Commodities | Dec 07 2011
By Greg Peel
Last week the price of gold rallied over US$63 to US$1746.75/oz, representing a 3.76% gain for the week. The main impetus for the move was the November 30 announcement from the US Federal Reserve of a coordinated policy change with five major global central banks to lower the borrowing cost between central banks, and the establishment of bilateral swap lines, allowing liquidity to be provided in each jurisdiction in any currency, if necessary.
While not specifically stated, the move was clearly an attempt by the Fed to be proactive ahead of any potentially dangerous collapse in Europe. The last such global central bank initiative occurred after the fall of Lehman. In particular, the agreement allows the European Central Bank to swap euros for dollars to then lend to those European banks weighed down by toxic sovereign debt and now finding US dollar funding lines very expensive.
As the European crisis has deepened, the call across the world has become louder for the ECB to provide the funding needed to prevent eurozone member default and the subsequent collapse of European banks, just as the Fed did in 2008 with regard to US banks and has done ever since with its quantitative easing program. QE requires the printing of money by a government to give to the central bank to loan back to the government via the purchase of government bonds. The problem, however, is that there is no eurozone common bond, just a common currency.
The European Union treaty does not accommodate a euro-bond and indeed many believe the ECB's individual purchases of distressed debt – most recently Spanish and Italian sovereign debt – breaches the charter as well. What such purchases do do is effectively take from the strong and give to the weak, which is all well and good but for the strong's bitterness over the weak's profligacy. The German and French governments are now trying to move quickly towards changing the EU treaty to enact closer fiscal union and central control in the eurozone. While Germany is still specifically opposed to the idea of a euro-bond, the ECB has signalled its capacity to become more receptive once a closer union is in place.
In other words, when you put all of the above together, last week's coordinated central bank move was a precursor to money printing by the ECB at some stage. Money printing undermines the value of a fiat currency, and the natural store of wealth as a hedge against such monetary inflation is gold.
Gold undertook one of its now regular departures from its longer term upward price trend back in August when Greece again brought the European crisis to a head. A combination of financial panic and not wishing to miss out saw gold hit a blow-off top at US$1920/oz before gravity again prevailed. By the time Standard & Poor's was downgrading US Treasuries markets were busy dumping risk assets and madly trying to raise cash for margin calls which, as has always been the case since 2008, meant cashing in gold positions. Gold subsequently hit an oversold level of US$1600/oz.
Such sell-offs usually find gold's true believers standing aside until the time is right to reinvest at more attractive levels. Lingering talk of possible QE3 from the Fed helped gold back over the US$1700 mark before a plan to save Europe (the one involving the leveraged EFSF and Greek bond haircuts) and the subsequent meandering uncertainty left gold fluctuating over November without a lot of clear direction.
While actual QE from the ECB may yet be some way off, the central bank is expected to cut its cash rate on Thursday by at least 25, if not 50, basis points. Societe Generale analysts are expecting the Fed to specify at its January monetary policy meeting that its cash rate will be kept near zero until either US unemployment falls below 7.5% or core inflation moves above 3% on a sustained basis. The Fed has been suggesting such specification as a policy option for some time now.
Come March, SocGen expects the Fed to launch QE3 with another target in the US$600bn range.
ANZ analysts note that after the Fed announced QE2 in late 2010, gold then underwent a 12-month rally from US$1270 ultimately through to US$1920. While the US$1900 level was seen by some as irrational exuberance on the part of inexperienced gold traders, SocGen suggests such a price would close the gap between the US monetary base and the implicit price of gold in US dollars.
SocGen further notes that were the gap to the expansion of the monetary base since 1920 to be closed (which did occur briefly in 1980), gold should now be US$8500/oz. Not that SocGen is setting such a target.
UBS analysts believe there is a lot of “potential energy” in the gold market at present with regard to central bank policy and expected policy, but that fears of a European collapse are keeping the buyers at bay. Until such fear abates, investors will be recalling 2008 when the fall of Lehman brought a counter-intuitive and rapid 31% fall in the price of gold. While gold might be the traditional hedge against a crisis, you can't eat the stuff, and raising cash for margin calls or simply to keep out of the poor house meant gold positions had to be jettisoned in a hurry.
Nevertheless UBS believes gold could be in for some “potentially explosive moves” in 2012.
Not all analysts are convinced of such potential however. The problem is based on those two hats gold typically wears – being hedges against both crises and inflation. While a round of globally coordinated QE intended to drag the world out of its post-GFC malaise once and for all is a positive for gold on the monetary inflation side, such action also implies a resolution to the crisis.
Writing just before the central bank announcement last week, National Australia Bank analysts were forecasting a fourth quarter average gold price of US$1680/oz with upside risk dissipating in 2012 as the global economy improves. NAB nevertheless expects the gold price to remain “elevated” given near term financial market volatility.
In the meantime, there is always the simple demand/supply equation to consider.
The demand side for physical gold is dominated by jewellery demand, particularly out of India, China and the Middle East. While increasing emerging market wealth and a growing middle class has been a clear driver of gold jewellery demand this past decade, significant price hikes in periods of global uncertainty and central bank action have seen that demand fall away and market corrections follow. With the Indian wedding season now upon us, jewellery producers are anxious to see whether current prices are incentive enough for decent demand seeing as we've been to US$1900 and back.
NAB notes Indian demand fell solidly over the year to September as gold prices surged, albeit Chinese demand rose over the period which likely reflects growth in Chinese incomes.
The other significant source of gold demand outside the investment market is central banks. Prior to the GFC central banks were substantial net sellers reflecting heavy sales out of Europe where most of the world's bullion outside the US and IMF is held. Since the GFC, European central banks have stopped offloading arguably the only thing keeping their currencies alive while emerging countries have sought to address the lack of gold in their net reserves. Emerging markets have made the mistake in the past, obviously, of believing the reserve currency and other developed market currencies were solid.
Barclays Capital had forecast a total 325 tonnes of central bank buying in 2011 but that total had already reached 370 tonnes by the end of October. Russia increased its gold reserves by 140t in 2010 and had purchased 82t in 2011 by October and officials have indicated no end in sight to Russia's accumulation intentions. Recent buying has also come from Kazakhstan, Belarus, Bolivia, Columbia and Mexico, while Germany has been a slight seller for the purpose of producing commemorative coins, while a number of other euro economies have looked to raise some cash in November.
China has been the largest central bank buyer of gold amongst emerging markets since the GFC, absorbing a good deal of its own world-leading production. Now the sixth largest official holder of gold, China's gold reserves still total only 1.7% of net reserves which is very low by global standards. US Global Investors notes China imported 140t of gold in the September quarter compared to 120t in all of 2010. Beijing is actively promoting the purchase of gold and silver to its citizens.
Such accumulation is now acting against global mine supply growth whereas once central bank sales augmented mine supply. Despite increased global gold production and a big increase in global scrap supply, as both producers and individuals seek to take advantage of high gold prices, central bank offtake has meant a reduction in net gold supply. NAB notes that while total gold supply rose 2.1% in the June quarter it fell 1.3% in the September quarter to be down 4% for 2011.
Not helping the battle for supply have been various disruptions across major global gold operations including those from earthquakes, floods and droughts, as well as industrial action by miners from South Africa to Peru. Worker dissatisfaction is yet to be resolved and who wants to suggest the weather will settle down now?
All in all, it is difficult to find an analyst (outside NAB, for one) that doesn't expect gold to see US$2000/oz in the not too distant future. It must be noted, however, that end-2011 forecasts of US$2000 were quite popular only a month or two ago.
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