDR
1,600 1,400
Gold Shares has been one of the fastest
1,400 1,200
growing ETFs in the US. The holdings of
1,200 1,000
the ETFs in the trust show the
1,000 800

800 600
underlying demand for gold since this is
600 400 designed to track the price of gold. A
400 200 part of the secular Bull Run in gold
200 -
prices can be attributed to this strong
Q1'05
Q2'05
Q3'05
Q4'05
Q1'06
Q2'06
Q3'06
Q4'06
Q1'07
Q2'07
Q3'07
Q4'07
Q1'08
Q2'08
Q3'08
Q4'08
Q1'09
Q2'09
Q3'09
Q4'09

Q2'10
Q3'10
Q4'10
Q1'11
Q1'10

Q2' 11-Till Date

alternative investment demand. Growth
SPDR Holdings(RHS) Comex Gold Spot(LHS)
of the holdings remained on a
continuous uptrend at the facet of
inflation and global economic
slowdown. However, the recent run out of holdings can be the result of investors’ short slightness to breach the
record $1577 level. Even, billionaire investors like Paul Touradji sold all of its shares (173000) in the SPDR gold
trust, valued at $24 million as per the filing to the US Securities and Exchange Commission led gold to retreat most
recently. However, the Central banks of Mexico, Russia and Thailand have increased their gold reserves valued at $6
billion after the dollar plunged to its two years lowest.

Silver
Like SPDR, I-share silver holding is the world’s largest ETF holder. Silver’s dream run was also influenced by the
uprising holdings of the trust. However,
40 12000
the recent margin hike led the silver price 35
10000
to shatter along with the holdings. At 30
8000
25
present, this fall in investment demand is
20 6000
the concern of investment demand for 15
4000
silver to get back its sheen. 10
2000
5
0 0

I-share holding (RHS) Comex Silver Spot(LHS)

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 BULLION QUARTERLY

Volatility
With uncertainties hovering all over the globe and inflation being at the forefront, the yellow metal appears to be the
protector of wealth. Gold once again has proved the mythology to be less volatile than the pother asset classes in
economic crunch. Volatility is normally used to quantify the risk of the financial instrument over a specified period.
Investors care about volatility because price volatility represents opportunities to buy assets cheaply and sell when
overpriced. It also means a greater chance of a shortfall when certain cash flows from selling a security are needed at
a specific future date.
Volatility does not measure the direction of price
45%
changes, merely their dispersion. This is because when
40%
35% calculating standard deviation (or variance), all
30%
differences are squared, so that negative and positive
25%
20% differences are combined into one quantity. Two
15%
instruments with different volatilities may have the
10%
5% same expected return, but the instrument with higher
0%
volatility will have larger swings in values over a given
period of time. For example, a lower volatility stock may

2011-YTD 2 Years 1 Year

have an expected (average) return of 7%, with annual
volatility of 5%. This would indicate returns from
approximately negative 3% to positive 17% most
Silver
of the time (19 times out of 20, or 95% via a two Gold

standard deviation rule). A higher volatility stock, US 10Yr Bond

CRB
with the same expected return of 7% but with
SENSEX
annual volatility of 20%, would indicate returns
DJIA
from approximately negative 33% to positive MSCI US

47% most of the time (19 times out of 20, or MSCI Asiapacific

MSCI World
95%).
-0.80 -0.30 0.20 0.70 1.20
Comparing the volatility with other asset classes
1 Year 2 Years 2011-YTD
like the safest US 10 years treasuries and the
equities, gold stood second (after Dow Jones) while silver as usual remained the most volatile asset for the year.
These two extremities have resulted in to highest return in silver and a stable rising return in gold as compared to all
other asset classes. After a huge fall in May, silver still is remaining the leading asset with highest return with gold
standing at the next. The CRB index, a bellwether for commodities, has advanced by 4.51% while gold has given two
times and silver has given four times return year till date. Equities however has had a mixed performance with Asian
stock at a negative return, precious metals are the only one sector to have the hedge against inflation and positive pay
off amid global uncertainties.

