The fact that investors around the world are turning
to gold is remarkable. Unlike a bond, stored
gold offers no yield and, unlike a stock, gold provides no leverage to the performance
of an enterprise. Buying gold is not an
investment per se, compared, for example, to buying a gold mining stock, where
a company's financial performance is linked to its resources and production, at
the same time providing leverage to the gold price. In fact, industrial applications for gold consume
far less than the annual supply, thus investing in gold is fundamentally
different from other commodities. According
to the World Gold Council
(WGC), investment demand for gold, e.g., from Exchange Traded Funds (ETFs), was
up 46% in the third quarter of 2009.
Gold is commonly viewed as an
inflation hedge and, because it is the only financial asset with no
counterparty risk, as a safe haven, but the spectacular rise in the gold price indicates
more than caution on the part of investors.
Gold hit a low of $713.50 per troy ounce on November 13, 2008 (London
Bullion Market Association PM Fixing) and closed at a 52-week high of $1,115.25
on November 11, 2009, up an astounding 56.31% from its 52-week low.
Chart courtesy of StockCharts.com
Central bank gold is the
proverbial elephant in the room that no one wants to talk about. With official gold holdings of 29,633.9 tonnes of gold
worldwide, compared to world gold production of roughly 2,400 tonnes per year,
central bank gold sales, leases and purchases, have a huge influence over the
gold price. Central banks are changing their reserve asset compositions and a number of central
banks, led by India and China (which
has been the world's largest gold producer since 2008), are buying gold. Evidently,
the full faith and credit of the United States of America isn't what
it used to be. Faced with a weakening world reserve currency, the questionable status of the world's largest economy, and unsustainable US government spending, central banks are
rendering a quiet vote of no confidence on the US dollar.
The US economy, the US
government, US banks, and US stock markets exhibit various problems including unemployment, looming commercial real estate defaults, the US budget deficit, a massive public debt and huge unfunded
liabilities, residual toxic assets on bank balance sheets, mounting mortgage
defaults and credit
card delinquencies, an emerging stock market bubble, etc.
Unless the economic problems of the US can be addressed, the US dollar will
quite probably loose its status as world reserve currency. Whether a transition to a new world reserve
currency would take place in a cooperative manner, e.g., a managed retreat of
the US dollar, or in a more disruptive way is unclear.
Gold Supply and Demand in 2009
Under ordinary economic
conditions, a rising gold price might reflect, for example, increased demand, the
effects of currency debasement or inflation expectations, but a sustained rise
in the gold price characterized by growing global investment demand indicates something
more. New York University Professor of
Roubini has suggested that commodity prices reflect an emerging global asset
price bubble fueled by the fast-growing US dollar carry trade. While Professor Roubini's "mother of all
carry trades" thesis accounts for the effects of low US interest rates driving global
speculation and a decline in the US dollar, it does not specifically consider
gold, which has unique supply and demand characteristics.
Based on data provided by the
WGC, Gold Fields Mineral Services Ltd.
(GFMS), and the US Geological
Survey, the world gold supply is expected to be approximately 2,400
tonnes in 2009. Gold demand is expected
to exceed supply by roughly 1032 metric tonnes (1 metric tonne is the
equivalent of 32,150.7466 troy ounces), a large shortfall equal to 43% of the gold
Assuming the average decline
in industrial consumption for all of 2009, compared to 2008, will be roughly
the same as that of the most recent quarter:
- The jewelry industry, by far the largest
industrial consumer of gold, is expected to consume roughly 1,705 tonnes
of gold by the end of 2009. Jewelry
demand was down 22% in the third quarter and is expected to account for only
71.04% of the 2009 gold supply.
- The electronics industry, where consumption was
down 25% in the third quarter, is expected to consume roughly 76.1 tonnes
of gold by the end of 2009.
- The field of dentistry, where consumption was
down 11% in the third quarter, is expected to consume roughly 49.75 tonnes
of gold by the end of 2009.
- For all other industries, where consumption was
down in the third quarter an average of 9%, total consumption is expected
to reach 79.08 tonnes of gold by the end of 2009.
Total industrial demand is,
therefore, expected to reach 1,909.93 tonnes of gold by the end of 2009, or
approximately 79.58% of the estimated 2009 gold supply.
Although gold is not actually
circulated as money, gold coins and bullion bars are in high demand and investment
demand was up 46% in the third quarter.
