Bipolar Gold
With the price of gold lurching first one way then the other, it looks like the market has been suffering from bipolar disorder. I expect this split-personality behavior, characterized by extreme price volatility, to continue for some time to come with big swings up and down — but, importantly, around a rising trend with support levels moving up step-wise over time.
In short, gold is heading much higher, but not without more struggle and occasional disappointment for those looking for a speedy ascent. Further out — over the next year or two — I have no doubt that gold will move to new historic highs well above the $1030 level touched a year ago March.
The principal engine of gold’s ultimate ascent is the continuing rapid pace of monetary expansion - in part necessitated by a trillion-dollar stimulus program in the United States — and the acceleration in U.S. price inflation will surely follow sometime in the next year or two.
There are at least three other less certain but entirely possible developments any one of which could touch off a real panic in the gold market and carry the metal’s price to levels most would consider unimaginable:
- First, another large-scale financial catastrophe in which one or more financial institutions seemingly suddenly need hundreds of billions of dollars more in government bail-out funds.
- Second, a growing reluctance on the part of foreign central banks and other major investing institutions to continue underwriting the U.S. federal budget deficit without a significant rise in nominal U.S. interest rates.
- Third, a run on the U.S. dollar, though it is hard to imagine where dollar holders would run since other currency markets (and certainly the gold and other precious metals markets) are not large or deep enough to absorb a major shift in currency preferences and when other major currencies are also losing creditability as reliable stores of value.
History Lesson
It is instructive to examine the forces that held gold back during the past year for clues to the metal’s future path.
Much of gold’s weakness during the past year and its inability to sustain periodic price advances was due to the indiscriminate selling of commodities-related investments by hedge funds, other institutional players and some wealthy families in order to raise cash, increase liquidity, cover big losses in equity and other asset markets.
Often these institutional sellers were not holding individual commodities but baskets or indexes that included gold - so gold got dumped along with everything else. In other words, gold was sold not because it was singled out as an unworthy holding but because it was a component in the indexed baskets of commodities held by many hedge funds and institutional traders.
In addition, the decline in inflation and inflation expectations due to the fall in oil and other commodities prices and the increasingly gloomy economic outlook dampened demand for gold among some who look to the metal as an inflation hedge.
Despite all of this, one must still acknowledge the yellow metal’s staying power and relative performance as a store of value during a tumultuous period for the world economy and the sizable loss of value in other asset classes.
Indeed, gold has done rather well compared to the $30 trillion loss in world equity market capitalization, the unfathomable loss in real estate values, and the $1.2 trillion of losses and write-downs on worthless assets held by banks worldwide (IMF estimates). Measured in U.S. dollars, gold is now up a few percent from the end of 2007 - but it is at all-time highs against nearly all of the major currencies.
Bipolar Investment Demand
By late 2008, the wave of commodity disinvestment had come to an end. Simply put, the commodity holdings of hedge funds and other large-scale players had been largely depleted — and, to the extent that these were actual physical positions, the gold has moved to stronger hands.
Recent data from commodity futures exchanges confirm that the liquidation of long gold futures positions has not only ended but has been replaced with some fresh buying. In the week ending January 27th the net long position increased by 49 metric tons to reach a total of 564 metric tons (18.1 million ounces). This compares with a net long position of 516 tons (16.6 million ounces) at the end of last year and a recent low point of 213 tons (6.85 million ounces) in mid-November.
An even more encouraging indicator of gold’s future price is the continuing strength of investor interest among retail investors and conservative institutional investors wishing to hold physical metal. Importantly, these buyers are not traders looking for quick gains but many are simply scared individuals, families, and prudent institutional investors seeking to protect their wealth, their savings, and their retirement nest eggs (for themselves or their clients).