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Correlation
There are various asset classes with whom gold share a strong correlation, may it be positive or negative. For
example, gold and bond is internally related since both of them track one common factor: inflation. This factor
indicates how an asset is related to
gold and to what extent. These
DJIA
relationships may change over a
CRB Index specified time period from a long
time period. For example, Gold and
Crude Oil
crude were positively related till

US 10YR Bond Q1, 2011. The drastic change came

in the Q2. From a positive relation
Dollar Index
more than 60% for the last three

Silver years, it has changed to a negative

33%. With rise in inflation the
-1 -0.5 0 0.5 1 bond yield fell while gold gained
Q2, 2011 2011-YTD 3 Years 5 years
and there by the strong negative
correlation is being seen between gold and bond yields. US treasuries yield fell as the bond buying program by Fed
approaches to an end. So, gold in contrary gained as both the bond yields and dollar index lost the ground.

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Economic Outlook
The quarter ahead is a very crucial one for bullions. As the QE2 is cease to exist after June 2011, concern raise
whether this would result in crashes in stock and commodity market? It is quite likely that Fed will introduce QE3 by
the end of 2011 if weakness in the US economy continues to persist. However, this might not happen due to current
political mismatch between the Congress and Republicans. Thus, additional QE measures as well as an
accommodating monetary policy would be one of the few options remaining to support the US economy in the
coming months. If we end up with a recession, which will depend upon the fiscal and monetary policy chosen, it can
certainly be said that- Monetary stimulus will be more damaging. It has caused a worldwide commodities and energy
bubble - which is single-handedly damaging the U.S. economy by making it more and more expensive for consumers
to fill up their tanks. It is also likely to have contributed to the growing job-market malaise and with good reason of
Economic theory which suggests that when capital is very cheap, businesses will use more capital at the expense of
labor, reducing the demand for workers. That’s what led the US to have unemployment level at 9.1%. Calls for
another round of public spending "stimulus" will become deafening. Expect the same emotional call for a third round
of Fed purchases of government bonds aimed at holding down interest rates - to be created after the current round
ends on June 30. With this third round of quantitative easing - known as "QE3" - there may be a short-term boost to
the economy. But the benefits will be very limited - and will be quickly overwhelmed by spiraling inflation as energy,
commodities and other goods rise in price.

When the Fed chairman Ben Bernanke tells that the Fed must be vigilant in preserving its hard won credibility for
maintaining price stability in repeated attempts, in really engross us to ask whether it is just a feint or Fed is really
happy to see its credibility ebb away. By saying that the current rising inflation is just transitory, it implies that they
are actually not able to tame it as because the economy itself is weakening and Fed is mum in case of raising interest
rate since it may hamper the economic activities. To make it simple, US are under “Liquidity Trap”, in which
monetary policy is incapable to stimulate the economy further. Even at the near zero interest rate, where the cost of
borrowing money is essentially free, fails to encourage more spending or investment.

If prices are falling with nominal rate of interest at near zero, the real rate (nominal rate – inflation), would still be
positive. In other words, saving cash for no nominal return would still leave you spending power in future, because
prices will be lower.

If incomes are falling, then people will save now in order to have something to spend later. Similarly, businesses are
unlikely to invest in new stock or greater productive capacity if their potential customers are getting poorer.

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Forecasting of Economic scenario with Precious Metals Outlook
In recent times we have seen that US government has announced different sets of boost-up packages to counter-
balance the economic slowdown faced by its economy. We have also seen the continuous fall of prices of goods and
services along with adjustments of different monetary and fiscal policy measures to boost up the domestic demand as
well as the confidence levels of the investors. But still GDP is not moving at the rate that was expected. Being close
followers of economic activities the basic question that strike us is what is the need of these boost up packages
and despite of all these activities why GDP is not moving to the desired level?

Well, to start up with, let us introduce investment saving (IS) and liquidity preference money supply(LM) to describe
this paradoxical situation, where it fails to explain the current global slowdown scenario, where despite of fall in
successive rate of interest (nominal), GDP fails to reach its desired level. From the traditional theory, the hypothesis
said that, a government's deficit spending ("fiscal policy") has an effect similar to that of a lower saving rate or
increased private fixed investment, increasing the amount of demand for goods at each individual interest rate. An
increased deficit by the national government shifts the IS curve to the right. This raises the equilibrium interest rate
and national income. The equilibrium level of national income in the IS-LM diagram is referred to as aggregate
demand.

