Is it over for gold?

On the other hand, mention to goldbugs that gold's worth is derived from a purely atavistic viewpoint and you may find yourself being lectured on the repeal of the Bretton-Woods Agreement in 1971 and the iniquity of the fiat currency system, and that the metal's buying power has held up remarkably well over the years. Indeed, while in dollar terms gold may be worth a lot more today than it was a decade ago, it still buys roughly the same amount of oil and is close to the average for this important ratio.

Certainly, gold's fans have welcomed the fall as manna from heaven, an opportunity to snap up more. A research note published by Jeremy Batstone-Carr at broker Charles Stanley in the wake of the price collapse viewed the sell-off as "extremely healthy as it shakes out weak holders and forces the more committed holders to re-examine the basis of their holdings". This would be cold comfort for anyone who bought into the metal at $1,693 an ounce (oz) at the end of January in the hope of immediate gains, but "strong and committed owners", as Mr Batstone-Carr puts it, aren't especially focused on short-term price moves.

Even so, all this conjecture is essentially white noise. Arguments over the intrinsic value of gold are largely academic - there is no 'fundamental' analysis that can tell you how much gold should be worth, and the recent price fall, or more accurately, the reaction to it, underlines the fact that there seems to be no middle ground where gold is concerned - you will be hard pressed to find a dispassionate assessment on the likely trajectory of the gold price.

What ultimately matters is the availability of counterparties, and on that score the gold market has rarely been in better shape - private and central bank buyers of physical gold are in abundance, even if ‘serious’ investors are sceptical of gold's bull run.

Central banks' golden handshake

Despite the recent pullback, we maintain there are a number of factors that will underpin long-term demand for the metal, not least of which the proposition that treasuries across the globe are systematically increasing the proportion of gold within their reserves as confidence in US dollar-denominated assets wanes.

A report from Thomson Reuters GFMS reveals that, during 2012, net gold purchases from the world's central banks increased by 17.4 per cent on the previous year to 536 tonnes - the highest level in almost half a century. National treasuries had been net sellers of gold for decades – offloading between 400 and 500 tonnes a year - but the trend reversed in 2010 when they bought 77 tonnes, increasing to 457 tonnes during the following year. That equates to a huge swing in demand of 1,000 tonnes of gold in just three years. And even this figure is based purely on official data, which doesn't adequately reflect the influence of the People's Bank of China in the market, which many believe is understated.

Understandably, China's reserve bank is reluctant to reveal the full extent of its buying activity for fear that this would lead to a surge in the gold price and possible devaluation of its $3.14 trillion in foreign exchange reserves. China is essentially engaged in a balancing act, in trying to diversify its reserves in favour of bullion (and other physical assets) without inadvertently driving down the values of the underlying currencies.

By comparison to other big economies such as the US and Germany, China's gold holdings represent a tiny proportion (less than 2 per cent) of their overall foreign reserves, but Beijing is intent on rectifying that situation. Currently China's treasury holds 1,054 tonnes (although the actual figure could be double that), but it is said to be targeting a tenfold increase. That's a reserve base of around 10,000 tonnes, which equates to roughly 32 per cent of the gold currently held by the world's treasuries, or around 7 per cent of all the gold that has ever been mined. That's a lofty ambition when you consider that many other emerging market economies are following suit - Brazil doubled its bullion holdings through 2012 (as did the Bank of International Settlements), albeit from a fairly low base. Other big buyers in 2012 include Russia and Turkey.

It's especially interesting to try to understand why China has stepped up its purchases of the precious metal. Many now believe that Beijing is seriously intent on repositioning the renminbi as a viable alternative to the greenback as the global reserve currency. This is supported by the fact that China has substantially increased the number of bilateral trade agreements with other nations that are conducted in currencies other than the US dollar. In addition, the Chinese government now buys all domestic production - which, as the world's largest gold producer, equates to around 361 tonnes a year - and has removed existing restrictions on personal ownership of the metal, while legalising domestic gold exchange traded funds. As mentioned previously, Beijing is engaged in a 'balancing act' due to its reserve exposure to US dollar-denominated assets, so it would hardly be in the country's immediate best interests if currency traders started dumping the greenback in anticipation of a changing of the guard. Obviously, a great many benefits would accrue to the Chinese economy if the renminbi became the global reserve currency, including a marked reduction in transaction costs for Chinese exporters and importers, but Beijing will need to tread carefully if the renminbi is to gain primacy in world trade. Timing, as ever, is everything, but it appears that the nation's strategists believe that a large bullion reserve is a prerequisite, so the People's Republic will remain in the market for the foreseeable future.

And the debasement of the greenback may have some way to run, according to the Investors Chronicle's trading editor, Dominic Picarda. Although there have been suggestions that the secular decline of the dollar has been arrested – and that the US could halt its bond buying spree given concerns over its efficacy and signs that the US economy is on an improving trajectory - Dominic in fact thinks that the process is barely off the ground. He takes the view that the US Federal Reserve and other central banks are looking to repeat the US post-war experience when interest rates were deliberately held below the rate of inflation in order to inflate away a sizeable portion of the accumulated war debt.

However, he points out that America's ratio of gross federal debt-to-GDP indicates that "deleveraging has yet to begin in any meaningful way". Western governments would be extremely wary of increasing interest rates at a time when many economies are barely registering any growth at all, so Dominic maintains that once the "inflationary inevitability" of current economic policy becomes more apparent "the price of gold should resume its mighty upward trend". Christopher Pratt, writing for the Serious Investor Group last year, summed up gold's attraction neatly: "Gold is stepping up to the plate as good collateral in a world of bad collateral."

