Commodities | Oct 16 2012
– Gold price going nowhere
– Maybe there's a reason
– CBA suggests the answer lies in US bonds
By Greg Peel
The equation is simple. All things being equal, if the value of the US dollar falls, the value of US dollar-denominated gold must rise. The greater the pool of US dollars to tonnes of gold, the greater the value of that gold. Gold is thus a hedge against inflation, and monetary inflation occurs when the money supply is increased through monetisation of debt, otherwise known as quantitative easing.
After another fall in the gold price last night, gold is effectively unchanged from the point at which Fed chairman Ben Bernanke announced “open-ended QE”, which is another way of announcing “we will just keep printing more US dollars until the US economy picks up”. While it's early days for QE3, the anticipation alone should have sent gold higher as the US dollar falls. The US dollar is nevertheless also unchanged.
The US dollar is somewhat irrelevant nevertheless given it is an exchange rate not a true “price”. The US dollar index is impacted mostly by the euro, yen and pound, and all of the ECB, Bank of Japan and Bank of England are conducting or intend to conduct QE and/or currency intervention. The result is an exchange rate stalemate. However in theory the price of gold should disconnect from its denominator currency in such circumstances given the global supply of fiat (non asset-backed) currency is rising irrespective of stalemate exchange rates. But it hasn't.
Central banks are unconcerned about monetary inflation in the near term given QE is only deployed in the face of potential monetary and fiscal deflation (debt reduction and economic recession) to act as a safety net and short term shot of adrenalin. As soon as that potential subsides, easy monetary policy will in theory be swiftly reversed. The so called “gold bugs” argue, however, that inflation is likely to take hold a lot faster than central banks can, or are yet prepared to, back-pedal. Gold bugs are also currently disappointed that the price of gold remains well off the highs seen earlier this year.
Gold pays no dividend, so as an investment it can only be a wealth store and not a growth asset. If you hold gold in periods of deflation you lose wealth, and vice versa with inflation. If central banks actually get it spot on with monetary policy – serving only to offset deflation and withdrawing as soon as inflation threatens – then in theory gold can't really go anywhere. Indeed both deflation with QE and inflation without QE don't offer up much of a price-hike prospect for gold.
Commonwealth Bank believes the negative real rates (nominal rate minus the rate of inflation) committed to by the Fed until 2015, and the risk of another US sovereign ratings downgrade on the strength of its excessive debt to GDP ratio, suggest a weaker US dollar and thus a higher USD gold price ahead. At least until 2015, when presumably the Fed will allow real rates to rise again. So in CBA's view, gold fans have a couple of years of potential price appreciation ahead and to that end the analysts have upgraded their gold price forecasts by 3% in FY13, 5% in FY14 and 16% in FY15.
Excited? That takes the respective forecasts to (US$/oz) 1738, 1780 and 1660. Right now gold is trading at 1735, and if we assume the AUD-USD has little chance of breaking out of its trading range anytime soon, AUD gold prices will be similar.
It cannot be denied, nevertheless, that the price of gold was not much more than 400 when the US housing bubble peaked in 2006 and the world began to unravel. CBA notes that from 1992 to 2011, demand for gold as an investment grew at a compound annual growth rate (CAGR) of 8.4%, but that the GFC affected a CAGR of 37% from 2007 to 2011. The US introduction of gold exchange traded-funds in the early noughties has provided more general access to gold investment.
Increased gold investment was most notable in the US and Germany (representing Europe), which in recent times seems to confirm that gold is perceived as a store of wealth in a time when real interest rates are negative. China and India are two of the biggest consumers of gold (as jewellery) but as developing economies, lag in the investment stakes.
CBA believes the potential for countries such as China and India to increase gold investment remains. (China recently opened its first gold exchange.) This means that even if gold prices subside once global interest rates start to rise again, a floor is suggested by newfound developing world investment interest. From 1992 to 2011 the growth of gold investment and the gold price has exhibited a correlation of 96%.
In the GFC period, gold has also shown a tight correlation to the benchmark real US ten-year bond yield (inverting the yield). The current nominal yield is around 1.7% and inflation is running around 2%, suggesting a slightly negative real rate.
CBA research further reveals peak correlation exists when real ten-year yields are below 2.25% but breaks down below 1.00%. “We believe,” suggest the CBA analysts, “this reflects investors in other asset classes fleeing to US bonds as a safe haven of final resort”.
This seems counterintuitive. Surely gold, which is an unqualified physical asset, would have more of a “last resort” attraction than an IOU from a government who believes debt is best overcome by printing more money. It's a bit like your mate saying “Can I borrow some money?” Yes. “And I can I borrow more money every month without paying any back?” Yes. “And can you pay me interest [negative real rate] for the privilege of lending me money?” Yes of course.
CBA posits that the reason US bonds seem to be the “tier one” safe haven and gold the “tier two” is that in recent years the gold price has tended to drop sharply when fear levels reach their peak.
Such drops is usually attributed to investment leverage, such as margin lending for the purpose of buying risk assets such as stocks and commodities (gold is a currency in this context). If share prices drop sharply, margin investors may find themselves in a negative cash position and thus need to sell something else to raise cash. The “wealth store” of a gold position is a good source, and hence down goes the price of gold. And thus down goes “wealth”, and value of gold as a store.
On the flipside, investors pile into US bonds at any price, where they feel their money is at least safe with the US government.
There are plenty of analysts out there who believe that gold must soon pass through 2000, on the back of global QE. Yet we are currently in a new phase of QE or pending QE, and gold's gone nowhere. CBA research, and a consideration of deflation, inflation and QE, may throw some light.
Technical limitations
If you are reading this story through a third party distribution channel and you cannot see charts included, we apologise, but technical limitations are to blame.
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