Feature Stories | Sep 30 2008
By Greg Peel
As I write, US Treasury secretary Hank Paulson’s plan to rescue US financial markets has been rejected by Congress despite many concessions to the US taxpayer being included. The US stock market has suffered its biggest fall since 9/11, inter-bank lending is frozen, and investors have rushed once more into safe-haven investments – US government securities and gold.
The rejection of the plan did not result in any significant move in the US dollar index. This is because the problem is not isolated in the US but is a very global one. Exchange rates move only on a relative basis, so when the story is the same for everyone the relativities need little adjustment. Nor will an asset switch from stock market to government bond market have much net effect on the US dollar. Yet with little movement in the dollar, gold has jumped another US$27/oz higher in the session to be over US$900/oz once more, the latest move in a rally that began under US$740/oz only a week ago.
The move in gold has thus not been simply reflective of the opposite move in the US dollar. This implies the intrinsic value of gold has increased as buyers find safety in its capacity to store wealth in a time of crisis. If the price of gold were only to reflect the inverse of US dollar movement then its price in other currencies would always fall as the US dollar gold price rises. But gold can rise in price against all currencies simultaneously as long as demand outweighs supply. Gold can “decouple” from the US dollar.
Gold’s rally from US$200 at the turn of the century to over US$1030 in March was driven by a weak US dollar, but also aided by simple demand factors. Emerging market demand for gold has jumped significantly as the economies of China, India and the Middle East have surged. In the case of China and India in particular, the emergence of a previously non-existent middle class has led to a huge increase in gold jewellery demand for the traditional gifts cultural festivals require.
It must be appreciated that 70-80% of the world’s gold ends up as jewellery. As emerging market economic growth has kept pace with gold’s rise in price, so too has the “tolerance” price for gold purchases been ratcheting higher. Most recently strong gold demand reappeared out of India, for example, at the US$800 mark. Demand in developed countries for minted gold coins also jumped so significantly it caught mints in the US, Canada and South Africa by surprise, leading to supply of minted coins actually running out.
As the gold price took another dive down to under US$750, buyers in the physical market stood aside. Volatility keeps physical buyers out of the market given the risk a jewellery maker takes on the time between purchasing gold bar and selling a fashioned item.
The rapid fall of gold from its high was all about a bubble that burst – gold had run too high. Then as the rest of the world’s economies showed signs of weakening, the US dollar rallied. Hard commodity prices suddenly fell, and there was a rush to withdraw from leveraged commodity investments. There was also a rush to sell gold investments for cash in order to pay margin calls on stocks and other assets. And finally, a weak global economy and falling commodity prices imply lower inflation, rather than the higher inflation the world had previously been very concerned about. As gold is seen as a hedge against inflation, it was sold.
All this deleveraging and panic selling is indicative of the other driver aiding gold in rally from US$200 – the introduction of direct investment products such as exchange traded funds. ETFs allow investors to hold a charge over actual gold without the need to provide storage. Previously small investors and large pension funds had difficulty in investing in anything other than shares of gold mining companies in order to be “long”. The gold futures market is enormous, but volatility and margin calls keep big and small investors alike on the sidelines. Futures are left to the likes of hedge funds and other high risk players, and their involvement in the gold market has exploded along with the explosion in interest from everyone else buying ETFs.
Last week investment in gold ETFs reached a record 1056.7t. That’s up 33% on 2007 and 2007 investment was double that of 2006. If gold ETF investment represents “the central bank of the people”, as the London Financial Times coined on the weekend, then it is now the seventh largest central bank holder of gold. The most gold is held by the US (8133t), there followed by Germany (3413t), the International Monetary Fund (3317t), France (2540t), Italy (2452t) and Switzerland (1064t).
As gold rose toward its highs, volumes of long positions held in futures contracts also reached record levels. This is your classic “speculative bubble”. Despite rising inflation and growing financial market turmoil, the gold price accelerated too far. When that bubble burst it was inevitable there would have to be a big shakeout. Citi analysts noted this month that the equivalent of 500t of gold had been sold since mid-July in futures/ETFs. However 90% of that figure was futures – the short term play – as opposed to the longer term investment represented by ETFs.
ETFs are popular with pension funds as it allows them an easy means to include a gold hedge in their enormous balanced portfolios. As a hedge, there is no reason for pension funds to sell out at the first sign of adverse price movement.
As the rubber band had stretched too far on the upside, gold’s heavy fall to below US$740 represented a similar overstretch on the downside. Such is the nature of markets. Once the short term speculators had bailed out, they met a new problem. The fall of Lehman Bros froze credit markets once more – a factor that suggests high level financial market instability and as such a positive for gold, and then Paulson suggested The Plan, which would require the printing of US$700bn of US dollars (via the sale of US Treasury securities). This was the very big positive for gold. How far could the world’s reserve currency be tested?
