Commodities | Dec 11 2012
By Greg Peel
FNArena has oft pointed out that gold, that “barbarous relic”, tends to wear different hats at different times. Depending on the circumstance, gold can be popular as an “inflation hedge”, a “currency hedge” and a “safe haven”. Realistically the first two are much the same thing, while the safe haven aspect of gold is challenged every time the latest risk episode sparks a sudden “flight to cash” sell-off of investment gold.
Credit Suisse has cited research conducted by the US National Bureau of Economic Research which has brought into question a few of the “myths” surrounding gold. The research was prompted by the fact that since 2009, the “real” price of gold (adjusted for inflation) has rallied and is now very high compared with historical standards. Why is this so?
After extensive study, the NBER has found little evidence gold acts as an effective inflation hedge over time, either in the short term or the long term. Nor does the “gold as a currency” argument hold much water given fluctuations of the real price of gold over time are much more volatile than foreign exchange changes. Besides which, if gold were able to provide a hedge in one's own currency it cannot provide a hedge against other currencies.
The NBER also decided that low real yields on other assets (such as government bonds) do not cause the gold price to be high. Indeed, in recent years, the economists argue, the high price of gold might be keeping yields down. Nor do the data suggest gold has been very effective as a safe haven. As a true safe haven, gold seems only effective to the very remote possibility in mature economies of Weimar-style hyperinflation.
Instead, the NBER deems the rally in the price of gold to be more a simple case of demand-supply. On current estimation, only 20 years' worth of gold reserves remains unmined. Yet despite the significant increase in price, gold mining production has not much increased of late. On the flipside, the demand for gold as an investment has increased exponentially, with the introduction of US gold exchange-traded funds (ETF) affecting a significant steepening of the demand curve. The largest US-listed gold ETF currently holds more gold than the official reserves of China.
Why has the gold price thus rallied to a point well beyond historical standards in “real” terms? If we assume “inflation hedge”, “currency hedge” and “safe haven” to be drivers, and those drivers to be proven erroneous according to NBER research, that just leaves the accessibility provided by ETFs and a “herd mentality” driven by fear of ongoing central bank monetary debasement. Such behaviour suggests a bubble.
Having said that, the NBER notes that were investors to hold a “balanced portfolio” of investment assets, based on the relative size of the global stock, bond and gold markets each investor's portfolio should contain 9% gold. Reduce the gold market to only “investable gold”, that figure becomes 2%. Statistics show very few investors hold 2% gold in their portfolios. Were this every investor's target, clearly the gold price would remain under upward pressure.
In a similar argument, were the BRIC emerging economies alone (Brazil, Russia, India, China) to increase their official gold reserves (as they are currently doing) to levels equivalent to the US on a ratio to GDP scale, gold has a long way further up to go. And don't even think about what price would come of an equivalent gold-to-population scale, but then there is not that much gold in the world.
Academic studies aside, Goldman Sachs issued research last week suggesting the price of gold will peak in 2013.
Over 2012, Goldman notes, US real rates have steadily declined and central bank gold holdings have risen. Under normal circumstances, the price of gold would rise on these factors. But in 2012 the price of gold has done nothing but range-trade. To understand this conundrum Goldman's commodities team expanded their modelling to include the impact of Fed easing.
The modelling found it is only when the Fed balance sheet is actually expanded through easing, such as through the open-ended purchase of securities (QE), does gold respond. Albeit gold responds on the rumour rather than the fact. Non-expansive easing, such as the Fed's Operation Twist which has been in place all year, has no impact. On this basis, for the gold price to rally again the market must expect further Fed balance sheet expansion.
The FOMC will meet on Wednesday and Operation Twist – due to expire at year-end – will be on the agenda. If the Fed swaps a Twist for more straight QE, as many expect, then 2013 should see further Fed balance sheet expansion. Given Goldman Sachs expects the US economic recovery to slow early in the first half, the combination of weaker growth and Fed easing should be supportive for gold prices.
But Goldman thereafter expects the US economic recovery to accelerate in the second half. If this is the case, real interest rates should start to rise once again, putting pressure on the gold price. The analysts suggest an improving US economy should outweigh Fed easing with regard to gold price influence, suggesting a peak for gold some time in the second half of next year. The risk in this thesis is provided by the as yet unknown of the fiscal cliff and its potential impact on US growth.
One can also presume that if the US economy starts to look healthy, the Fed will begin winding back its easing programs. The central bank has pledged to keep the cash rate low until 2015, but there is plenty of balance sheet reduction (QE-reversing) the Fed could undertake before needing to lift its cash rate. If one considers every QE strategy as akin to shifting the rate further and further into the negative, it's a long way back to zero.
Goldman Sachs has subsequently lowered its three-, six- and twelve-month gold price forecasts to US$1825/oz, US$1805/oz and US$1800/oz respectively (current spot US$1712/oz), and has introduced a 2104 forecast of US$1750/oz. Under the analysts' expectations, the gold price may yet spike higher within the first three months before peaking out.
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