Gold on hold: what will move bullion?

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During the recent phase of market optimism that has driven global equities more than 50 per cent higher since March, gold prices have remained relatively stable.

Bullion prices during this period have not sold off on dramatically elevated levels of risk appetite, nor have they risen strongly through bouts of risk aversion. Meanwhile, the dollar sell off since March has only had a limited impact.

So what will drive gold out of its current range between $890 and $990 an ounce? Will the dollar regain its influence? Has inflation yet to have an impact?

Suki Cooper on the Commodities Research team at Barclays Capital focuses on precious metals markets, covering gold, silver, platinum and palladium and took questions on Monday, August 24.

Why is gold considered a hedge against inflation? And what is the best way of leverging or owing gold? What about gold-coins, or gold mining stocks?
Michael G O’Toole, Ireland

Suki Cooper: There are many studies investigating the relationship between gold prices and inflation upon the view that gold will return to its long run purchasing power. However gold is not proved to be an effective hedge against inflation.

Gold tends to be more volatile than inflation in the short run and thereby provides a leveraged return. The timing of the investment will also be crucial, although gold tends to act as an effective inflation hedge over a prolonged period of time it will not necessarily provide a hedge for short periods therefore it needs to be managed tactically as a hedge.

Some studies have shown that gold is a leading indicator of inflation but even here the timing of such investments is critical. Gold prices tend to benefit from a rise in inflation expectations.

Depending upon risk appetite, there are a variety of ways to gain exposure to gold, some of which have only been introduced in this decade. Physical exposure can be obtained through holding coins or bars and of course as jewellery. But here one needs to consider such costs as storage, security and insurance. Physical-backed exchange-traded products (ETPs) or allocated/unallocated accounts overcome some of these issues, with some ETPs offering the cheapest route to gain exposure to gold. Non-physical exposure including futures, options and structured products enable leveraged exposure. These methods offer direct exposure to gold, with the alternative through gold mining equities.

Unless gold is leased, it does not pay ’interest’, whereas equities pay dividends. An investor also needs to differentiate between producers with the greatest potential while assessing management capabilities, mining and regulatory risks (for example, power problems in South Africa halted production for five days in January 2008), as well as operating costs to name but a few. Many producers still maintain healthy cash margins because even though operating costs have risen, they remain well below current price levels.

Even though capital expenditure budgets have not been curtailed as sharply as for other commodities, lead times in mine development have become longer and expansions have proved to be less fruitful. Despite record gold prices, the supply response has been muted. Investing in equities does not give the investor full exposure to the gold price especially if production is hedged.

Do you think we will see a significant correction in the price of gold (as we have seen with platinum and copper) now that fears of a complete economic meltdown are receding? Or will the effect of loose monetary policy (resulting in inflation in the future years) have a greater effect?
Shalin Thakrar, Nairobi

SC: A vast number of factors can drive gold prices.

They range from fundamental drivers, - such as jewellery demand, - to external dynamics - such as haven buying and currency movements. Depending on the economic climate and market sentiment, different factors will take it in turn to drive gold prices.

They range from fundamental drivers, - such as jewellery demand, - to external dynamics - such as haven buying and currency movements. Depending on the economic climate and market sentiment, different factors will take it in turn to drive gold prices.

Prices gathered pace towards the end of 2007 as investors turned to gold amid rising counterparty risk and widening credit spreads. When gold prices hit their all-time high in March 2008, gold was sought after as a dollar and inflation hedge as the dollar reached record lows against most major currencies. The intra-year high reached this year was driven by recessionary fears and a deteriorating macro environment which prompted haven buying amid market uncertainty.

At the start of this year, investment demand was exceptionally strong. Going forward, we would expect jewellery demand to pick up upon price dips as we enter a traditionally seasonally strong period of jewellery demand. At least in the first instance we would expect physical demand to provide a floor to prices. However we do not believe investment demand will completely fade as although we saw fresh haven demand in Q1, we believe investors who may use gold as a dollar hedge or an inflation hedge are likely to return to the market and in turn provide prices with a second boost.

