When gold began its correction, soon after the US election, it looked as  it was only the beginning; and contrary to what many wanted to believe, this proved to be the case. In addition to this fact, and to the disappointment of the yellow metal's investors, gold's negative dynamics have not exhausted their power yet. The global macro backdrop is rapidly changing. A new regime shift is about to occur in the US, and gradually to spill-over to the rest of the developed world as well. In anticipation of this regime shift, which involves the accommodation of monetary policy with fiscal expansion for the first time in many years, long-term real interest rates began their ascent, weighing on gold's price (NYSEARCA: GLD). What is more, if other governments beyond the US and the UK begin to adopt this paradigm, like for example Germany or France under pressure from the Italian referendum vote, then the new era of fiscal and monetary coordination will have vast repercussions for financial markets. Among these repercussions, long term real interest rates could climb higher. In this light, gold seems to have not found its ultimate support level during this market cycle, meaning that investors could experience more troublesome volatility ahead.

What Drives Gold's Correction?

Since the US election day, gold plummeted by more than 7%, driven by an abrupt spike in long-term real yields. In fact, the 10-Year real interest rate, as calculated by the difference between the 10-Year swap rate and the 10-Year breakeven inflation rate, has rebounded strongly from the sub-zero territory to 0.30%, reaching an 8-month high. This means that the long-term perspectives for US bond holders have rapidly changed from negative to positive, since the interest income from holding their bonds to maturity more than compensates them for the risk of inflation. As a matter of fact, these long-term perspectives haven't changed only for US investors but for the rest of the world too. As long-term bond yields have jumped in most of the advanced and developed economies across the globe, their respective real rates moved up as well. This resulted in a generalized drop of gold with respect to the most important currencies, in addition to that against the US dollar. The ratio of gold's spot price over the US dollar bear ETF (NYSEARCA: UDN) has corrected in the aftermath of the US election. The drop of this ratio, which is the gold's price in terms of a weighted average of the euro, the yen, the Sterling, the Canadian dollar, the Swedish krona, and the Swiss franc, is a testament of a truly global force behind recent gold's action, and should not be taken lightly.

Source:  tradingview.com, St. Louis Fed.

When such a shift in real-rates happens on a global scale, investors begin to substitute their precious metals for the greenback, and secondarily for other currencies, as the option of cash gives them more bang for their bucks. The direct negative correlation of long-term - and not short term as many believe - real rates and gold is clearly evident in the latest behavior of these two markets. This means that in order to estimate where gold is heading to, we basically need to know in which direction the long-term real rates are going.

These real rates have two components, the interest rate and the inflation expectations. Exogenous shocks to the global economy can cause either inflation or rates or even both to move abruptly. The latest two shocks, namely the Brexit vote and the Donald Trump's victory, have moved both of these variables in a counterintuitive way. Inflation went up but long-term rates climbed even faster. Italy's referendum has the power to produce a third shock, accelerating the bullish trend in long-term real rates if it manages to set in motion a new policy paradigm in the Euro-area. In case of a "no" vote, systemic fears of disintegration in the Euro-area may prompt the core members, Germany and France, to react by indicating that they are willing to relax their fiscal tightness. This could not come at a better time for the world's economy, because it could coincide with similar indications from the new US administration, as well as by Teresa May's government in the UK. In such a case long-term nominal yields will most certainly go higher, driving real rates up with them.

For the first time in many years and just at a  point where monetary policy has spent all of its ammunition, the fiscal hand seems willing to come in play with a promise to relieve the monetary hand from its exorbitant burden to save the world's economies. Even the mere speculation of that happening, could drive real rates substantially higher from current levels, and that's a reason to pay close attention to the Italian vote in early December.

US Dollar Funding Shortage Pressures Gold

Apart from the economic policy shift, gold faces another threat closely related to the global financial system; USD funding shortage in developed as well as in emerging markets. After the US money market fund reform took place, the cost of borrowing and hedging dollars internationally skyrocketed, since the pools of money which could cheaply finance dollar lending disappeared. The elevated costs of dollar hedging force big non-US investors, like sovereign pension funds, who need to invest in US interest-bearing assets to do so without buying foreign exchange protection. This pushes the greenback upwards. As USD hedging cots increase with time, the greenback strengthens (NYSEARCA: UUP) and this weighs on gold's price.

Under such light, there are only two circumstances which could halt dollars bullishness and revere gold's fate. Either the Fed unleashes its USD swap lines with other central banks in order to alleviate USD funding pressures internationally, or these funding pressures become so extreme that freeze dollar lending abroad and initiate the collapse of the global economy. In the latter case, long-term yields would dive back to new lows, lending a hand to gold.

In any of the above cases, the US dollar could ultimately correct and gold could reign again, as long-term rates would plummet. Until, and if, that point arrives, though, gold has another big reason to weaken further.

Gold's Retracement Levels

With so many negative forces weighing on gold, it is of no surprise that its technical dynamics point to a test of the $1,100 level. A sizable head and shoulders topping formation, solidified earlier this summer, makes gold looking still bearish and points to this target.

Source: tradingview.com

Equally important though, is the fact that the international price of gold has begun its own correction towards the support of its long-term uptrend line (trend line F), which rests about 8% lower than current valuation levels. Chances are that the foreign price of gold will try to test this trend line, before bouncing back up again, in a new appreciation cycle, and that leaves the yellow metal technically vulnerable.

Source: tradingview.com

Investors Have Not Capitulated Yet

Despite all these bearish macro and technical dynamics, investors have not yet exhibited an extreme negative positioning in gold, which could reflect their ultimate capitulation. The latest CFTC gold speculative net long positions have certainly shrunk to about 170K from 300K+ earlier this summer, but they in no case constitute an extreme bear sentiment, as that which was witnessed during the previous gold market's turnarounds. Just before the gold's positive turnaround in early 2016 took place, for example, speculative net long positions almost zeroed. The same capitulation was evident a couple of weeks before the gold's positive turnaround of August 2013, as well as that in early January 2014. Currently, investors haven't been forced to unload their full speculative long positions, possibly because of the fear of well-advertised systemic risks. Yet, the nature of market swings is such that most reversal points occur exactly at a time that investors feel there is no hope in keeping their long positions; and gold's market hasn't yet reached such a degree of desperation. This means that from a probabilistic and sentiment standpoint, the trough of the current gold market cycle hasn't been reached yet.

Source:  investing.com

While, admittedly there are a lot of systemic risk factors out there, spanning from abrupt yuan devaluation to an escalation of the USD shortage crisis in emerging markets, gold has more pain to feel before it serves its wealth preservation purpose. For the time being, the cyclical behavior of gold market will be driven more by the political seismic shift towards a global fiscal initiative and the inflationary acceleration of the Asian region, and less by concerns over cataclysmic risks. Investors have used to perceive gold as a safe haven asset, but this time Italy's referendum might demonstrate, for a third time in a row, that safe havens can suffer.