According to the theory of demand we all

4.5 know that when there is a fall in price,
4
demand is supposed to increase. But in
3.5
recent times, things have started moving in
3
2.5 Deflation opposite direction implying the fact that
Prices
2 Falling despite fall in price, demand is also falling
1.5 (growth of demand is falling). Isn’t it
1 striking? Have a look in to the US inflation
0.5
since 2008, the year of housing bubble. So,
0
a fall in price coupled with a near zero
-0.5 2008 2009 2010 2011
-1 interest rate of 0.25 percent from
December 2008 – laid the way to have
Inflation
Quantitative Easing.

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 BULLION QUARTERLY

r
0
LM0 (M /P)
0
LM1 (M /P1)
0
LM2 (M /P2)
Vicious Cycle
of Disinflation
r0

IS0 IS1 IS2

0 Y0 Y1 Y2 GDP
Figure 1

Background

Where the economy breaks down…

Depending on this, government is coming up with various stimulus packages (which shifts the IS curve from IS 0 to IS1
to IS2) to keep r constant at r0 with continuous fall in inflation as well as nominal rate of interest (since r = i – π, with a
fall in π to keep r constant, i is also falling, which implies peg r by decreasing i at the same rate of fall in π) as what
happening in US also.

According to IS-LM theory, with expansionary fiscal policy if r remains constant there should not be any crowding
out. So, GDP should have increased from Y0 to Y2. But actually what is happening right now is, GDP is not increasing
up to Y2. Somehow some leakages are taking place which resist GDP to increase up to the desired level. Thus the IS-
LM model fails to explain this crowding out theoretically.

To be more specific, Aggregate Demand – Price Adjustment (AD-PA) or Aggregate Demand – Inflation Adjustment
(AD - IA) is better to interpret such type of economic phenomenon.

Explanation

1. The AD curve is also referred as Aggregate Demand Inflation curve (ADI). AD denotes the relationship
between GDP and inflation instead of GDP and price
2. The price adjustment line is referred as the Inflation Adjustment line (IA). PA describes the behavior of
inflation rate in the economy.

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The ADI curve

It is derived from two relationships –

(A) A negative relationship between GDP (Y) and real interest rate (r). This is analogous to IS curve i.e.
higher real interest rate leads to fall in investment demand, followed by fall in consumption demand
and fall in net exports through an appreciation of domestic currency, all of which lead to fall in GDP
(Figure 3).
(B) A positive relationship between inflation (π) and real interest rate (r). It is based on the absence of
Central Bank, which typically responds to increase in inflation by raising nominal interest rate and
vice-versa (Figure 2).

For a given expected rate of inflation policy makers can achieve a particular real rate by manipulating nominal rate.

Now when inflation increases Fed increases nominal interest rate (it) at period t by enough to increase rt (real
interest rate at period t) which leads to lower spending which in turn leads to lower GDP, implying a negative
relationship between π and GDP (Figure 4).

r r

π GDP

Figure 2 Figure 3

AD
GDP

Figure 4

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 BULLION QUARTERLY
PA line

It comes from Philips curve,

Πt = Πte+ α (Yt – Yt*) + εt ; where,

= actual rate of inflation

= expected rate of inflation

= actual GDP

= potential GDP

= external shock, random in nature

( ) = output gap

It would be fixed in short run without external shock. Then, PA line is horizontal [for simplicity, otherwise
upward rising with ( ), > 0] with vertical intercept signifying the prevailing inflation rate in the
economy. PA may shift up or down depending on (Figure 5).

π/ PA
/

πt PA

//
PA
π//
AD

0 y* Yt Y* GDP

Figure 5

So, from the above figure it is clear that when Yt > Yt*, inflation increases and vice-versa.

Question arises, why do the repeated attempts of government to boost the economy by increasing government
spending or proving quantitative easing is not working?

Recall that downward slopping AD arises because of negative relationship between rt and GDP, and positive
relationship between rt and inflation. Also it = rt + πt, or rt = it - πt.

This implies that the only way to get a positive relationship between rt and inflation is to move it in the same
direction as inflation by a larger magnitude than the change in inflation.

