What Will Stop Gold?

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 By Greg Peel

It’s midday in Sydney as I write, and while the northern hemisphere is still asleep on a Sunday night and Hong Kong gold desks are just opening the gold price has already leapt more than another US$10/oz – from its New York close of US$1150.90/oz on Friday to US$1162.60/oz. There seems little to stop the gold locomotive.

The World Gold Council’s third quarter report has just been released and makes for interesting reading. It appears a 10% increase in gold demand in the third quarter over the second was largely due to increased jewellery demand. We must take the report with a grain of salt of course, given the third quarter is now a long time ago in gold market terms.

The period from July to end-September was a period in which gold struggled to find a direction within a US$900-1000/oz range, having peaked for the second time at US$1000 in February. While underlying weakness in the US dollar was putting upward pressure on the USD gold price, traders who had already ridden gold for such an outcome were taking profits and switching back into risk assets such as stocks. Commodity funds were also taking profits and redirecting their portfolio weightings to energy and base metals. It appeared that US$1000 would again prove a barrier, and investment in exchange-traded funds also saw a reduction.

Toward the end of the third quarter of any year demand for jewellery would normally pick up ahead of the upcoming Indian wedding season. But given Indians had borne at least some brunt of the GFC like the rest of us, it was unclear as to whether demand for gold would still chime back in at prices well above US$900. If anything, the world was bracing for a potential bounce in the US dollar which might send gold tumbling back to US$750.

Nothing could have been further from the truth. In the end, gold began the third quarter at US$900 and ended it at US$1000. There followed a break into blue sky. It is now apparent that a 15% increase in world jewellery demand in the third quarter over the first was an important driver, despite demand still being 30% down from the third quarter ’08. This is mostly due to a 41% year-on-year drop in demand out of India, which represents 24% of the jewellery market, but China is catching up at 21% and it saw a 7% increase year-on-year.

Demand for gold as an investment was up only 1% in the quarter but down 46% year-on-year. This has to be put into context, because the third quarter ’08 was when Lehman went under and investors rushed into gold in fear of financial Armageddon. The balance of this third quarter’s increase has come from bar and coin demand while EFT investment saw quite a drop-off. (This is not terribly surprising given investors are much keener now to have real gold in their hands rather than some promise from an organisation which may also falter in a financial disaster.)

On the supply side, a lack of central bank selling and a reduction in scrap saw an 8% fall for the quarter. Supply is down 5% for the year, a figure also impacted by less producer dehedging (they’ve all been there already) and a general downward trend in annual fresh gold production.

Citi’s North American analysts see the World Gold Council data as suggesting a positive trend for gold into 2010. They note Indian jewellery demand is recovering, the initial burst of scrap supply at high prices is abating, and central bank selling is down and may turn into net buying. Clearly currency movements and monetary inflation expectations will also be an important factor.

Ironically, evidence in the fourth quarter to date is that Indian jewellery demand has since collapsed now that gold has left not only US$1000 behind but US$1100 as well. The bulk of Indian buying comes out of the middle classes honouring age-old traditions, but that market is very price elastic. Citi believes there may yet be demand upside as buyers acclimatise to a higher price, which is consistent with past years, although there is usually a demand gap as buyers throw up their arms in the interim. The irony is that the recent price surge also came out of India – this time when the Reserve Bank of India jumped out from behind a tree and bought 200t of the IMF’s 403t on offer.

On the flipside of weak jewellery demand at this price is, however, a resurgence of EFT and Comex futures demand. EFT levels have pushed back up to records and activity in Comex futures and futures options is also causing astonishment. At the end of the day India’s US$6.7bn gold purchase is not that significant on face value. What is significant is its implication.

BNP Paribas Fortis has just released its November “Yellow Book”, which spends a lot of time discussing Indian implications. Given the RBI has been very coy, no one is quite sure why the sudden haul. Is it really a matter of wanting diversification away from the US dollar in foreign reserves, or is there some offsetting trade yet to happen, such as selling the gold to support the rupee (which is partially pegged to the US dollar)?

The latter could be discussed for hours without a result, so assuming the former is true then analysts are bracing for what might be a significant change of direction on the part of world central banks. India’s gold purchase might open the floodgates from China (who was expected to take the IMF’s gold) to other emerging and not so emerging markets. Over in Europe, it appears there is little intention to sell gold out of legacy central bank coffers despite a 400t per year allowance under the Central Bank Gold Agreement.

One can argue that gold headed back through US$1000 on general fear of currency inflation via massive global stimulus efforts, and while nothing has changed on that front the kick through US$1100 was all about speculation as to what central banks might do next.

Fortis makes an interesting point, coming back to jewellery, which challenges Citi’s view that Indians can once again adjust to a higher price. The accumulation of dowries containing gold as a gift for brides to grooms is an ancient tradition, and one which a modern Indian government has actually passed a law against. No one has much paid any attention however, and the tradition continues. But intentions have changed.

Young Indian women, notes Fortis, with the support of young Indian men, are more liberated and equality-conscious than their parents, leading not only to rebellion against arranged marriages but also rebellion against the notion of a mandatory dowry loaded with gold jewellery. Such obligations are a very big drain on the average middle class purse. While this is yet to lead to any phasing out of dowries altogether, Fortis notes today’s dowry contains less gold and more along the lines of practical items for the newlywed such as as a plasma TV, a computer, or a mutual fund investment.

The implication is that maybe down the track Indian jewellery demand will decline altogether, but of course the flipside is that if Indian’s economy continues to grow then gold affordability will keep pace with the gold price. And at the end of the day, what blushing bride is going to turn down a gold bracelet and what Indian merchant is going to pass up the opportunity to affirm his status by being generous with the sparkly stuff? Fortis agrees the demand equation ahead is unclear.

Which brings us back to whether or not gold will push through US$1200 just as quickly as it passed US$1100 and whether talk of US$2000 and beyond is not so fantastic after all. In the shorter term, Comex traders note that someone out there has a very big short position and is trying, vainly, to push the price down. At some point that position may bottle sending gold into a “blow-off” (meaning a sudden significant spike which is not ultimately supported). Beyond that, there are also very big positions in December US$1200 call options which might suck the price towards that level as well, before expiry brings an end to the trade (tonight).

It is also notable nevertheless that the last few big runs in the gold price have began late in the year and not ended until around the end of the first quarter.

All of this is left for the gold trader to contemplate, along with the lingering factor of excessive US debt and the inherent weakness of the US dollar. And that’s not to mention ongoing global monetary inflation as stimulus packages continue with vigour, adding fuel to a gold rally which has become largely currency-irrelevant. It is hard to stand in the way of gold at present, despite just about everyone calling the price higher.

For Australian investors, Morgan Stanley notes both Newcrest ((NCM)) and Lihir Gold ((LGL)) appear undervalued. USD gold has rallied 32% in 2009 while LGL shares are up only 17% and NCM shares only 5% due to a concurrent rally in the Aussie dollar. Morgan Stanely believes the currency factor has been overstated. This is supported by the fact gold has rallied in AUD over the month from A$1120 to A$1240/oz.

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