As Citi analysts put it, “After languishing amid de-leveraging, distress selling, and dis-inflation, gold is finally displaying classic safe-haven attributes and decoupling from basic materials and energy”. In other words, the gold priced stopped falling as commodities like oil fell, for any price inflation hedge consideration was outweighed by the devaluation of the US dollar (monetary inflation) stemming from The Plan, and general turmoil in all other asset classes.
Respected financial market commentator Dennis Gartman has long been an avid and successful gold trader. As a short term player, his vehicle of choice has been futures contracts. However last week Gartman took delivery of physical gold for the first time since the collapse of Continental Illinois Bank in 1984 – the previous record holder for the largest US banking failure in history, now topped by a very large degree by last week’s collapse of Washington Mutual.
The reason Gartman eschewed gold futures again this time (although not stated in his report) is because futures markets represent leveraged paper-only contracts. In the case of a devastating collapse of the global banking system, holders of short gold futures positions may simply go bankrupt before settlement, rendering any long position profits potentially unattainable.
Noting that speculative selling pressure has reverted to short covering, and that physical demand remains “brisk”, Citi is very bullish gold. The analysts see a combination of a “powerful new phase of investment” meeting seasonally strong jewellery fabrication. They suggest gold will see US$1000 again by end-2008. “Longer term we would not be surprised to see it double or triple”, they add.
Demand and supply are the drivers of any price, and while gold is now back to acting like a currency rather than a commodity, one must remember that it has a limited supply. Each decade global gold production trends lower and lower, despite a higher price regime this century attracting renewed mining interest. It has been many years since a geologist stumbled upon a new world class gold deposit. There is no argument here that the world long ago reached “Peak Gold”, but that’s the best anyone can assume for the time being.
As gold is not a consumable commodity, it is claimed that the total volume of gold ever mined in the history of mankind is a known amount. What hasn’t been fashioned into jewellery or some other aesthetic item is held in reserve by the world’s central banks, to varying degrees. In 1999 the largest European central bank holders of gold agreed to limit their annual sales under what is known as the Washington Agreement. This came as a response to the financial turmoil following the collapse of hedge fund Long Term Capital Management in 1998. At the time, the US encouraged central banks to sell their gold in order to once again prop up the reserve currency in its time of trouble. The UK sold half its holdings at the lowest price available.
Europe was concerned about what became uncontrolled sales of bullion, and in response formed the agreement. The agreement put a net limit on gold sales by participating banks to 500t per year, with the year ending each September.
As the gold price rose in more recent years, some central banks were keen sellers and others were not. The disparity was representative of a “two-speed” European economy, contrasting strong current account surpluses in the likes of heavyweight Germany with runaway deficits in Spain, Italy and others. There was further heavy selling as the credit crunch hit – out of necessity – while at the same time Germany was deciding it would hang on to as much gold as it had.
The latest Agreement year has just ended, and net central bank sales have been the lowest since its inception. Eurozone banks (along with neutrals Sweden and Switzerland) sold a net 343t compared to 476t in the previous period. As the viability of the world’s reserve currency continues to come under threat, it is the trend of lesser central bank gold sales will continue.
Thus as global demand increases, global supply is decreasing, both in mining production and central bank sales.
On the flipside of central bank gold market involvement is China and friends. In the most recent ranking of central bank gold holdings (not including the IMF) China came in eight with 600t, and Russia ninth with 473t. India does not make the top ten. Bear in mind that US holdings are recorded as 8133t, and that the US also controls the IMF.
It has long been a matter of conjecture as to whether China would begin to meaningfully increase its gold holdings. At present, US gold holdings represent 77.3% of US total reserves (third highest behind Turkey and Portugal on that ratio) and Germany’s 66.4% of its reserves. China’s figure represents 0.9%. The bulk of China’s foreign reserve holdings is in US government (Treasuries) and government agency (such as Fannie Mae and Freddie Mac) debt.
It does not take much of a stretch of the imagination to understand that China is none too pleased with its investment. Mind you, it only has itself to blame, given the experience of its neighbours in the Asian Currency Crisis of 1997 drove China peg its currency to the US dollar and invest its surplus in US dollar-denominated assets. Thus began the dichotomous relationship between China and the US. China consumed the world’s commodities to manufacture exports for the US market. The US paid for those exports using debt financing provided by China’s acquisition of US Treasuries. This was a closed circuit that saw both China’s surplus and the US deficit explode. But the US has even more massive imbalances with the second two biggest world economies of Japan and Germany. It all had to end in tears one day.
