There are diverging views on the price outlook for gold and exchange traded funds tracking the precious metal. While the gold price has rallied 6% in the last six months, futures market selling prompted a modest sell-off last week.

Futures market selling stands in direct contrast to increased demand for gold from the exchange traded product sector, with global ETP holdings rising last week to another all-time high of 84.5m oz. [Gold ETFs Gain Inflows Despite Price Weakness]

Investors appear to be split across most asset classes, with both equity and bond markets posting gains last week. Given strong physical demand, we expect the gold price weakness to remain temporary. Investor demand for gold ETPs is likely to remain high as strategic investors use gold as a hedge against worst case outcomes from the fiscal cliff negotiations and European fiscal and debt problems.

Italian Prime Minister Monti’s threat over the weekend to resign (and his possible replacement by former Prime Minister Berlusconi) substantially adds to Europe’s sovereign debt risk profile. [Italy ETF Falls on Monti News]

In addition, the official sector continues to build gold positions to diversify reserves. South Korea’s central bank bought around 14 tonnes of gold in November, a jump of around 20% in its holdings.

With the US manufacturing ISM slipping back below 50 and US fiscal policy likely to tighten in 2013, the FOMC is likely to further ease monetary policy to ensure its target of lower unemployment is met. Therefore while a recovery in US growth in 2013 may cause real interest rates to rise and add headwinds to gold price performance, there are enough supporting factors to indicate relatively limited gold price downside. Meanwhile, there are many potential upside tail risks.

Euro and Franc weakness could have opposite impact on gold

The euro reversed earlier strength on the back of downward GDP growth forecast revisions by both the ECB and Bundesbank at the end of the week, with a strong US dollar putting downward pressure on the gold price.

While the Swiss Franc (CHF) also weakened versus the US dollar after Swiss banks started to charge negative interest on deposits, ultimately this could potentially benefit gold demand, as defensive investors begin to incrementally prefer gold over the CHF as their wealth preservation currency.

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