Investment demand is expected to account for roughly 1,727 tonnes of
gold in 2009, an amount that exceeds the demand of any single industry.
Outside of the electronics
industry, where scrap gold recovery is high, and the field of dentistry, gold
is not typically consumed destructively.
As a result, unlike any other commodity, the vast majority of gold mined
throughout history, estimated at 162,780
tonnes by the end of 2009, remains in existence today.
Central Bank Gold and the US Dollar
Despite the fact that it is
not generally used as money, gold is held by central banks as a currency
reserve and official central bank gold holdings amount to 29,633.9 tonnes
worldwide. Official gold holdings
represent roughly 18.2% of all gold ever mined and the expected 2009 gold
supply is equivalent to roughly 8.1% of official gold holdings.
Since gold no longer served an
official monetary purpose after 1971, which marked the end of the Bretton Woods
system, central banks began to sell and to lease gold based on their individual
requirements and continued to do so until 1999.
Prompted by the UK Treasury's planned sale of 415 tonnes of gold (58.04% of
UK gold reserves at the time), the Washington
Agreement on Gold was established in 1999 to maintain the value of remaining
central bank gold reserves by coordinating central bank gold sales. Under what is now the Central
Bank Gold Agreement (CBGA), central banks have sold gold in limited
quantities (400 tonnes annually between 1999 and 2004, 500 tonnes annually between 2004 and 2009, and 400 tonnes in 2009).
However, official sales do not account for gold leasing.
Central banks lease gold to
earn interest thus offsetting storage costs by leveraging what had been until
this year an otherwise marginalized financial asset to generate cash flow. Rather than borrowing cash at higher interest
rates, gold producers, for example, may lease gold and sell it to raise cash,
paying the lessor in physical gold from future production. Gold dealers may wish to lease gold in order
to cover derivative positions, such as options or futures, either paying the
lessor in physical gold or settling contracts in cash. In cases where leased gold is sold by a
lessee into the open market, the gold supply is affected, which might affect
the gold price. Although gold
lease rates, which have been historically lower than interest rates, and central bank participation in gold leasing arrangements are
documented by the London Bullion Market Association (LBMA) and other
organizations, gold leasing remains an unregulated market. Since gold leases can be settled either in
gold or in cash, it is difficult to calculate the effects of gold leasing on the
supply and demand dynamics of gold or on the gold price. In any case, since 2008, central banks have
reduced gold leasing at traditionally low rates, e.g., rates below 1%.
What is more important is
that central bank gold sales had begun falling short of the
annual sales allotment of the CBGA in 2006, declining to an estimated 345.5
tonnes in 2008. Since 1999, the gold
supply has averaged approximately 2495 tonnes per year, while central bank gold
sales through 2008 averaged an estimated 394 tonnes, equivalent to 15.8% of
annual supply on average. In 2009,
banks became net buyers of gold and some central banks began to repatriate
gold reserves. China, for example, began adding
gold to its reserves and India recently agreed
to purchase 200 tonnes of gold from the International Monetary Fund (IMF).
Setting aside gold leasing,
central bank gold sales, having effectively added an estimated 15.8% annually
to the gold supply for the past decade, can only have had a dampening effect on
the gold price and as well as on gold investing. Therefore, the effect of central banks rather
suddenly switching from net sellers of gold to net buyers of gold is equivalent
to a reduction in the 2009 gold supply of approximately 15.8%.
In addition to the projected
43% shortfall in the 2009 gold supply, the US dollar's precipitous decline led to a rise in commodity
prices across the board. The US Dollar
Index hit a 52-week low of 74.93 on November 9, 2009, down approximately 16.39%
from its 52-week high of 89.624 on March 4, 2009.
Chart courtesy of StockCharts.com
Demand for gold in 2009 is
expected to exceed the supply by 43%, including a reduction in supply of
approximately 15.8% due to the effective termination of central bank gold
sales, while the US dollar is down approximately 16.39%. At the same time, there has been a fundamental
shift in central bank policy. Eastern central
banks in particular, led by India
are buying gold, while Western central banks have cut back gold sales and have
reduced gold leasing at traditionally low rates.
Setting a Gold Price Target
The 16.39% decline of the US
dollar tends to be reflected rather directly in commodity prices, thus the gold
price, considering that the demand for gold is global, could reasonably be
expected to rise approximately 16.39% from its 52-week low in 2009 based solely
on the decline in the US dollar.
