Why Gold Prices are Ready to Rally

Gold prices hit a four-week high last week as the market waited for the highly-anticipated congressional testimony by Federal Reserve Chairman Ben Bernanke.

But gold bulls were pushed aside Thursday after Bernanke, in a speech to Congress, failed to deliver a definitive answer on monetary easing.

Deutsche Bank analysts wrote in a Friday research note via Dow Jones, "The past week has demonstrated how expectations [toward] quantitative easing can have a powerful effect on the gold price."

Now investors need to wait for the June 19-20 FOMC meeting for more clarity on what the Fed could do this year and how metals prices will be affected.

Gold prices have recovered since then, and on Tuesday the yellow metal pushed above the $1,600 an ounce mark. The weekend's news about the Spanish bank bailout and lingering concerns over the Eurozone debt crisis has increased alarm about the global economy, making gold more attractive.

But news from Europe and Fed policies aren't the only factors that can move gold prices. Here's what else is affecting the metals market now.

The Biggest Factors Moving Gold Prices

#1: Central Bankers are Buying Gold

For the first time since 1965, central bankers are purchasing gold.

According to World Gold Council, the central banks have increased their gold collections by 400 metric tons or almost 2,205 pounds in the last 12 months through March 31.

This is a rise from the previous year's 156 tons.

Look for this to continue from the central bank as the council noted it "is now confident that central banks will continue to buy gold and has added official-sector purchases as a new element of gold demand," according to Austin Kiddle in a Sharps Pixley report.

Jeff Christian, founder of New York-based commodities consulting firm CPM Group, told Barron's that central banks "will probably be continuous buyers of small volumes of gold for the foreseeable future," accounting for roughly 10% of the gold supply.

Christian noted that central bankers will avoid buying any quantity that dramatically affects the price of gold. Yet steady buying of 10% of annual supply is certain to help buoy gold prices.

#2: Short-term Speculators are Exiting the Marketplace

While central bankers have entered the gold market, short-term speculators are headed toward the exit.

Open interest in managed futures funds, which is a good representative for speculators, has tanked 28% since the start of September; as of June 5, this figure sat at 203,224 contracts.

George Gero, a precious metals strategist at RBC Capital Markets, told Barron's, "I think we'll see more volatility in gold because of the absence of speculators." Speculators can usually put a damper on volatility with their liquidity.

Gold prices could be ready to make major moves in very short periods - too big and fast for speculators, reported Barron's. Without the speculators, long-term gold investors who can withstand short-term volatility will get back in the market to protect against weakening fiat currencies.

"The best way to play gold is as a long-term investor as a hedge against loss of purchasing power of paper money," said Gero.

#3: Gold Sentiment has Plummeted

Sentiment surrounding the gold sector has been increasingly negative this year.

The Hulbert Gold Newsletter Sentiment Index, which measures the exposure recommended by short-term gold market timers, was recently negative for 29 straight days -- longer than any other stretch in history.

In other words, how investors view gold is about as negative as it can get, and is ready to reverse.

"Gold traders' increasing impatience has led even more of them to throw in the towel - which, in turn, is why contrarians are confident that gold's next major move is most likely up," Mark Hulbert told Money News last month.

Meanwhile, gold stocks are cheap. The gap between gold stocks and gold prices widened to almost historic highs this year. On May 1, gold stocks were trading 29% below where they normally would trade, according to John Doody of the Gold Stock Analyst.

The only time these stocks have ever traded at a greater discount to gold was in the October 2008 crash, when they traded at a 34% discount.

This means many gold stocks are badly oversold, and the upside potential for gold shares clearly outweighs the downside risk.

Gold ETFs have seen some luster lately.

Investors flocked to gold ETFs last week. SPDR Gold Shares(NYSE: GLD) are up about 1.3% since Thursday, and now in positive territory for the year after a slow decline since February. GLD hit a one-month high of $159.20 last Wednesday and rose above its 50-day moving average.

Mining ETFs have also joined the bull party with the Market Vectors Gold Miners ETF(NYSE: GDX) hitting a midweek high of $48.52 before closing at $46.33 for the week. The Market Vectors Junior Gold Miners ETF(NYSE: GDXJ) also got a bump last week, and rose 2.55% in morning trading Tuesday.

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