article 3 months old

Gold (Again)

Feature Stories | Feb 03 2009

(This story was first published on January 29, 2009. It has now been republished to also make it available to non-paying members at FNArena and readers elsewhere).

By Greg Peel

“We have, however, seen these US$50 rallies before, only to see excitement fade once more as the sellers move back in to win the day. We nevertheless know that while short-covering may have been a feature [last week] there is plenty of real demand in the market to bolster a rally”.

Last week gold shot up over US$50 to once again breach the US$900/oz level. As the above quote suggests, such rallies are not unusual these days. Nevertheless, the quote is mine, from an article written last November entitled “Gold Ready To Rumble” (Commodities; 24/11/08). At that time gold had also just breached US$900/oz again after a US$50 rally.

Indeed, gold passed through US$900 for the first time twelve months ago on its way to US$1030 before dropping once more. Since the first drop, gold has had no less than six more shots at US$900 over the course of 2008 and into 2009, including this last one. There is thus little doubting that 900 is a formidable barrier. Beyond that barrier lies, in the belief of many, a target somewhere between US$1000 and US$2000 or more. But gold has fallen as low as US$700 in the meantime. And that level was reached when the US and world economies were on the brink of disaster. Interestingly, US$700 seemed like a formidable barrier for gold all the way from mid 2006 to late 2007. Once breached, there was only a brief stop at US$800 on the way to US$1000.

For twelve months, gold fans have been expecting their precious metal to reach for the heavens. It’s a simple theory based on the fact the world is facing its greatest financial crisis since the thirties and responding to it by printing ever more paper money. Gold is the only remaining true, indestructible store of wealth. For more on this, please see “A New Golden Age” parts I and II (Sell&Buyology; September 08) which was the previous time I highlighted the gold story in feature. It seems I have been highlighting gold all year – in vain – but then I’m not exactly alone. The reasons gold has not been able to retest US$1000 are many, and highlighted in the aforementioned articles. There are a lot of dejected gold fans about.

There are also a lot of frustrated commodity analysts about, most of which have also been calling gold in quadruple digits over the last twelve month period. While one golden (sorry) rule of trading is that if everybody believes something must go up, it will go down, in the case of gold the facts seem hard to ignore. If you wanted one reason to believe in gold, consider this one:

After the Great Depression, once the Second World War was out of the way, world leaders agreed that all currencies, and thus all debt, should be benchmarked to the price of gold. This Gold Standard was ratified by the Bretton Woods Agreement in 1945 at a time when gold was US$37/oz. There have been suggestions in the latest financial turmoil (British prime minister Gordon Brown being one to raise the issue) that perhaps a return to a Gold Standard – a Bretton Woods II – is the answer to avoiding another debt implosion in the future. Such suggestions have not been taken particularly seriously, which is understandable if you consider that the same US debt to US Federal Reserve gold ratio of 1945 would today imply a gold price of US$41,000/oz (Source: CIBC).

As I noted in “The New Golden Age Part I”, the current financial crisis did not begin in mid 2007 when two Bear Stearns hedge funds collapsed under the weight of worthless CDOs, it began in 1971 when the Gold Standard was dropped in favour of the US dollar as reserve currency. Thereafter, all global debt has been benchmarked to a paper currency which can be printed at will.

It is the relationship that gold has had with the US dollar since 1971 that lies behind the general belief gold should at least retest US$1000 some time soon. In simple terms it is an inverse relationship – the weaker the US dollar the stronger the gold price – with a correlation coefficient (R-squared) in the nineties. The US government has done nothing but conjure up rescue packages out of thin air all through 2008 (remember that the US entered 2008 already in debt as measured by its massive current account deficit) and the new administration is set to do exactly that again and more. The simple equation should be: print more dollars; dollar value falls; gold price rises. The only problem is, the US dollar isn’t actually going down against its trade-weighted index. Not by much anyway.

