Gold Near $800 (August 25, 2008)
Gold near US$800 remains vulnerable in the near term to a stronger dollar but is underpinned by rising physical demand in key global markets, deteriorating macroeconomic and financial environments, accelerating inflation, and tight supply/demand fundamentals.
A pop in the U.S. dollar, prompted by signs of deteriorating economic activity in Europe, has once again undercut gold, just as the metal looked like it might hold and build support around $830 an ounce.
Having failed to establish a foothold over $830 an ounce, gold is greatly oversold but still looks technically vulnerable. A further decline to the $790 to $800 range — or even briefly lower — is certainly possible, especially if the dollar continues to rise against the euro. But, I believe any decline below $800, however deep, will be short-lived as price-responsive physical demand increases in tandem.
To put the price in perspective, at its recent lows near $790 an ounce, the metal is still more than 20 percent above the lows of last summer (around $650) . . . and at the current price in the $820-to-$830 range gold is about 26 percent higher than it was last summer. Stock market investors (and homeowners) would kill for annual returns of this magnitude.
If anything, gold promises to remain volatile. The credit crunch has reduced liquidity available to precious metals traders and speculators, the result being increased volatility both up and down – and this will continue day to day and week to week.
In the near term, gold-price movements will continue to reflect the ups and downs in the US dollar/euro exchange rate. Deteriorating confidence in Europe’s economy and signs of recession in the euro-zone are affecting expectations about monetary policy and interest rates. Not so long ago, the European central bank was focusing on rising inflation and threatening higher interest rates. Now, with the economy softening rapidly no one thinks the central bank will raise rates this year . . . and there is beginning to be talk of lower interest rates to cushion the downturn.
Expectations of higher inflation-fighting interest rates in Europe have been replaced with expectations of lower recession-fighting interest rates, pulling the prop out from under the euro and the British pound.  The flip-side of a weaker euro has been a stronger dollar — and the stronger dollar has been a key factor in bringing gold down. Shifting expectations about the European economy, euro interest rates, and the U.S. dollar/euro exchange rate will continue to influence gold in the short term. But this should become less important over time as market fundamentals play a more important role and more investors shun both the dollar and the euro in favor of their favorite metal.
Fortuitously, physical demand has picked up sharply in the past month — particularly among retail (non-institutional) investors. We’ve seen this in Europe where demand for small bars and bullion coins is up, we’ve seen this in the United States where the U.S. Mint had temporarily suspended deliveries of American Eagle gold bullion coins to dealers and retailers for lack of supply, and we’ve seen this in India where jewelry demand has picked up early in response to low prices ahead of the coming festival season.
In my 36 years as a gold analyst, I’ve noticed that Indian housewives are far better forecasters of the gold price than most of us paid to do the job — and, today, Indian housewives are buying the yellow metal.
India jewelry manufacturers are paying as much as five to six dollars an ounce above the world market price of gold, reflecting tight local supplies — and, even so, delivery times are several days above normal. Given the recent price responsiveness of demand and the advent of festival season beginning next week, India, historically the world’s largest consumer of gold, should provide strong support to the world market, cushioning and probably limiting any decline to $800 or below.
Another plus that may provide some support and sustenance to gold in the days and weeks just ahead is the return of Chinese retail and hoarding demand. Gold buyers in China, glued to their TV sets to watch the Olympics, took a vacation break from gold during the past two weeks. Now, these buyers are coming back with some pent-up demand and continuing worries about local inflation and a weak stock market.
Fortuitously, seasonal factors everywhere are turning positive. Gold demand — from the jewelry industry as well as key Asian markets — is at its seasonally weakest in July and August. As a result, the metal is especially vulnerable during the summer months to other negative factors and forces. Seasonality turns positive in September and builds in the fourth quarter as Christmas-related jewelry fabrication demand and seasonal Asian buying picks up.
European depositaries are reporting much traffic — in and out — suggesting a shift in gold ownership to stronger hands. What we have not seen yet is a return of institutional fund demand — which was the fuel behind gold’s skyrocket advance early this year to record heights above $1000 an ounce. We expect funds to return gradually as the U.S. economy continues to deteriorate and as the credit crisis claims more victims among the big banks and financial institutions.
A wild card for gold — both short term and long term — is the continuing possibility (or, if you ask me, likelihood) of further major credit-crunch disasters. The Fannie Mae / Freddie Mac saga and the almost daily litany of bank write-offs are reminders that many major financial institutions remain vulnerable. More bank failures and write-offs at top financial firms are coming — and there is a growing fear that federal regulators don’t know how to respond to the problems in the financial sector in order to minimize their impact on the real economy. As we have pointed out since early this year, a worsening credit crisis will continue to boost investment and hedge demand for gold for some time to come.
Long-term price prospects remain as bright as ever — and nothing in the recent market performance has changed our forecast of record high prices in the next few years: We still expect to see gold back over $1000, if not late this year, then almost certainly in the early months of 2009.  With the right confluence of economic and geopolitical developments we could see gold as high as $1500 or even $2000 an ounce in the next few years — and a buying frenzy could briefly take the metal much higher.
Looking forward, the gold market will be supported by a deteriorating economic situation in tandem with positive supply-demand fundamentals.
In brief, rising incomes and wealth in China, India, and other newly developed nations will more than compensate for any shrinkage in the top industrial nations. Meanwhile, investment and hedge demand will trend higher reflecting reflationary monetary policies and rising inflation everywhere.
On the supply side, world mine output will be slow to respond in a meaningful way to higher prices while production in South Africa will continue to deteriorate.
Importantly, the South African gold-mining industry has operated at 90 percent of its electric power needs since a nationwide power shortage forced a shutdown of the mines for about six days in January.  At best, ESCOM, the national electric utility, will not have increased generating capacity for four years while the country’s household and industrial needs will continue to grow. As a result, further reductions in electric supplies to the mining industry with intermittent power outages seem likely to continue at a heavy cost of significant reductions in the country’s gold-mine output. .
With U.S. economic activity (measured by production, housing, employment, consumer spending, etc.) softening, home prices plummeting, and consumer price inflation continuing to accelerate, Federal Reserve policy-makers find themselves between a rock and a hard place. Despite tough talk on inflation, the Fed will not raise interest rates with the economy teetering on the precipice.
And, increasingly, it looks like the European and Japanese central banks are finding themselves in the same leaky boat. As inflation everywhere continues to worsen, European and Japanese central banks are joining the United States in recognizing that there is no room to raise interest rates.
The key for gold, in the longer term, is that inflation everywhere — in the United States, Europe, Japan, India, China and southeast Asia, Latin America — is accelerating. China and India, the biggest gold consuming nations, each recently reported double-digit year-over-year consumer price inflation rates. Measures of monetary policy — growth in broadly defined money supply and real (inflation-adjusted) short-term interest rates — are already at inflation-fueling levels.
There’s no doubt about it, inflation is now a global phenomenon — and the acceleration of consumer-price inflation in the major gold consuming countries and regions, especially India, China, and Japan, will support investment and hedge demand even as gold moves higher.