I frequently hear comments like the appetite for risk has diminished so people are flocking to the US dollar. As a result, the price of gold falls. This seems perverse to me - the US dollar must be a riskier bet than gold. Do you think that the relative risks of dollars and gold will be more realistically aligned any time soon?
Richard Scott, Argyll

SC: Historically the relationship between gold and the dollar has been a negative one , and one that becomes stronger during periods of dollar weakness and weakens during periods of dollar strength.

During the first quarter, the long term historical relationship between gold and the dollar broke down. Even as the dollar appreciated, gold gained momentum, much of this was tied to investors flocking to gold as a haven asset, given its relatively stable performance in 2008 compared to other assets. Meanwhile at the start of the year, the dollar benefitted relatively to other currencies. Alongside the Swiss franc, the dollar and dollar-denominated assets are perceived to be among the safest currencies/assets.

The dollar benefitted from the elevated uncertainty surrounding the growth outlook of emerging countries. Default funding tends to take place in dollars, thus deleveraging of risk appetite in emerging currencies supported the dollar.

Barclays Capital’s foreign exchange strategists noted that the dollar had been surprisingly resilient in the first quarter in the face of the rapidly deteriorating US fiscal position and the implementation of quantitative easing. One of the other factors they believe had supported the dollar was the effect of lower oil prices on real interest rate differentials and current account positions. Foreign demand for US Treasuries appeared to be undeterred by the huge supply in the pipeline and possible inflationary consequences as higher relative yields continued to draw record net foreign buying of dollars.

Both have benefitted from haven flows and a diversified investor would choose to hold a variety of ’safe’ assets. Going forward, our foreign exchange strategists expect the dollar to weaken against the euro, in turn given the correlation between the dollar and gold prices strengthens during periods of dollar weakness, we would expect gold prices to benefit.

Will the removal of secrecy relating to Swiss accounts have any impact on the gold price?
Daniel Sieff, unknown

SC: Aside from gold’s history as a monetary asset, another feature which weakens the link between gold’s price movements and its underlying supply-and-demand flows is the level of gold inventory.

All of the gold that has ever been mined still exists in some form or another. Gold is not like other commodities such as oil (which are consumed upon use) or industrial metals (where scrap supply can only be extracted and recycled upon the completion of its end-product life and even then perhaps not in its entirety).

Whether it is worn as adornment or used in electronics, it can still be retrieved. Thus stocks are the equivalent of all the gold mined, estimates run around approximately 150-160 thousand tonnes. Most of this is estimated to still be held in jewellery form; around a sixth is estimated to be held in private holdings. Although the amount of gold mined is small compared to industrial metals, its ’available’ stocks in terms of consumption is very high. For industrial metals this is currently around 2-9.5 weeks of demand depending on the metal, for gold the same would be well over a year. Of course these are estimates, thus greater transparency would help to divide the pie more accurately.

Thus if revealed private holdings were much greater, they would account for a larger level of stocks, and vice versa.

If, in this scenario, private holdings did turn out to be much greater, it would imply potential supply that could be mobilised is also greater, and thereby it could add downward pressure to prices.

If the opposite was revealed, the ‘unknown quantity’ would be reaffirmed, and in turn the view that less available secondary supply could emerge.

The amount of ’scrap’ readily available as supply, is quite small in proportion to total stocks. One of the interesting trends we have seen this year has indeed been the mobilising of previously thought of illiquid secondary supply in the form of selling of unwanted jewellery in Europe and the US, where historically sentimental value of such items have meant ’scrap’ supply in the west has been limited compared to countries within Asia.

Certainly the surge in secondary supply helped to meet the sharp increase in investment demand in the early months of this year.

The long run Gold price should follow inflation in general. However, since 2006, Gold price has skyrocketed from 500 to 900+ now. Which is certainly larger than the inflation rate. While the 2006-early 2008 Gold movement was probably due to the Global Bull market, and the bull run early this year probably due to safe heaven effect; with the removal of both support in future, do you think Gold should fall back to match its regression line with inflation? Or will the depreciation of USD causing a greater effect?
Guo Jiayu, Singapore

SC: As you have mentioned, inflation is not the sole driver of prices. Indeed, during 2006-2008 there were a number of bullish factors at play at some point over that period within the gold market.