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As what is happening in US, given the i t π

AD
cannot be less than zero, the Fed has
been unable to lower it in response to a
fall in inflation rt = - πt a
decrease in inflation would lead to an
it=0
increase in rt, which would lead to a πt PA

fall in GDP and vice-versa. Therefore,

once we have reached it = 0, we should
π1 PA1
expect a positively slopped relation
between πt and GDP, or the downward Deflation Spiral or Recessionary
Trap or Liquidity Trap
slopping AD develops a kink at it = 0
which implies AD becomes upward GDP
Y1 Y0 Y*
slopping (Figure 6). This is the GDP
recessionary trap or deflationary spiral. Figure 6

Because Yt < Y* firms will lower relative price to reduce inflation. Now, lower inflation will lead to a higher real
interest rate and will actually reduce investment (pessimism is another factor of lowering investment) and
thereby lowering GDP. This pushes Y further below Y* and sets off another series of negative shocks as firms
lower price again. In other words, economy gets trapped in a deflationary spiral that is very difficult to break
off.
Policy prescription π
AD2
(A) Slightly expansionary fiscal policy that moves AD1
AD
AD curve to AD1 and the economy output to Y1
(Figure7) will not be able to stop the deflationary
spiral. Any tax cut or spending has to raise the
output to or above Y* to break free of the
deflationary spiral.

So, this explanation suggests that inflation or PA=PA”

more precisely the promise of future inflation is PA’
the medicine to cure the ill.

Higher inflation expectation will raise the actual

inflation rate in the economy and will help lower Y0 Y1 Y* GDP
real rate of interest when coupled with a fixed Figure 7
nominal rate.

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(B) When an economy is in liquidity trap, an increase in money supply fails to reduce the real rate of interest. If real
rate does not fall, consumption and investment cannot be stimulated and output will not rise.

Now, both consumption and investment depend on the expected real rate of interest, defined as the difference
between nominal rate of interest and expected rate of inflation. So, if you cannot get the expected rate of inflation
down by dropping nominal rate of interest, the only way is to raise expected inflation.

Precious Metals Price Forecasting

Gold-Crude Ratio
The main happening of the Q2 FY11 OPEC meeting and the failure of its members to reach an agreement on how to
deal with high oil prices which has posed the risk of destabilizing the economic recovery. Saudi Arabia, the group’s
most powerful member, wanted to raise production, but others prior to the meeting signaled they didn’t want to.
Saudi Arabia on one side saying that high prices are having an impact, and should be lowered to support the global
economy. On the other side, Iran believes the world is slowing down anyway, and increasing output may lower prices,
damaging its ability to fund domestic projects. The summer driving session which has already started, is expected to
demand more oil but the current economic situation is not supporting it. Unemployment remaining at 9% with the US
government facing the challenge to hit the debt ceiling, faltering global industrial and manufacturing sector is
therefore likely to demand lesser oil. Hence, this summer seems to be tuff for the US as well as for crude.

As we have already discussed the probable economic scenario, Gold may remain strong for the Q3. The summer
months although historically tend to be a weak period due to seasonal slowing demand and this year we have the
added spice of QE2 finishing at the end of June. These factors could have an impact on investor behavior but whether
this contradicts the seasonal factors after the May correction is to be seen. The overall factors like strong central bank
and investor demand, negative U.S. real yields and general uncertainties continues to put a floor under the market.

Historically the Seasonality Index for gold has shown a traditionally quite summer and maximum relative strength
late in the calendar year. This is an average that can be
560 108
550 106 used to compare an actual observation relative to what it
540
104
530
520 102 would be if there was no seasonal variation. Traditionally
510 100
500 98
gold tends to trade weaker during the summer as demand
490 96
480 that had picked up during the Asian wedding season dries
94
470
460 92 up and much of the population turns its attention to their
450 90
Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec holidays. This year however, things are a lot less
Q3 Avg. Price Q3 SI Q2 SI traditional and more uncertain. QE2 is to conclude at the
end of June, but it has been well telegraphed by the market.

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 BULLION QUARTERLY
Of bigger concern is the Aug. 2 deadline, when, if a solution is not reached about how best to raise its constitutionally
mandated debt ceiling, the US will be unable to pay its bills in full.

