Commodities | Apr 03 2009
By Greg Peel
Last night the European Central Bank surprised the market and cut its cash rate from 1.5% to only 1.25% rather than the 1.0% expected. Given the market had set itself long US dollar/short euro ahead of the decision, trades were reversed and the US dollar fell. A weaker US dollar served to fuel stronger commodity prices (oil, copper etc) which in turn added to exuberance on Wall Street. The Dow rallied strongly.
In most circumstances, a gold investor would expect that a fall in the US dollar would also spark a rally in the USD gold price. But last night gold fell over US$20 to around US$903/oz. How can this be so?
The simple answer is there is a battle raging in gold. On the one side is the “safe haven” trade and on the other is the “inflation” trade. When the credit crunch first hit gold made it to US$1000/oz on a weaker US dollar and fear of risk in the US financial system. When the credit crisis became the GFC gold again made it to US$1000/oz despite a rebound in the US dollar (which was brought about by the world buying the other safe haven asset – US bonds) on fear of risk in the global financial system. The latter was exacerbated by the inflation trade as investors bought gold against the huge amounts of paper money being printed across the globe.
The inflation trade is still on. Central banks across the globe are madly increasing their money supplies to fight the GFC. But right at the moment the safe haven trade is reversing. Stock markets have bounced, and many are now hoping the bottom has been seen. So now we have the exit of the safe haven fighting against the inflation trade – as was the case last night.
What is heartbreaking for investors of Aussie dollar gold is that last night the Aussie dollar also rallied, further reducing the value of AUD gold. Indeed, while USD gold has battled in a range between US$900-1000/oz recently the Aussie has crept US10c higher, sending AUD gold lower.
Investors holding on to gold for the inflation trade – and their number is vast as indicated by record holdings of gold ETFs – expect gold will breach US$1000/oz again when the US dollar inevitably falls. The dollar must fall, they argue, given the amount of money being printed by the US Treasury to fight the GFC. For AUD gold holders this is not necessarily good news, because if the US dollar falls, the Aussie should rise.
However, gold has shown in the past 6-12 months that it can rally (in USD) even as the US dollar rises. Hence there should be no reason why it can’t also rally (in AUD) even as the Aussie rises. But it comes down to the long and short of it – time frame, that is.
If this stock market rally proves to be something more than just a fleeting bear market snap-back, more and more investors will come out of their caves and reivest their wealth in stocks, commodites and other risk assets and sell out of their safe haven gold positions to do so. In other words, gold has a very good chance of breaching US$900/oz again. Unfortunately for gold investors, history suggests this will likely happen.
Underlying demand for gold as an investment is demand for gold for jewellery fabrication, and the latter traditionally represents 70% or so of all gold demand. Jewellery demand reaches its pinnacle twice a year – once in April-May to coincide with one Indian wedding season, and again in August-September to coincide with another Indian wedding season. There is a brief hiatus in October, but be November jewellery demand starts climbing again ahead of Christmas and through to the Chinese New Year. So realistically the big hole in jewellery demand occurs in June-July.
Unsurprisingly, the gold price tends to go into retreat over this period as well.
So all things being equal, we would expect that gold might also take a rest in June-July of 2009 as well. But this year there are further influences. The first is the aforementioned unwinding of safe haven gold positions, were this stock market rally to continue, or even if the economic slowdown simply appeared to be slowing in its pace.
The second is that in 2009, unlike 2008 and several years prior, the economies of India, China, SE Asia and the Middle East are also now in slowdown. In past years these economies had continued to boom even as the developed world began to be credit crunched. Hence there was still plenty of gold demand, at ever higher prices, from these major sources of jewellery buying. That demand has now receded.
Not only has it receded, but gold analysts at RBC Capital Markets expect demand will even reverse. In other words, Asians will start selling their jewellery in the face of their economic hardship. Such sales are known as the gold “scrap” market, and RBS points out that the last time Asia was in trouble – in the Asian Currency Crisis of 1997 – scrap sales jumped significantly.
So as we head into June-July, we could have safe haven investors bailing and jewellery demand not only receding but fully reversing. That is not a good equation for gold. All that is left is the inflation buyers.
It is assumed by the inflation traders that the US dollar must eventually fall against other currencies because the US is printing trillions of dollars to fight the GFC. But the US dollar has not yet collapsed because every major economy across the globe is also now printing money, in varying degrees. Were everyone to keep printing at a similar pace, then relative currency movements should be minimal.
Another development last night was that the G20 agreed that no member country would enact any protectionist measures at the expense of the others. This includes the deliberate devaluation of a currency to make export prices more attractive. Such devaluation can be achieved by various measures, but they all largely amount to printing money. If no one is allowed to go over the top with its printing and exchange rates are held in check, then in theory gold has no reason to rally.
However, last night the G20 also agreed to pump another US$1 trillion into the IMF – together. The G20 also ratified the IMF’s request to sell 403t of gold, but this we already knew. The move to bump up IMF coffers is a compromise between those members who wish to keep reflating through money printing (such as the US and UK) and those who are against it (Germany, France) for fear of aforementioned protectionism being a back-door result.
But pumping money into IMF solves two problems: (1) it is a victory in a sense for the UK and US who wanted globallly coordinated reflation; and (2) Germany and France are happy because it provides the IMF with more funds to bail out Eastern Europe, to which Western Europe has enormous loan exposure.
So at the end of the day there is still a lot of paper money being printed around the world in one sense or another, and that is inflationary – even if exchange rates don’t move much against each other. Gold could rally in price against ALL currencies.
And that is why AUD gold can still rally even if the Aussie is stronger. It is a case of global inflation outweighing relative currency movements. RBC puts it this way:
“In the current macroeconomic environment, we continue to believe that the extraordinary amount of monetary and fiscal stimuli should ultimately have a positive impact on gold prices. As the global economy, and Emerging Market economies in particular, begin to recover, the impact of low/negative real rates and accelerated money supply is expected to sustain the positive environment for higher gold prices…”
That, however, is the longer term. In the shorter term:
“After the last two years, during which gold outperformed most other asset classes, we continue to favor gold as a form of portfolio insurance and diversification. However, as investors regain confidence in a broader range of financial assets, we would expect to see liquidation of this portfolio insurance and hence the movement of our recommended gold weighting from overweight to market weight within an investment portfolio”.
In other words, keep your gold in the bottom draw for ultimately higher global prices but don’t jump into the investment trade at this level, looking for a quick rally to US$1000/oz and beyond, as forces are now acting against gold in the shorter term.
RBC has set its average gold price forecast for 2009 at US$850/oz, US$875 in 2010 and US$900 long term. These numbers look a bit depresing for a gold investor. However RBC expects the gold price to be volatile, and US$1000 can well be tested again at any time.
The bad news is RBC believes US$750 could be tested on the downside in the next few months. The good news is the analysts see a move towards US$750 as a great buying opprtunity, and that US$1000 will be tested in earnest again in late 2009 or early 2010. The analysts also concede their average price forecasts are conservative:
“…the impact of low/negative real rates and accelerated money supply is expected to sustain the positive environment for higher gold prices, likely well above our current average forecasts.”