Such factors included rising geopolitical tensions, widening credit spreads, oil prices rallying towards their all-time highs, muted mine supply growth, producer de-hedging, subdued official sector sales.

There is a school of thought that gold will always return to its long run purchasing power, however the timing of this is not always consistent and may take a number of years or even decades to do so. Although a long-term positive relationship exists between inflation and gold prices, implementation of some form of inflation targeting has perhaps contributed to inflation driving prices to a lesser extent on a short term basis. Thus we would not necessarily expect prices to revert to its regression line in the near term.

Currently we would view dollar movements and the wider economy as being more important, as the correlation between these two drivers has become more significant (currently 1-month and 3-month rolling correlation are above 0.7). However we expect concerns over rising inflation coupled with expectations of a weaker dollar to support prices over the forthcoming months.

Do you think platinum and palladium will continue to rise if the auto industry recovers from it all time lows. The cash for clunkers has greatly reduced the inventory of autos at dealerships, but will they be keen to restock now that the incentive scheme is about to end? Will these metals fade if demand for new autos falls after the end of the cash for clunkers programme?
Fred DeVito, Stafford, Va., US

SC: Platinum group metals (PGM) consumption in the transport sector is tied to three main dynamics: the level of vehicle sales, emissions legislation and the level of PGM loadings.

Auto sales in the US have shown signs of bottoming finding support from the strong start to the government’s Car Allowance Rebate System scrappage programme. This “cash-for-clunkers” programme could boost sales by a total of 675,000 which would boost platinum and palladium scrap supply by 3 per cent and 8 per cent of the markets respectively, based 2008 demand.

On the flip side, new vehicles should result in fresh net demand, however, given the elevated inventory levels at the start of the year this is not necessarily going to translate into fresh PGM demand. Assuming inventory levels are low and auto manufacturers are operating on a just-in-time basis, under current loadings, 675,000 vehicles would result in boosting platinum by 1 per cent of global platinum auto-catalyst demand and 5 per cent of North American auto-catalyst demand and by 2 per cent and 5 per cent of the palladium market respectively. To see the boost in sales translate into fresh PGM demand, inventories do need to remain low.

The scrappage programmes have broadly received a positive uptake around the world, but are in turn likely to increase scrap supply particularly of palladium. On balance the schemes should create net demand if inventories remain low. I would agree the risk in the near term is that the programmes have only provided a temporary boost but longer term, tighter emissions legislation should continue to support underlying demand as PGMs continue to prove their efficiency at reducing pollutants to match stringent legislation.

It is also worth noting, platinum has also benefited from an increase in jewellery consumption this year, as lower prices have stimulated demand most notably in China. Despite the rapid growth in jewellery and investment demand this year, both of the PGMs are still heavily reliant on the auto sector for the demand side to recover.In the short term, jewellery demand can pick up the slack for platinum and the potential launch of the physical PGM exchange traded funds in the US is likely to prove supportive.

Given gold’s run-up over the medium term and more recent consolidation in the $900 range, my fear is we are drawing closer to a major shift to the upside. Whether we fear inflation or deflation, aren’t the actions of cental banks in countries such as the UK and US only going to lead to further currency debasement and a rush to the ultimate safe ’currency’?
Mark Harris, London

SC: Gold is often perceived to be a hedge against inflation, and rising inflation expectations generally tend to support and drive gold prices. We do believe prices are likely to gain upward momentum towards the end of the year and into 2010 , and would highlight fears over rising inflation as one of the key drivers coupled with our expectations for a weaker dollar.

A notable trend has emerged this year. While investment demand remains pivotal for prices, short term, more dynamic investors have traded places with ETP (Exchange Traded Products) investors and in turn short-term gold price drivers, such as oil prices and the dollar, have become increasingly important again.

The 3-month rolling correlation with the dollar has risen from negative territory in mid-April to back above 70 per cent currently. Thus, currency movements are likely to be key for gold’s price trajectory. We do believe prices are likely to breach the $1000 /oz level on a more sustained basis but this will require a pick up in investment demand.