The Gold-Crude ratio as shown below has remained in a downtrend from Jan, 2011 till April implying crude’s
worthiness relative to gold. Q1 Fy11 has seen a strong positive correlation between gold and crude while the
relationship has been disturbed in Q2. Since the Libyan issues took a back seat, oil retreated 12.50% in a single
quarter while gold gained 8.26% in the
17
16.5 same period leading the ratio to improve
16 from 13.23 to 16.52. Hence the divergence
15.5 in prices can be seen in the graph shown
15
14.5
below. Quarter ahead, as we have discussed
14 already, it can be expected that the
13.5 divergence to widen more and the ratio to
13
12.5
improve. We may expect the ratio to hit 18
12 with crude hovering around $90; gold is
Jan-11 Feb-11 Mar-11 Apr-11 May-11 Jun-11 therefore to touch $1620.

Gold/Crude Ratio

Gold-Silver Ratio
While both precious metals are typified as safe havens and hedges against inflation, silver accounts for a much larger
share of industrial demand than gold. Consequently, it will tend to out-perform gold as the global economic recovery
takes hold and under-perform once the economy slows. Thus, it can be a great proxy for 'risk', as a lower gold/silver
ratio promotes risk taking and a higher ratio suggests risk aversion. This is predominantly explained by silver's
typically lower margin requirement and greater volatility in the futures markets.
Interestingly, at the end of April the ratio made a fresh 28-year low around 31 and then saw a sharp rebound higher,
briefly touching 45. We expect Gold to out perform silver in this quarter and hence the ratio to improve.

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 BULLION QUARTERLY
Statistical Estimation of Gold Price Forecast

Methodology:
Since gold share strong correlation with silver, crude oil, dollar, equities and bonds, here we have taken 1626
observations for each variable and have regressed those on gold. The Least Square Regression technique has been
used to find the gold’s projected price for the next quarter.

Regression Equation:
The regression equation thus came out considering gold as dependent variable and silver, crude oil, dollar index, Dow
Jones and US 10 year bond yield as independent variables, is as follows:
(Gold)P = 1369.66 + 29.74*(Silver)P + 0.868*(Crude Oil)P – 3.727*Dollar Index - 0.021*DJIA - 127.402*US Bond
This equation indicates that gold price is positively correlated with silver and crude oil while negatively correlated
with the dollar index, DJIA and bond yields. This result can also be traced out from the Correlation Matrix given
below:

Correlation Matrix Gold Silver Crude Dollar DJIA US Bond

Gold 1.00
Silver 0.89 1.00
Crude 0.50 0.58 1.00
Dollar -0.60 -0.60 -0.76 1.00
DJIA -0.04 0.24 0.47 -0.34 1.00
US Bond -0.71 -0.46 -0.11 0.35 0.51 1.00
Data incorporated from Jan, 2005- YTD

Summary Output:
Measurement of Goodness of Fit:
Given below is the regression statistics table. Of greatest interest is the “R-square” value. Being a multivariate model,
the “Multiple R” which gives 95.65% of correlation between actual gold price and estimated gold price, is a good sign
of the model’s fit. When it is squared, gives the “R square” value of 0.9149,
Regression Statistics
meaning that 91.49% of the variation of estimated gold price around its mean
Multiple R 0.956519
R Square 0.914928 price is explained by the repressors’ (independent variables). More specifically,
Adjusted R Square 0.914665
the “Adjusted R square” which is used in a multivariate model, also has given
Standard Error 88.75617
Observations 1625 more than 91% explanation of price variation.
Overall, it can be concluded that the model estimates are highly significant in explaining more than 91% of the
metal’s price variation.

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Interpretation of Regression Coefficient Table
The regression output of most interest is the following table of coefficients and associated output. Let βj denote the
population coefficient of the jth regressor (intercept, silver, crude, dollar index, DJIA, US bond). Then,

Column "Coefficient" gives the least squares estimates of βj.

Column "Standard error" gives the standard errors (i.e. the estimated standard deviation) of the least squares
estimates bj of βj

Column "t Stat" gives the computed t-statistic for H0: βj = 0 against H1: βj ≠ 0

Column "P-value" gives the p-value for test of H0: βj = 0 against H1: βj ≠ 0. This equals the Pr{|t| > t-Stat}where t is a
t-distributed random variable with n-k degrees of freedom and t-Stat is the computed value of the t-statistic given in
the previous column. Note that, this p-value is for a two-sided test. For a one-sided test divide this p-value by 2 (also
checking the sign of the t-Stat).

