Gold many have been one of the best-performing asset classes of the past few years. But that doesn't mean it won't continue to rise. There are at least five reasons why this is so.
Gold bugs were not disappointed when the Federal Reserve Open Market Committee (FOMC), the rate-setting arm of the US central bank, in effect opened the door last month to another round of quantitative easing to give a boost to the country's weakening economy. Analysts at investment bank Goldman Sachs expect "a sizeable asset purchase to be implemented in the coming months" in the order of at least $1,000bn, while Morgan Stanley thinks it could be significantly more. Jeremy Batstone Carr, investment strategist at brokers Charles Stanley, has speculated that the FOMC could be lining up a "shock and awe" asset purchase scheme at its meeting on 3 November. If past performance is any guide, then gold bugs are right to be excited at the imminent prospect of QE2.
In fact, the US Federal Reserve has almost trebled the size of its balance sheet from $800m to $2,300bn by buying US Treasury bonds to drive down long-term interest rates and ease monetary conditions. This has been very beneficial for the gold price for three main reasons.
Firstly, holding physical gold mitigates the risk that central banks have been buying back government securities in an attempt to monetise ballooning budget deficits with the consequence of debasing their currencies. It was therefore no surprise that the first round of QE last year was accompanied by a sharp fall in the dollar - on a trade weighted index the dollar fell 17 per cent between March and December 2009. It was no coincidence either that the gold price, which is denominated in dollars, rose 30 per cent during this time, in effect acting as a natural hedge against dollar weakness resulting from QE.
Secondly, gold is also a hedge against the risk that the ultra lax monetary policies being pursued by the world's leading central banks will ultimately end up in a bout of inflation - the easiest way for highly-indebted countries to erode the real value of their debt mountains.
Thirdly, as central banks force down long-term interest rates by buying in government bonds, this reduces the opportunity cost of holding non-yielding commodities like gold, which supports investment demand from investors looking to diversify their portfolio asset allocation as well as from speculators. There is little sign that investment demand for gold is abating with the 36 per cent surge in global gold demand in the second quarter driven by the purchase of 291 tonnes of gold through ETFs and similar investment funds (Source: The World Gold Council (www.gold.org)). And speculative demand for gold remains high, too, with net speculative long positions recorded on COMEX outnumbering short positions by a ratio of seven to one.
It is not just the US Central Bank that is driving the gold price up as news that Bank of Japan is embarking on a Y5,000bn asset buying programme to boost liquidity in the financial system, as part of a "comprehensive monetary easing policy", can only be supportive to the gold price. And with the central bank cutting its overnight interest rate target to virtually zero per cent, investors will be more likely to recycle some of the cash from these asset sales to the Japanese government into other asset classes, including commodities.
Currency Flows
Gold has also been benefiting from the 'carry trade' whereby investors borrow funds in low-yielding currencies, and in particular those that have resorted to quantitative easing, to invest in higher-yielding assets overseas.
This is a major reason why the higher-yielding Australian dollar has hit its highest level against the dollar since it was floated on foreign exchange markets in 1983. For while the US economic recovery is faltering, and the Federal Funds rate is at an all-time low, Australia's economy has been going from strength to strength and the Reserve Bank of Australia has been tightening monetary policy. In turn these currency flows - from low to high yielding currencies - have the effect of weakening the dollar, which buoys demand for gold as the commodity acts as a natural hedge against devaluation of the world's reserve currency.
It also explains why the surge in the gold price since the summer has coincided with a sharp rise in the Australian dollar against the dollar. In fact, the $200/oz rise in the gold price since the end of July has coincided with dollar weakness against most currencies, with the dollar Trade Weighted index falling 4.5 per cent in the same period. In other words, gold is acting as a leveraged play on further weakness in the dollar.
€urozone worries
The problems in the Eurozone grabbed the headlines in the first half of this year and culminated with a European Union and International Monetary Fund bail out of Greece and other member states with the establishment of a €750bn (£625bn) stabilisation scheme.
The single currency has since regained its lost ground against the dollar, mainly as currency traders have been betting heavily that the US Federal Reserve will embark on another round of QE next month – a move that would that weaken the US currency. Short-term currency movements aside, there remain serious concerns over the long-term stability of the euro and it is clear from gold buying patterns that investors are yet to be convinced that the 'shock and awe' financial programmes, designed to prop up the finances of Eurozone member states, can prevent ultimate default on sovereign public sector debts.
In the circumstances it is rational for investors to reduce exposure to the euro by investing in gold, an asset that has stood the test of time as a store of value over the past 2,500 years. The numbers certainly support this view with European retail demand of gold soaring 115 per cent quarter-on-quarter between April and June this year - the highest level since the last quarter of 2008. It is noteworthy that Germany and Switzerland accounted for 83 per cent of the total as private investors moved cash into gold to hedge against a further spike in risk aversion on Eurozone sovereign debt worries. In fact, net retail investment demand, which increased a fifth to 243m between April and June, hit a record quarterly high of US$9.3bn.
Supply/Demand Imbalance
The supply-demand balance in the gold market has been tightening in recent years and mainly as central banks turned net buyers. China, Russia and India have all made significant purchases, but there is ample scope to raise holdings further. For instance, China has accumulated 1,054 tonnes of gold, worth $43.4bn, but this only represents a miniscule 1.6 per cent of its burgeoning foreign exchange reserves. And at the same time that emerging markets economies have turned net buyers, aggregate sales among the 19 signatories to the Central Bank Gold Agreement have been miniscule.
It's also worth noting that supply and demand was only kept in equilibrium between April and June this year due to a 146 tonne increase in recycled gold (to 496 tonnes) that in turn led to the 16 per cent rise in world supply (to 1,131 tonnes). To put this segment of the market into perspective mine production only rose 47 tonnes to 659 tonnes in the same three month period which highlights how producers have been unable, or unwilling, to ramp up supply in response to higher prices.
So with the moderately higher output from the industry unable to satisfy increased levels of investment demand, recycling activity is becoming increasingly more important to maintaining the supply side. The clear risk is that consumers will decide to hold back recycling gold in anticipation of higher prices in the future. Interestingly, this now appears to be happening in the all-important Indian market and if this trend becomes more widespread, then this could lead to significant further upward pressure on the gold price.
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This is part 2 of a 6-part feature