Do you see Federal Reserve and Central Banks substantially increasing their gold reserves in their near future, fuelling gold prices? It is reported that the China government has been doing just that. Is there any truth in those rumours?
Gio Marcondes, Joburg

The head of the State Administration of Foreign Exchange announced in April that China’s gold reserves had risen by 454 tonnes to 1,054 tonnes since 2003 through purchases from the domestic market and domestic producers.

However the price response to the news was subdued.

There are three key reasons why this may have been the case. First and most importantly, the announcement stated the purchases were internal therefore limiting the direct impact upon the global market. China became the world’s largest producer of gold in 2007, producing 271 tonnes.But it is also the second largest consumer of gold.

The supply and demand data implies China has been a self-sufficient market in the past whereby it consumes all of its production predominantly in jewellery form. Following an end to the People’s Bank of China’s monopoly in gold trade and the establishment of the Shanghai Gold Exchange (SGE) in 2002, imports/exports can be carried out by four licensed commercial banks and supplied into the local market via the SGE (which trades spot gold).

Second, the timing of the purchases is also unknown but has been accrued since 2003 and finally third, the purchases have been quite small over that period. Although China’s gold holdings have risen by 75 per cent, gold still represents a very small percentage of China’s total reserves. Gold’s share of the reserves in 2003 represented less than 2 per cent and given the accumulation of dollars, it still represents less than 2 per cent.

Should China wish to significantly diversify its dollar holdings into gold, much larger gold purchases would be required. There has also been some buying outside of the Central Bank Gold Agreement which has buoyed positive sentiment towards gold and perhaps more importantly has reignited gold’s relevance as a monetary asset.

Will the future demand for gold in India and other emerging markets drive gold prices much higher?
Shiko, London

SC: We have seen an interesting shift in gold demand this year.

Five years ago, around four-fifths of gold’s end use was accounted for by the jewellery sector whereas investment demand was less than 10 per cent. Given the surge in investment demand at the start of the year and the impact of high and volatile prices combined with the economic downturn upon jewellery demand, we estimate gold’s demand profile in 2009 is more likely to shift towards jewellery demand falling towards 60 per cent and investment demand growing to a third.

The bulk of the investment demand has been driven by Europe and the US. However jewellery demand is skewed towards emerging markets with India accounting for around a quarter of the jewellery demand last year and China making up around a sixth.

India has traditionally been the largest consumer given its cultural link, although demand has fallen this year due to a catalogue of weak factors including fears of a poorer than normal monsoon season as well as an increase in import duty (albeit this is a relatively small percentage) as well as those factors mentioned above. China is the one country that has bucked the trend and gold demand has continued to grow this year.

Although it is investment demand that tends to drive prices higher, it is jewellery demand that tends to provide the floor for prices, in turn demand from emerging markets will remain vital.

Gold appears to have had lengthy periods of steady appreciation in the past, but its recent rise has been marked by extreme volatility within a range from $920 to $1000 - does this reflect its entirely intangible value? And has it been ever thus?
Mark Rapley, London

SC: With the exception of scrap supply, gold’s supply over recent years has been relatively stable, thus the volatility perhaps better reflects the underlying demand and whether it stems from investment demand or jewellery demand.

Jewellery demand tends to provide a steady floor (however in the absence of jewellery demand, prices are more susceptible to downside risk), while investment demand will drive prices higher.

Prices had been propelled higher by positive investor sentiment emerging at the start of the year. At the start of the year, hefty exchange traded product inflows buoyed prices but with the emergence of short-term tactical traders once again dominating gold market flows, the types of large swings in both positions and prices seen previously could become more common.

Recently, the establishment of fresh positions in Comex gold and long liquidations have coincided with rallies and dips.

In turn, external factors have become more important such as dollar movements, equity market movements, credit spreads, oil prices, inflation and more importantly inflation expectations.

A rise in volatility has also coincided with periods of greater uncertainty however despite an increase in volatility; gold’s volatility is still lower than some other asset classes and commodities.

Will the Central banks start selling their gold reserves any time soon?
Khalid Qurashi, Dubai

SC: There is a mechanism in place for signatories of the central bank agreement to sell gold, however sales have been subdued and well below their allowance.