Columns "Lower 95%" and "Upper 95%" values define a 95% confidence interval for β j

Testing of Zero Slope Coefficient

The coefficient of silver has estimated standard error of 0.4748, t-statistic of 62.64 and p-value of 2.5E-70. It is
therefore statistically significant at 95% significance level as p < 0.05. The same can be observed in all other
independent variables. Hence, we can say that the model is statistically significant.

Regression Coefficients Coefficients Standard Error t Stat P-value Lower 95% Upper 95%
Intercept 1369.66 73.5277 18.62781 2.53E-70 1225.441 1513.879
Silver 29.74701 0.4748 62.64946 0 28.816 30.678
Crude 0.868769 0.1830 4.746167 0.005695 0.510 1.228
Dollar -3.72712 0.7816 -4.76855 0.005105 -5.260 -2.194
DJIA -0.02117 0.0025 -8.44694 6.56E-17 -0.026 -0.016
US Bond -127.402 5.5911 -22.7865 6.5E-100 -138.368 -116.435

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Overall significance of the Model Fit: Analysis of Variance (ANOVA)
The ANOVA table splits the total sum of square in to two parts: Residual (or error) sum of square and Regression (or
explained) sum of square. The following table gives the estimate of the model’s overall fit. The column labeled “F”
gives the overall F-test.
To test the null hypothesis H0: all of the regression coefficients are equal to zero
Against, alternative hypothesis H1: at least one of the regression coefficients is not equal to zero
The F value is the ratio of the mean regression sum of squares divided by the mean residual sum of squares. Its value
will range from zero to an arbitrarily large number. The column labeled significant F has the associated probability
that the null hypothesis for the full model is true. For example, if Prob(F) has a value of 0.010 then there is 1 chance in
100 that all of the regression
ANOVA Table df SS MS F Significance F
parameters are zero. This low a value
Regression 5 137165215.4 27433043 3482.386 0
would imply that at least some of the
Residual 1619 12753927.72 7877.658
regression parameters are nonzero
Total 1624 149919143.1
and that the regression equation does
have some validity in fitting the data. Since, in our model the value is less than 0.01 we reject the null hypothesis at
99% level of significance. Alternatively, we accept the alternative hypothesis and therefore can conclude that the
regression equation does have validity in fitting the data, i.e. the independent variables are not purely random
with respect to the dependent variable.

Summary: The above model projects

gold prices are as follows:
JULY: $1578

AUG: $1596

SEP: $1602/60

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 BULLION QUARTERLY
Statistical Estimation of Silver Price Forecast
The same data period has been considered for silver price forecasting. Methodology being the same as gold, the result
obtained is as follows:
Multiple R standing at 93.75% shows a good fit of the model while the independent variables are able to define
87.90% of price variation is silver as given by the Adjusted R
Regression Statistics
square. Overall, it can be concluded that the model estimates are
Multiple R 0.937569
R Square 0.879035 highly significant in explaining more than 87% of the metal’s
Adjusted R Square 0.878662
price variation.
Standard Error 2.511933
Observations 1626 The Regression Coefficients are also supporting the model’s
trueness. The “t statistic” is a measure of the likelihood that the actual value of the parameter is not zero. The larger
the absolute value of t, the less likely that the actual value of the parameter could be zero. The computed probability
of t-statistic being very low satisfies the less likelihood of the parameter could be zero. P-values for all the
independent variables except crude oil are far below 0.05. Hence they are statistically significant. We can conclude
that Crude oil being statistically insignificant is not efficient enough to explain silver’s price variation.

Regression Coefficients Coefficients Standard Error t Stat P-value Lower 95% Upper 95%
Intercept -29.9341 2.16915329 -13.7999 4.86E-41 -34.1888 -25.6795
Gold 0.023821 0.000379881 62.70785 0 0.023076 0.024567
Crude 0.009839 0.005209513 1.888699 0.059111 -0.00038 0.020057
Dollar 0.090421 0.022161792 4.080042 0.032292 0.046952 0.13389
DJIA 0.00112 6.69284E-05 16.73844 3.94E-58 0.000989 0.001252
US Bond 1.122982 0.179675185 6.250069 0.000244 0.770562 1.475402

