GOLD: An Investment, Hedge or for Protection?

Why gold is rising and will keep rising

While gold has rallied 350% from the lows of 1999 and is up about 285% when adjusted for inflation, this still pales in comparison to the 1976-1980 bull market in bullion. During this period, the price rose by more than 750%. (See chart 1)

To some, this suggests that history is repeating itself and gold is heading beyond US$2,000 per ounce. That might be why John Paulson is launching a pure-play gold fund.

Let’s start with the U.S. dollar, which the price of gold is widely understood to mirror (See chart 2). When the dollar falls, the price of gold has to rise, assuming nothing else has changed in the supply and demand balance.

When fundamentals make gold more attractive, it overcomes its normal relationship, according to J.P. Morgan analyst John Bridges. “Don’t be surprised if gold is strong even on a modest dollar bounce,” he said.

So while the short-term correlation between gold and the dollar index has strengthened recently, it leaves much still unexplained.

Moving onto supply and demand factors, the gold market appears relatively balanced. The decline in mine supply in recent years has been supplemented by increased scrap sales and sustained central bank gold sales. In the first quarter, scrap sales rose sharply as gold re-visited its all-time high.

Meanwhile, central bank reserve sales, which have play ed a key role in keeping gold prices in check during the past decade, have slowed recently, according to Citigroup. In the 1990s, central bankers were acting as a group to reduce their gold holdings, confident that the fiat currencies were a better store of value.

Now gold’s attractions are re-emerging and bankers look set to be net buyers, which should help tighten the market, according to Mr. Bridges, who also sees sharp increases in industry costs supporting the gold price.

With industrial demand for gold limited, unlike other precious metals like silver or platinum, changes in demand are primarily due to fabrication needs, which have dropped sharply since 1997, according to a Citigroup report. Add to that the fact that the economic downturn, coupled with higher prices, further reduced the demand for jewelery, and supply-demand changes add little in terms of explaining bullion’s rise. With the exception of the 1976-1980 period, gold prices show little to no relation to changes in the Consumer Price Index, the firm noted.

So far the massive expansion of the U.S. Fed’s balance sheet and those of other central banks has not affected inflation due to the scale of the de-leveraging and slower money velocity. If it is not current inflation the market is worried about, then its future inflation, right?

The evidence is scant here too. Ten-year U.S. treasury yields have definitely rebounded from their end-of-2008 lows between 2% and 3.3%, but this can hardly be deemed conclusive evidence of inflation fears, according to Mr. Hart at Citigroup.

Yes, the government bond market is highly distorted right now, but markets don’t appear to have embraced the inflation thesis so far. So it can’t be said that gold buying is definitively a result of inflation fears.

Then what about speculation and ETF buying? Looking back to the surge in crude oil to US$147 per barrel in 2008, the market justified the move with an array of structural factors. This might suggest that a similar speculative bubble is forming in gold.

However, one obvious difference is that when oil peaked, the forward market was in backwardation, indicating that the market was expecting a decline in prices. The gold market does not and prices a value of US$1,268 per ounce for June 2014. While ETFs were cited as a culprit for the rise in oil and are also playing a role in the gold market, their impact has been limited of late, Mr. Hart noted.

ETFs may have been active buyers early in 2009, but their activity has leveled off since. There has been a sharp increase in long forward positions in gold at the Commodity Futures Trading Commission (CFTC) and net longs have reached a record.
”However, more often that not, these flows correlate with spot moves and rarely serve as a leading indicator. As a result, speculative positioning hardly represents the main factor driving the recent spike in gold prices,” the analyst said.

Despite all the attention being paid to sales of gold by central banks and the fact that world gold holdings have experienced a broad decline, holdings in industrialized economies are on the rise as a share of total foreign reserves. And this trend was renewed in the first quarter.

There is a popular presumption that developing economies will increase the share of their gold holdings. However, Mr. Hart explains that gold holdings in advanced economies are largely a function of the legacy of the previous gold standard. So if the rest of the world is to move toward the industrial country average of 40% of reserves in gold, then industrial economies would presumably have to sell some of their gold holdings, which would offset upward price pressure.

China does remain a big unknown in all of this and its reported gold holdings seems to suggest a large degree of under-reporting. This is particularly significant now that Chinese authorities can make their purchases on the domestic market.
So what about gold as simply another currency?

First off, this is factually untrue since it does not serve as legal tender in any economy, Mr. Hart points out. Yes, it is an investible asset, like cash, and its supply is limited, so it can serve as a more suitable store of value that fiat money.
“But unlike other assets, it doesn’t yield a return. Holders simply incur capital gains or losses and these are as uncertainas those of other assets over the long term (the relevant time horizon for central banks),” Mr. Hart said.

Then why hold gold? The answer lies in an increasing lack of confidence in paper-based currencies. The debasement of the U.S. dollar has a broad effect that undermines confidence in other currencies. And with central banks and policymakers still far away from removing themselves from their unprecedented fiscal and monetary accomodative positioning, this could continue for much longer.

So it is not a case of whether gold leads the dollar or the dollar leads gold, Mr. Hart explains, rather price movements in both are the expression of the same underlying malaise with the lingering effects of the financial crisis.

“Occasionally, investors lose confidence with currencies, and when this happens, because the pool of gold and related investments is so small, demand for gold can become intense,” Mr. Bridges said.
Some reprint from Jonathan Ratner



Saverio Manzo