The US dollar index has fallen 23% since only 2005. A relative novice at this investment business, China has learnt the hard way what risks are inherent in capitalist financial markets, no matter how big you are. Not only has China lost out from the falling value of the US dollar in debt investments, it also made sovereign wealth fund excursions into US bank stocks at what has now proven to be too early in the credit crisis. When the US Treasury nationalised Fannie and Freddie but honoured its bonds, China and others were firmly in the government’s mind.
China had already begun a long process of direct investment in the very commodities it was consuming, through deals in the resource rich continents of South America and Africa in particular. With no alliance to the US other than a financial one, China has also been free to do oil deals with Iran or any other of America’s enemies. China has also tried hard to make inroads into Australia’s vast commodity resources, but has met strong resistance from government review.
If it were never clear before, it must certainly now be clear to China that direct investment in its economic future is best served by bypassing the financial market connection. Mines and mining stocks, oil wells and oil stocks are obvious targets across the globe. If China is looking for another currency to substitute for its excess of US dollar investment, then simply diversifying into euro or yen debt is not the answer. Those economies are also on the brink. But as China has found in its frustrated efforts to buy into the Australian iron ore industry, it may not be so simple just to buy up the world in the short term. In the mean time it needs to preserve its wealth.
Dennis Gartman notes that for China to increase its percentage of gold reserves from 0.9% to the 50-80% numbers of the large developed world economies, it would take an impossible investment. There’s just simply not enough gold. But there is little stopping China from simply increasing its gold reserves, and as it is starting from a very low percentage there’s no telling what impact this might have on the gold price.
If that’s what China decides. Speculation has been rife for a couple of years now that China must start to buy more gold, but as the numbers suggest, that day has not yet meaningfully arrived.
For the gold price to “double or triple” would require an ongoing weak US dollar. Analysts are unclear as to just how any financial market rescue plan from the US government would impact on the dollar. On the one hand, if stability in credit markets is achieved then the risk of a full-scale recession, or even depression, are diminished – stable US economy, stable dollar. If the economic situation proves to be worse in Europe and perhaps Japan, as many analysts are suggesting, the US dollar could even rise.
On the other hand, any rescue package increases US debt – in this case manifestly – thus devaluing the US dollar. If it is the US government doing all the spending, then the value of the dollar should fall against other currencies.
But don’t forget that the US dollar is an arbitrary benchmark. If the US rescue package fails then all economies are affected, and thus all currencies, meaning the relativities will remain static. This is basically what happened when the Plan was voted down in Congress. If the US dollar falls alone, then it will be incumbent upon the central banks of all of its trading partners to provide support. This is already happening as central banks around the world, including the Reserve Bank of Australia, inject funds into the global system. The next step would be direct currency intervention, where central banks exchange their currencies to artificially stabilise exchange rates. When the US dollar threatened to trade through US$1.60 to the euro earlier this year, the G7 hinted at impending currency intervention.
It is not in the interests of anyone for the world’s reserve currency to collapse. It only breeds the same sort of inflation the world was trying desperately to control earlier in the year and undermines the export industries of other nations as their own inflated currencies price them out of markets. The reserve currency must only fluctuate, not crash. Otherwise it has no value as a reserve currency.
And maybe it doesn’t.
I mentioned earlier the concept that the price of gold can “decouple” from the US dollar, even though it is denominated in US dollars. This happened briefly in late 2005 when gold made its earlier “bubble” push to US$725/oz in 2006, only to fall back to US$550 by mid-2006. Fears over the ballooning US current account deficit sparked a rush into gold, and the new ETF products provided the means. Suddenly everyone wanted gold, and so the price rose even as the US dollar rose temporarily.
When Congress rejected the Plan on Monday gold well and truly decoupled from the US dollar, as it rose US$27/oz with the US dollar falling. But this was a safe-haven trade. This is the trade that assumes all paper currencies are devalued as one, even if their relative exchange rates remain static.
We focus on the price of gold in US dollar terms. Barclays Capital technical analysts noted last week that the euro gold price has also broken to the upside of a downward price channel developed over 2008 to date. Gold prices in both British pounds and Swiss francs were also nearing break-out levels, implying that as of last night they would be through.
These are shorter term considerations in a wider picture. If there is at least some Plan passed by Congress soon, one can well expect a sudden drop in the gold price given it is instability and uncertainty that has driven recent spectacular gains. But in the greater scheme of things, the near collapse of global financial markets has exposed that which many have been warning about for years – developed world debt has grown to bubble proportions. That bubble is now bursting. The bubble is represented only as paper currency IOUs from world economies, and not from hard assets.
It is naive to think that the world will suddenly decide tomorrow to once again return to the safety of a Gold Standard, even though there is many an observer advocating just that. However, irrespective of shorter term violent fluctuations you will be hard pressed to find an analyst who doesn’t suggest the gold price will be trending higher in coming years. This debt mess needs to be resolved, but it won’t be resolved simply by a Plan.
