Commodities | Feb 09 2010
By Greg Peel
In November last year, the world was briefly shaken out of its stock market recovery euphoria when Dubai announced a freeze on its debt repayments. Oh that's right – we had a GFC in 2008 and perhaps it hasn't yet completely gone away, traders mused.
But once the United Arab Emirates stepped in to guarantee Dubai debt the world shrugged and once more it was back to business. The business was the “reflation trade”, one which saw large shorts in the US dollar based on a perceived inevitable decline, a corresponding heavy demand for gold and other dollar-denominated commodities, and a stock market pushing up returns ahead of the year-end close of books.
The rally in gold, which took the metal very quickly from a break-out beyond the previous high over US1000/oz in October to near US$1220/oz by the end of November was spurred on by a sudden and unexpected Indian sovereign purchase of 200t of gold from the IMF at an average of US$1042/oz. Around the same time, global gold mining major Barrick Gold closed out its hedge book, which also effectively meant buying gold. Barrick was one of the last of the world's gold majors to concede that gold hedges were holding back earnings.
If Barrick was buying, it meant the company's view on gold was positive. If India was buying, at the market price no less, it meant long-expected emerging market gold purchases by central banks were now underway. At the same time, legacy European central banks were holding off on filling allowable gold sale quotas. And it was China that everyone thought might buy the IMF's 403t of gold on offer, with Russia not far behind. India? Where did India come from?
In short, gold was going to the moon as far as the market was concerned. Forget US$1200, next stop is US$2000! But like most such parties, and especially gold every time its chart turns “parabolic”, an inevitable blow-off followed. The warning signs were there when there was no apparent buying coming out of the Indian commercial market (gold's biggest physical consumer), as opposed to its central bank, at such inflated prices. It was wedding season, but proud fathers of the bride were nowhere to be seen. All buying was thus purely speculative.
Then in early December, credit rating agency Fitch downgraded Greece's sovereign debt. The “inevitable” slide in the US dollar turned into a short-covering rally. Gold was sold and sold hard. We managed to get through to the new year with little new development in the Greek situation, and so Wall Street went back to pushing stocks up again. But US dollar traders were feeling a bit once-bitten.
Then in mid-January, the Greek situation reached a head. Greek bonds were under attack from the market, and attention turned to Portugal. Then the much larger economy of Spain was implicated. And now Italy has come under scrutiny as well. What are variously now known as “Club Med” or the “PIGS” (Portugal, Italy, Greece and Spain) have sent a rocket through renewed risk appetite. The GFC is back again like a petulant ghost. And gold has been hit hard once more.
Gold's response to the European crisis has many investors confused. Gold is meant to be a hedge against currency crises and sovereign risk. It is a safe store of wealth in an uncertain world. Why, then, is gold being sold off in a big hurry?
Readers may recall that exactly the same question was being asked around September, 2008. Gold had run from US$700/oz one year earlier as the subprime crisis became a reality to at or near US$1000/oz in March and again in July of 2008 when the global credit crisis was in full swing. But when Lehman went down and the credit crisis became a GFC, the gold price collapsed back to US$700/oz once more. Gold investors were confused back then too.
Gold responded firstly because it is in this case denominated in US dollars, and the downtrend of US dollar suddenly reversed when what was previous assumed to be mostly just a US crisis suddenly became a global crisis. Money rapidly flowed out of “risk” investments across the globe and back into the sanctuary of short term US Treasury debt. And stocks were sold in panic.
Panic-selling in stocks was exacerbated by the amount of leverage investors had used to make their stock market investments. Falling prices meant margin calls, margin calls meant selling, selling meant falling prices. Whatever investors had, it was going over the side in order to keep the balloon from crash landing. And that included gold. Investors desperately need to raise cash so they sold everything.
The sell-off was brief, because the rescue package organised for the the US banking system was very expensive for a nation already in heavy debt. Gold quickly began to rally again once the last of the margin call sellers had hit the wall. US$1000 was reclaimed in early 2009 and by December US$1200 had been breached.
So basically, we're at it again. The big US dollar shorts have been reversed and money is again flowing out of other currencies – in this case the euro in particular – and back into short term US dollar debt. The sharp reversal in the greenback and the sell-off in the stock market has once again sent gold packing.
There are other factors to consider as well, however. Remember that following a period of heavy selling from European central banks before and during the GFC (with Spain perhaps the biggest following its property market crash), more recent sales have been limited. No one was in a rush to lose more gold and render currencies vulnerable and it was agreed the usual quota of central bank selling would not be reached. India had to buy its gold from the IMF, who is releasing some of its vast store to fund potential sovereign fall-out from the GFC. Just as well, eh?
But is there a fear Club Med may be forced to sell gold to finance its overwhelming net deficit? One problem is that Greece might have gone cap in hand to the IMF but it can't really, because it is part of the European Union and the euro-zone. It shares a currency. IMF bail-outs always require immediate currency devaluation, but that is not possible in this case. So either the EU has to sort out Greece by itself, or kick Greece out of the EU as some are suggesting (particularly people called Klaus). In the meantime, Greece needs to reduce its deficit – somehow. Perhaps gold is the answer.
The Greek central bank has 112t of gold according to the IMF, representing 71% of foreign reserves. Spain has 281t (35%), Portugal 382t (84%) and Italy 2,452t (63%). Italy is the third largest holder of gold outside the IMF (US first and France second). There must surely be a clear and present danger that some of these gold stockpiles will hit the market.
On the flip-side we have India a supposed buyer, with further aspirations supposedly coming from the other BRICs – China, Russia and Brazil. China is hard to read, because it has been managing to buy all its gold to date from itself, that is its own local producers. But suffice to say there are potential central bank buyers out there who may be prepared to look at central bank selling.
The other good news is that as the second of the Indian wedding seasons ramps up, gold demand appears to be filtering back at these lower levels.
So all is not lost. Indeed, your average gold analyst maintains the view that gold is in a longer term uptrend. But every year or two gold has a bit of a bubble and bust, and this one's no different. At present, a continuation of the sharp decline will not surprise technical analysts.
Barclays Capital suggests gold will test first the previous high of US$1033/oz and possibly the psychological US$1000/oz mark, but there it should find a base. The analysts see a range of US$1000-1225 in the near term before the uptrend resumes to challenge US$1300 and later US$1500.
The popular ladies of the Aden gold report suggest gold will likely endure a sharper decline, but that the bull market will remain intact if US$965/oz is not breached.
The bottom line is, gold is currently responding to short term effects which do not necessarily impact on the longer term. Right now, however, it might be best to let gold run its course.