As already discussed, the probability

ANOVA Table df SS MS F Significance F of F-test is less than 0.05 even less
Regression 5 74281.05458 14856.21 2354.464 0 than 0.01 and hence the model is
Residual 1620 10221.88673 6.309807
Total 1625 84502.94131 having a overall good fit and therefore
can conclude that the regression
equation does have validity in fitting the data, i.e. the independent variables are not purely random with
respect to the dependent variable.
The Regression equation thus obtained is:
(Silver)P = -29.39 + 0.023*(Gold)P + 0.0098*(Crude Oil)P + 0.09*Dollar Index + 0.00112*DJIA+ 1.122*US Bond
While substituting values for the variables, the above equation thus gives the silver price to be $30.785 for the
next quarter.

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 BULLION QUARTERLY

Technical Analysis
Gold

Source: Bloomberg and KCTL Research

Recent wave: Minute b of Minor wave 4 of intermediate wave (5) of primary wave 5.

KCTL Outlook in gold for this quarter is on positive note as intermediate wave 5 of primary 5 is in action. We are
presuming that the minute c is in progress which may take gold prices initially down till 1470 (23.6% retracement of
the range $1154-1576). But, if market breaches the said support level then it is likely to taste next support level of
1430 (38.2% retracement of the given range and also swing high of minor wave 1). So a correction in the gold prices
is possible in the starting of this quarter. However, the impulsion is positive and therefore we expect that the said
correction may not last long and gold prices may remain bullish for the coming quarter. After minor wave 4, minor
wave 5 might come into action which may drive gold prices higher till $1577 and $1620.

As per the above Elliot wave count we expect gold prices may remain in the band of $1430-1620. Initially prices
may come down till 1470-1450 levels and then it may bounce back till $1577 to $1630.

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 BULLION QUARTERLY
Silver

Source: Bloomberg and KCTL Research

We are at a juncture which is finding us hard to say primary wave 5 is over and also presuming the bullish trend of
silver is yet to make its end. Therefore, we from KCTL research is making the wave count on Silver and believe small
wave degrees are to be closely inspected. The chart stated in this report is shown from the resumption point of
primary wave 5. Emphatically, four intermediate waves (1), (2), (3) and (4) of primary wave 5 have already been
discussed. This would have been also easy to complete intermediate wave (5) or primary wave 5. However, if we go
with the views of ending primary wave 5 then we may have to turn completely bearish for the coming one quarter
or one year. Hence, this deviousness has to scrutinize properly and we are waiting for the market to react and let it
decide the trend by its own. Nevertheless, it is very important to discuss the crucial levels. Going by the wave count
we believe market should not breach intermediate (4) of primary wave 5. In this regard the major support should
be seen at $30.00 (weekly close). Until then readjusting the count is not viable. However, if market clears $30.00
levels perhaps the correction could extend until $26.00 (ending of minute i).

The above analysis tells us the coming quarter should respect the crucial support of $30.00 and $26.00. Now, if
silver sustains above the said support levels then it is inevitable that market should rebound which should push this
commodity to move on the higher side till $40.00 by the end of coming quarter. Only on break of $40.00 the next
resistance should be extended till $45.00. The technical chart also pattern suggests market to hover within $26.00
to $45 for the coming quarter.

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BULLION QUARTERLY

TECHNICAL RECOMMENDATIONS
SELL at 1510-20 TP 1470/1450 SL 1560 ( Present scenario)
U.S Spot Gold
BUY at 1450-30 TP 1577 then 1630 SL 1390 ( Quarterly recommendation)
SELL at 22250-22350 TARGET: 20900, 20600 SL above 2300
MCX Gold
BUY at 20500-20750 TARGET: 22800 23200 SL below 19900
U.S Spot Silver BUY at $31-33 TP 40 then $44 SL below 26.00

MCX Silver SELL at 54000/54500 TARGET: 50000, 48000,47000 SL above 57000 (Present scenario)
BUY at 47000/48000 TARGET: 52000, 57000, 65000 SL below 44000(Quarterly recommendation)

Prepared By:

Aurobinda Prasad - Head of Research - aurobinda@karvy.com

Subhrasom De - Fundamental Analyst – subhrasom.de@karvy.com

Nikky Joshi - Technical Analyst – nikky.joshi@karvy.com

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