In simple terms, this is a mystery. The Federal Reserve keeps printing and printing and printing more dollars but the world keeps buying them and so the value of the US dollar is held aloft. The world “buys” US dollars by buying US assets, in this case mostly US Treasury securities – everything from short-dated notes to long-dated bonds. The US dollar is being supported because both domestically and internationally the mindset is that despite the US printing press, the US is still the “safe haven” when one compares it to the economic disasters that are the UK, Europe and Japan (and China?).

But gold is the true “safe haven”. Why isn’t everyone just buying gold instead? You could argue that gold pays no yield and thus is less attractive than US Treasuries, but currently real yields on Treasuries are actually negative in the short end and barely positive in the long. Frightened investors have moved their money into assets which will actually lose them money, but only lose them a little bit of money. Shares, for example, might lose them lots more money again.

Yet the reality is that small investors definitely are buying gold. So much so that mints around the world have simply run out of gold coins and retail bars and exchange-traded fund investment is at record levels. Larger investors find investment in actual, physical gold cumbersome and prefer to deal in liquid paper securities (as in paper securities that are liquid) and backed by the US Treasury rather than paper gold (such as futures) which are an IOU from a counterparty who may not be with us next week. This is also true for international central banks and sovereign wealth funds, to date, who find it hard to quietly buy gold in the open market without pushing the price up.

And so the US dollar has not fallen as expected but has maintained a level much higher than the nadir reached when gold hit US$1030 last March. If you want to list reasons why gold has not again breached US$1000 despite the Global Financial Crisis only worsening over the course of 2008 then those reasons could be simply listed as (1) the US dollar; (2) deleveraging; and (3) inflation fears giving way to deflation fears.

We’ve discussed (1), and (2) is related to (1). The world got itself well into debt through to 2007 and the US was the biggest culprit. Money was borrowed to invest in everything from shares to oil to emerging market bonds and also gold. When the margins were called, everything had to be sold, including gold, or gold had to be sold to raise cash to cover share margins for example. Such sales not only sent gold lower, it sent the US dollar higher as all those assets were converted back to cash.

Factor (3) is related to (1) as well, because as we entered 2008 we had a self-fuelling fire of inflation terror. The world got completely carried away with the China story and bought commodities as a hedge against inflation, which pushed up commodity prices and caused inflation. It also pushed down the US dollar, as dollars were converted into hard assets, thus pushing prices again higher. Gold was suddenly very popular, as it is the traditional hedge against inflation (given that inflation undermines the value of paper money but not gold).

This was a bubble that had to burst and when it did commodity prices didn’t just slip back, they completely tanked. Suddenly the China story was over and everyone had to deleverage and sell commodities, and the more money flowed out of leveraged investments and back to safe US Treasuries, the more the US dollar went up, forcing commodity prices even lower. If gold is the hedge against inflation, and the price of oil is a good proxy for inflation, it’s hard to see gold rallying when oil falls 80%. Indeed, under those circumstances you’d have to say gold has held up rather well.

Nevertheless, the inflation fears of early 2008 have become deflation fears in early 2009. Deflation is the worse of the two, because prices go down, thus margins go down, thus profits go down, as such jobs are lost and so on, but more importantly the real value of debt thus increases over time. If the world is facing deflation, then it’s hard to make a case for gold. Over a period of deflation the gold you hold now will be worth less in real terms in the future than it is now (the opposite is true for inflation). But periods of deflation never last very long.

The advantage of deflation, however, is that a central bank can print as much money as it likes and just hand out banknotes to everyone. That’s because printing money is inflationary, so inflation in a deflationary period only brings us back to net zero. And that’s exactly what the world is currently doing.

In the case of “periods of deflation never last very long” one can always draw upon Japan’s recent deflationary period that lasted more than a decade as a counter to this suggestion. Japan’s experience is not a common one however, probably because (a) the Japanese stock and property bubble reached ridiculous heights (at one stage the land occupied by the Emperor’s palace in Tokyo was valued at more than all the land in the state of California), and (b) economists universally accept that whatever the Japanese authorities could have done wrong on the policy front after the bubble burst, they did.