One need only look at the holdings of exchange-traded funds (or ETFs) such as the SPDR Gold Shares ETF traded on the New York Stock Exchange. Holdings of gold bullion on behalf of SPDR Gold Shares investors reached an all-time high of 859.5 tons (27.6 million ounces) on February 4th. This compares with 780.23 tons (25 million ounces) at the end of last year and 630 tons (20.3 million ounces) in early 2008.
Without doubt, the introduction of SPDR Gold Shares just over four years ago (along with a number of smaller exchange-traded gold funds in other global markets) has been an important structural change in the gold market facilitating the participation of individual investors as well as institutions, some of which have prohibitions from direct purchase and ownership of physical metal. Importantly, ETF gold investors have become a force in the market with total ETF holdings now exceeding the COMEX net long position.
Great Expectations
I remain bullish on gold because — even as the global economic recession deepens — governments will find the only way out of this mess is to print more money.
It’s not just the U.S. monetary authorities pumping up the money supply, though that would be enough to boost the U.S. dollar price of gold. Their counterparts in every major economy - including the United Kingdom and the Euro zone, China, Russia, Japan and on and on - are doing likewise.
We have never in the history of money seen such an expansion in its supply without, after a period of time, a rapid deterioration in its value. More than any other factor influencing the gold market, it is the inevitable devaluation of money and the corresponding rise in price inflation that will propel gold skyward in the next few years.
As sure as day follows night, reflationary monetary policies — however necessary — have long-term implications for global inflation. Typically, monetary creation affects price inflation with a lag of six months to a couple of years or more . . . so it may be some time before inflation is recognized as a serious problem. But gold prices have shorter lags and, in fact, have already begun moving up long before rising inflation becomes apparent or worrisome.
As I have said before, with the right confluence of economic and geopolitical developments we could see gold break through $1500, then $2000, and possibly still higher round numbers in the next few years.
Not Without Risk
Despite expectations of much higher gold prices this year and beyond, it would be wise to remember that gold remains volatile and vulnerable. We are in an unprecedented environment with daily evidence of a deteriorating U.S. and global economy, where policy makers are employing powerful, yet untested, tools to repair a broken economy, and politicians cannot be trusted to do all the right things. In this environment, we could still get a quick sell-off that would bring us back to support levels well below recent prices.
That said, there are some specific factors that could trigger a sizable correction in gold prices in the next few months:
First and foremost, a temporarily stronger U.S. dollar vis-à -vis the euro: The European Central Bank is a few steps behind the Federal Reserve in lowering short-term interbank lending rates. As the ECB catches up by lowering interest rates in two or three steps over the next few months, the dollar will likely pop up briefly each time - and, each time, a stronger dollar could precipitate a sell-off in gold as it did in January and several times last year.
Second, weakness in Indian gold demand: India, the world’s largest gold-consuming country with imports last year of 720 metric tons (23.1 million ounces), has seen a sharp decline in gold imports. The Bombay Bullion Association reports that gold imports plunged more than 90 percent to roughly 1.8 tons in January from 24 tons a year earlier. Imports are down largely in response to the record-high rupee-denominated price of gold.  High prices are discouraging demand and eliciting large-scale sales of old jewelry from profit takers, sales that are refined locally into bars and re-enter the market displacing imported metal.
Sources in India say the recent data exaggerates the situation and expect at least a partial recovery as gold buyers adjust to the high and rising price for the yellow metal. They also say that holiday and wedding-related demand, which is an important component of total consumption should pick up shortly. In addition, the new government program of offering small gold coins at rural post offices could be a spur to gold buying.
But if Indian buying does not pick up soon, there could be more metal available in world markets to satisfy the rise in U.S. and European investment demand and correspondingly less upward pressure on the price of gold.
Coming Soon to a Blog Near You
In subsequent posts, I will take a look more closely at some of the other variables that could influence gold - for better or worse — in the months ahead: Central bank and IMF gold policies and prospects, the economic and political situations in China, Russia, and Saudi Arabia - and, of course, we’ll continue to comment on the unfolding economic crisis and policy response in the United States.