Under the terms of the second European central bank Gold Agreement, signatories can sell up to 500 tonnes of gold in each year of the five-year agreement. The current agreement will expire on the 26 September 2009.

So far, in the fifth and final quota year, less than one third of the annual allowance (just over 140 tonnes) has been sold. Gold settled for the year so far is over 100 tonnes - and in one year over 200 tonnes - below gold settled over the same period in each of the quota years under the second agreement.

We believe sales this year will show the largest shortfall of the annual allowance and the lowest level since the start of the first agreement in 1999. The ECB released a statement on 7 August disclosing the details of the third European central banks Gold Agreement.

The new agreement commences on September 27 and reduces the annual sales quota to 400 tonnes from 500 tonnes, with sales over the five years capped at 2,000 tonnes, the same as the first agreement.

Sales for the whole five years currently total about 1,875 tonnes, well below the current limit and within the new lower limit.

According to some analysis, gold is the only safe haven in these days of unrestrained public / state spending. What explanation do you have for the fact that despite such high levels of stimulus spending this hypothesis has not lifted gold prices?
Orri Olaf, Ratingen, Germany

SC: Concerns over the stimulus packages and the possible inflationary consequences has led to some investors increasing their exposure to gold. Inflows into physically backed exchange traded products surged to all-time highs during the first quarter.

Indeed, inflows during the first two months of the year exceeded the total inflows for the whole of 2008 both in dollar terms and in tonnage terms. Even though mine supply is not able to respond to short term price movements, scrap supply is significantly more price responsive.

In turn, we saw a pick up in secondary supply that was prompted by higher prices - drawing out the less liquid scrap supply - and was indeed required to meet investment demand.

Producers almost stopped buying back forward hedged production (which creates additional demand), industrial demand for gold fell and jewellery demand dropped sharply, so not all demand was positive in the first quarter of 2009. However the growth in investment demand was sufficient to offset the slowdown elsewhere.

Are we already seeing the expectation of inflation impacting gold, maintaining gold’s price within a range that would otherwise be unsustainable given greater risk appetite in the markets? The two opposite forces effectively cancelling each other out?
Matt Jones, New York

SC: Although there are no means to quantify why investors choose to gain exposure to gold, some investors will have increased exposure on the back of concerns over rising inflation.

I would agree gold is likely to suffer as risk appetite improves, however in the past gold has not necessarily come under downward pressure amid a positive macro-economic environment.

Exchange traded product (ETP) demand tends to represent buy-and-hold investors, although there is a small proportion of speculative money, the bulk of investment has been ’sticky’. The drop in total ETP holdings in July was second largest monthly outflow since the inception of the first product in 2003. Although this would partially represent less committed investors, it also coincides with a period of improved economic data and a more positive performance from the equity markets.

We do expect prices to trade within their recent range in the near term, with physical demand emerging upon dips towards $900/oz and cushioning the downside.

However, the upside rests in the hands of investors and whether the external drivers start to evolve favourably for gold.

It seems to me that the rise in the price of gold from the beginning of the crisis until now has been largely a result of fear of banks rather than fear of inflation - after all, USD breakevens are at the same level as then, having been a lot lower in between. Can you therefore see the price of gold falling as the banking sector recovers? One would think that a banking sector recovery would be a pre-requisite to any serious inflation - is buying gold now jumping the gun a bit (aside from it being a horrendously crowded trade, of course)?
Ed Martins, unknown

SC: In the absence of a fresh catalyst, in near term prices are likely to trade within their recently established range. Gold’s correlation with a number of external factors has become more positive recently, namely the dollar, oil prices and equity markets, such that an improvement in equity market performance - including the banking sector - has largely seen prices trading range-bound.

Much of the buying towards the end of 2008 and the start of 2009 was due to the rising financial and economic market uncertainty and floundering performance across other asset classes which only bolstered interest in gold, as investors preferred to hold a physical asset that is nobody else’s liability.

Inflation is unlikely to have been a driver over this period; however it is a factor that is rising in prominence now. We do believe physical demand should limit price dips and maintain our forecast for prices to gain momentum towards the end of the year.

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