Periods of deflation never last particularly if for no other reason than prices just can’t keep going down to zero. Oil at US$5 a barrel? I don’t think so. But if the central bank has been madly printing money to kick-start the economy and cover debt, when the music stops, and the economy at least bottoms, what is the central bank going to do? Ask for the money back? The next step in the time-line is a period of hyperinflation.

Hyperinflation occurs when there are just so many banknotes out there that they rapidly diminish in value, and you end up with a Zimbabwe-like situation. The most famous recent example is that of Germany’s Weimar Republic of the 1920’s which madly printed Deutschmarks to repay war debts and rebuild a fallen Germany until Deutschmarks were no longer worth the paper they were printed on. CIBC notes that in 1919, one ounce of gold was worth 170 Marks. By 1923 one ounce was worth 87 trillion Marks. A bit like a loaf of bread in Harare.

CIBC thus argues, in summary, that in reality both inflation and deflation are actually positive scenarios for gold because deflation becomes hyperinflation ultimately anyway. The best thing about hyperinflation, nevertheless, is that debt becomes worthless. That’s basically what the US and other governments are trying to do at the moment – “retire” the world’s overblown debt by repaying it with freshly printed banknotes. But this just diminishes the value of the paper currency against real assets, and the “realest” asset of all is gold.

So in theory, the US dollar should collapse and thus gold shoot for the moon, given the sheer weight of fresh “money” being created in the US system. But while the world continues to buy US assets, the dollar cannot collapse. And now the Federal Reserve itself will also step in to buy US Treasuries in an attempt to keep a lid on the corporate borrowing rates that emanate from Treasury rates. The golden rule is “Don’t fight the Fed”. (Of course, this is like the borrower buying its own debt, but when you are keeper of the reserve currency you can do that). Nor can the Fed cut its cash rate any further, which would spark a US dollar fall, because it’s already at zero.

Moreover, the value of the US dollar is simply an exchange rate with other currencies, so if other governments and central banks are also madly printing money then there’s no reason why exchange rates should actually move too much, leaving the US dollar steady. This suggests that gold must also remain steady given the simple inverse relationship. However, gold does not always have to inversely track the US dollar closely. In early 2008 it did, given the US dollar was crashing as the Fed slashed its cash rate. When other central banks began to slash their own cash rates later in the year, those respective currencies crashed, effectively sending the US dollar higher and gold lower.

But in the turmoil of September and beyond gold broke its relationship as the force of the US dollar weakening once more was countered by simple deleveraging and the selling of “everything”. Correlation dropped to only 50%. Those who believed gold should have rallied strongly were disappointed.

Gold fans were not, however, disappointed in late 2005 to mid 2006 when gold shot up from US$450 to US$725 while the US dollar remained steady or even rose. Many factors were behind this correlation break, but sheer demand won out given newfound wealth in Asia was pushing jewellery sales and newly listed US exchange-traded funds had everyone from pensioners to pension funds buying gold directly for the first time. That rally nevertheless soon became a bubble that burst.

Standard Chartered’s gold analysts are of the belief the deleveraging rout is nearing completion. They also believe that the time is nigh for the US dollar to begin to weaken once more given the sheer weight of money the US government is injecting compared to other governments. Those two factors conspire to enforce Standard Chartered’s view that gold will be “unambiguously” supported.

CIBC’s analysts go one step further. They suggest that as the world economy begins to plateau, and US dollars begin to be redeployed back into investment assets, the US dollar will start to fall. Given any gold rally to date has been encumbered by deleveraging on the downside, and given correlation has diminished, the flipside will be true and thus “there is less need to invoke a total collapse of the dollar in order to justify higher gold prices”. On that basis, gold should be free to shoot for the moon even if the US dollar only slides quietly southward.