The effect on the gold price
of the 2009 supply shortfall of 1032 metric tonnes could be extraordinary if obvious
shortages were to occur, or it might be nominal if consumers of gold were to
substitute another commodity, e.g., silver.
Substitution, however, seems very unlikely both in terms of industrial
uses for gold and in terms of investment demand. Thus, a naive estimate of the impact of the
supply shortfall on the gold price might assume that the gold price would rise no
more than the shortfall in supply, i.e., by no more than 43% (inclusive of the estimated
15.8% reduction in supply due to the effective termination of central bank gold
sales and setting aside entirely the subject of gold leasing).
Combining the 16.39% decline
of the US dollar and the estimated 43% shortfall in supply might suggest a gold
price approximately 62.6% higher than the 52-week low of $713.50 (London PM
Fix), which occurred on November 13, 2008, 1 year ago, i.e., a naive price
target of 1,160.15 as of November 2009. The
52-week high of $1,115.25 on November 11, 2009 was approximately 56.31% higher
than the 52-week low, thus the actual gold price at that point was lower by roughly
6.29% compared to the 52-week low than the naive price target of 1,160.15. Based on these estimates, the gold price does
not seem to indicate an asset price bubble.
Which Way is the Elephant Going?
The proverbial elephant in
the room is on the move and the room is not very big in comparison. It seems likely that Western central banks
are holding off further gold sales, at least while discussions on a new world
reserve currency, i.e., IMF Special
Drawing Rights (SDRs), are taking place.
Led by India and China,
key IMF members want gold included as a component of the a world
reserve currency. As long as using gold
as a component of a new world reserve currency is a possibility, not only are
central bank gold sales on hold but central banks will almost certainly continue
to buy gold in the foreseeable future.
There is no fundamental reason
for the current gold price trend to reverse in the foreseeable future, and, despite
the steep rise of the gold price in 2009, gold does not appear overvalued. It seems possible, although unlikely, that if
gold were to again be marginalized in a new world reserve currency regime, as
it was under the US dollar standard after 1971, central banks might again start
selling and more aggressively leasing gold at some point in the distant future. In that case, the gold price would eventually
fall, perhaps to some stable, lower level, once again reflecting the conflicting
desires of central banks to both leverage their gold reserves and also maintain
their value. However, given the global
financial crisis stemming from of the US dollar's 64-year reign as world
reserve currency, it seems much more likely that central banks will guard their
hoards jealously in coming decades.
Alternatively, if a new world
reserve currency were to emerge having a significant gold component, what would
then be a certainly higher gold price would likely remain at a higher level
indefinitely. It also remains possible
that the decline of the US dollar could accelerate or that the apparent differences
between Eastern and Western central banks could become more acute, in which
case the gold price could rise more rapidly and the process of deploying a new
world reserve currency might be accelerated as well as potentially disruptive.
The Hindu deity Ganesha, widely
revered as the Remover of Obstacles, is readily recognizable because he has the
head of an elephant. Gold languished
from 1971 until 2009 as a commodity that central banks had little better to do
with than to systematically dissipate through sales and leases, while the most
significant problem they thought they faced was the risk of dishoarding too
much too quickly. From 1971 until 2009, central
bank gold entering the market was a factor of the gold price and a risk for investors. After 38 years, the effective termination of
central bank gold sales has rather abruptly removed that obstacle.
Desiring to mitigate risks
associated with the US dollar, central banks, led by India
have, in effect, promoted gold from its 38-year status as a non-financial commodity
once again to its historical role as the premier global financial asset. This historic change in central bank policy signifies
a profound break with the past and broadcasts a clear message: gold is a
world-class financial asset fairly valued at more than $1,000.00 per troy
ounce. With this momentous event, the
words "as good as gold" again have meaning.
An analysis of supply and
demand fundamentals suggests that the current gold price does not indicate an
asset price bubble, and the historic change in the status of gold by central
banks implies a major revaluation not yet reflected in the gold price. As the restructuring of the global economy
continues, particularly with respect to the world reserve currency, there is a clear
possibility that the gold price will move up sharply from current levels.
Nov 13 2009, 06:26 PM
Filed under: Federal reserve, US dollar, inflation, Asia, USDX, Gold, IMF, Bretton Woods, ETF, USGS, US economy, gold lease, SDR, GFMS, central bank, CBGA, LBMA