It must also be reiterated that the US dollar is measured in exchange rates. If all economies are equally weak then all currencies should be weak together, and if all central banks are printing money then all currencies should be devalued together, leaving exchange rates steady. However, if one considers the total of all “fiat” money on one side of the equation – ignoring exchange rates – and gold on the other, the printing of money across the globe should surely be an impetus for gold as a net effect.

If simple exchange rates are thus misleading, one might consider valuing gold in terms of the world’s most highly-traded consumable commodity – oil. Indeed, many gold analysts closely watch the gold/oil relationship. Oil is a good proxy for headline inflation and gold is the inflation hedge. This would imply the two should move in general tandem.

On a day to day basis, such correlation occurs a lot. However we’ve also noted that oil has fallen from US$147/bbl to US$32/bbl, or 80%, while the worst gold has fallen recently is from US$1000/oz to US$700/oz, or 30%. Gold is often lumped in under the general asset class of commodities, but this is fallacious. Only a tiny, tiny amount of gold is ever commoditized, as in used industrially, whereas nearly all gold is monetized as a store of wealth – a reserve “currency” – and that includes jewellery. Thus while one might suggest oil is set for a bit of a bounce-back, no one is keen on tipping much beyond about US$50/bbl in the short term and a number like US$100/bbl is seen as almost a pipedream from here given prevailing economic conditions. But as gold is not a commodity, it doesn’t need a rally in oil to rally on its own, and nor will a range-bound oil price prevent gold from very much doing its own thing.

The same story applies if you consider any other consumable commodity.

So if the US dollar has no reason to rise from here, and all governments are going to keep printing money, and deleveraging is nearing an end, what could be left to prevent gold from finding a more realistic (much higher) level?

Well there’s the other side of the equation of course – supply. While gold is a currency and not a commodity it is still dug out of the ground like a commodity and any surge in new supply could cause the gold price to collapse, just like any big copper find might do the same to the copper price. But the annual supply of new gold has been steadily declining for decades and there is no sign of that trend suddenly changing. Higher gold prices in the twenty-first century have brought a rush of new exploration but while many junior mining companies have cropped up overnight claiming some nice little finds there is yet to be any serious cries of “Eureka!”.

Indeed, given the financial crisis many of those juniors are now dead or dying, leaving further exploration with only the big boys. Don’t think the big boys don’t spend buckets of money every year looking for new gold deposits too. But they haven’t found anything of note for decades either.

The other potential supply of gold comes from central bank holdings, which is where most of the world’s gold that isn’t jewellery remains. Were central banks to decide to sell their gold holdings to raise cash (rather than just printing cash) then the flood of gold on the market would be devastating for the gold price. But were the central banks to sell their gold they would have nothing left, bar an economy down the toilet, to “back” their paper currency value with. Hyperinflation would surely ensue. And nevertheless the trend over the past three years has been for the largest holders of gold not to sell their annual quotas allowed under the Washington Agreement anyway. The expectation is that even less central bank gold will be sold this year.

Switzerland – a significant holder – had announced last year it would sell a large amount of gold over time. The reasoning was that as the gold price had risen, the value of gold within the central bank’s total asset holdings had risen above the bank’s preferred ratio. Sales would simply restore order. However, that idea has since been scuppered following the global meltdown.

The International Monetary Fund also now has permission, and a plan, to sell some of its (vast) gold holdings, and some pundits have pointed to such sales as being a potential dampener for the gold price. However, in the scheme of things, the volume (400t) is not huge. More importantly, one must consider the flipside – the potential for central banks to actually buy gold. If the IMF is selling, a good “off-market” opportunity presents.

European central banks hold most of the world’s gold outside the US, meaning the emerging economies of Asia and the Middle East in particular have very low comparative gold reserves. China, for example, has vast foreign exchange reserves as the bulk of its central bank holdings, most of which is invested back into US Treasury and agency bonds. CIBC points out that in 1996 China’s proportion of gold reserves to total assets was 4.4%. With the explosion of China’s export economy and foreign exchange receipts in the meantime, that proportion has fallen to less than 1% despite the rise in the gold price.

Having seen its US investments – both bond and equity – trashed over the past 18 months, China has been making lots of noise about no longer simply pouring money back into the US, or rolling over existing investments. Chinese authorities have hinted at buying other currencies, or other assets, or gold instead (or all of the above). Were China to restore its gold holdings to 4.4% it would need to buy about 3,125t of gold, according to CIBC. Now – that ain’t gonna happen. That sort of volume would mean chasing the price well into triple digits. But were China just to buy a comparatively small amount of gold?

So there appears little threat to gold on the supply side, and indeed a greater potential on the demand side. There are, nevertheless, two factors that will crimp the demand side. The first is that the current strong level of jewellery demand will wane if the gold price rises. Jewellery demand is always very price elastic, although as the Asian economies have boomed in the twenty-first century the tolerance price has gradually ratcheted up. Now, however, the economic boom has stalled, suggesting Asian demand will no longer chase the gold price very far – at least for now. On the flipside of that, there is supply of so-called “scrap”, which is mostly from jewellery that has been hocked. While pawn shops across the globe are no doubt doing a roaring trade at the moment, no one suggests scrap supply could ever reach such heights that would seriously force the gold price down.

The second factor is gold miner dehedging – or the lack thereof.

When the gold price was wallowing under US$300/oz at the turn of the century gold mining companies would mostly sell their gold “forward” before they had actually dug it out of the ground in order to lock in a profit. The risk was that the gold price would fall further in the meantime and a loss would be booked. Mining companies often sold an amount of gold forward every year for five to ten years. But while this ensured no downside price risk, it also meant the miners had to give away upside price risk as the cost of hedging. Since the gold price has exploded ever since, it has meant miners either partially or completely missing out in the spoils.

The response has been that over the past few years gold miners have been “buying back” their hedge books, or “dehedging”. This comes at a cost but it does clear the way for blue sky profits if the gold price were to keep rising. As dehedging effectively equates to buying gold, dehedging has been a source of upward pressure on the gold price over the past few years.

By now everyone who wanted to dehedge pretty much has, which removes that element from the demand side from here. Nevertheless, Standard Chartered suggests a lack of dehedging will merely “compensate” for dwindling new supply and the closure of credit-constrained mining and exploration projects. In other words, a lack of dehedging will crimp but not outweigh the demand side.

A final element which exists on the demand side of the gold equation – and has for centuries – is gold as the safe haven not just against financial turmoil but against all other sorts of turmoil, particularly political. The latest Israeli incursions just go to reinforce that “Peace in the Middle East” is a myth, and has been since Moses fled Egypt. Despite a great new world hope centred around the election of Barrack Obama, there is no suggestion the so-called War on Terror is about to wrap anytime soon either. Throw in Africa, South America, North Korea, China/Taiwan, and India/Pakistan, to name a few, and there is little doubting the world still suffers from several political hotspots. Then consider what current rioting in Iceland and other hard-hit European centres might imply, and it is hard to argue why investors would not consider an indisputable store of wealth as a sound investment.

We won’t even go into the potential for disasters of the natural kind.

So to conclude this (latest) gold discussion, consider that there is once again a groundswell amongst analysts that gold is set to hit quadruple digits again anytime soon. It is now appreciated that US$900/oz is a formidable barrier and that work may yet have to be done. Analysts were caught out earlier in the year and were forced to pull back their forecasts, but the tide is quietly turning once more. Were US$900 to be breached in a meaningful way, recent history suggests we might be in for a run. And there doesn’t seem to be much that could stop it.

Share on FacebookTweet about this on TwitterShare on LinkedIn

Click to view our Glossary of Financial Terms