It seems odd, therefore, that central bank activity was suggested as one explanation for the heavy price fall. News that the Cypriot government might be forced to offload its gold reserves to finance a €400m slug of its bailout caused consternation that the action could provide a template for the rescue of other indebted European economies, not least Spain and Italy, whose 2,500 tonnes of gold must be tempting to the Troika should its 120 per cent debt to GDP ratio prove unsustainable. However, given the scale of gold buying in developing economies, it seems unlikely that there would be any shortage of buyers even if such large slugs of the yellow metal came up for sale.

Household buying continues

While the impact of reserve authorities over the past three years has provided a positive beat for the gold price, the role of private buyers should not be underestimated. Although support for gold-backed securities may have wavered, there is strong evidence to suggest that, if anything, the clamour for physical bullion in the form of ingots, coins, nuggets and jewellery has intensified as pent-up retail demand has given way to price opportunity.

The recent price fall resulted in demand for Krugerrands more than doubling, according to the SA Gold Coin Exchange, while the US Mint ran out of its smallest American Eagle gold coin. This physical rally has been particularly true in relation to Indian buyers, who are still the world's most important retail consumers of the metal. Uncertainty stifled India’s retail market through the first quarter after the country's government, in a bid to alleviate its current account deficit, had threatened to impose another increase in import duties for gold. According to the Reserve Bank of India, around 80 per cent of the country's current account deficit - the widest among the large emerging economies - is due to gold imports.

It's certainly understandable why Delhi might wish to curb retail demand, but while Indians have always had pragmatic reasons for buying gold (decades of strict capital controls chief amongst them), the retail market in the country also amounts to a cultural phenomenon. Buying gold is considered auspicious in India during religious festivals - there's no shortage of those - and as part of the tradition of giving dowries. The bulk of the religious festivals fall between August and November, and these are followed by the wedding season. Naturally, gold analysts, who are finding it increasingly difficult to determine the global demand/supply balance - look to market activity on the subcontinent during these periods. Incredibly, India accounts for over a third of annual retail gold demand.

ETFs introduce gold volatility

The sharp sell-off in April came despite this healthy demand backdrop, and many suggest that the increased role of investment instruments in the gold market, and particularly ETFs, have increased its susceptibility to sharp price swings.

Gold's decade long ascent neatly coincides with the launch of the first gold ETF in 2003. ETFs' exposure to physical gold now totals over 2,000 tonnes. That's a level which, in aggregate, makes ETFs the world's sixth largest gold holder.

The sharp fall in April has been linked to an institutional sell-off in ETF contracts, with trading volumes on 15 April seven times higher than the daily average, and the highest on record. Nearly a billion dollars is said to have flowed out of the SPDR gold trust on the day, the third largest outflow in its history.

According to the World Gold Council, after a decade of steady inflows there has been a sharp swing to net redemptions this year, with nearly 300 tonnes flowing out of ETFs. Further redemptions of investment gold held in ETFs is seen as the biggest risk to prices in the short term by analysts at Barclays, which makes sense given that demand for investment gold has risen from 10 to 35 per cent of total annual demand over the past decade (jewellery demand, meanwhile, has dropped by over 1000 tonnes a year, which means its share of demand has halved to 40 per cent).

Some of those investing in gold via ETFs fall into the category that Mr Batstone-Carr at Charles Stanley might describe as "uncommitted holders" - in other words, those that opt for gold ETFs simply because they want to exploit increased price volatility, rather than those that hold it for more philosophical or fundamental reasons. That gold is in a traders' market was clear from extent of the mid-April falls, which were exacerbated by the fact that the gold price consequently breached two technical support levels. And the crucial $1,540 level that was breached on the way down to spark the collapse is predicted by devotees of technical analysis to be resistance on the way back up.

We think the surge in demand for bullion in the wake of the price fall provides a real clue as to underlying sentiment - follow the money. At the time of writing, the gold price stood at $1,442 an oz - a 9 per cent rise on April's three-year low, and $139 above and beyond its five-year average.

There may be blood on the water, but we're still at high tide. And any bearish sentiment was pretty short-lived anyway: on 10 April, Goldman Sachs cut its short- and long-term gold forecasts as prices approached critical inflection points, but the investment bank has just told its clients to exit 'short' positions on the gold price.

Indeed, Goldman Sachs' prominent role in the recent sell-off has prompted the usual suspicion that there was more to the plunging gold price than met the eye - especially as the fundamental reasons touted for the sell-off were hardly compelling. Goldman Sachs is reported to have made 15.5 per cent on its own book as a result of gold's plunge, and Charles Stanley's Batstone-Carr points to several gold market participants that observed unusual trading activity in the gold futures market in the run-up to the events of 15 April.

He also ponders whether the gold sell-off could have been orchestrated by even higher powers - the US government, whose policy, he says, remains "oriented towards convincing or coercing the world into believing that the dollar is the world's only safe haven not other currencies, or silver, or gold".

Gold's cost conundrum

Beyond a limited number of applications in electronics and aerospace, gold - unlike precious metal stablemates silver & platinum - has no real industrial market, so in that respect lacks the price discovery mechanism so important in other markets. But gold's subsequent performance since the sell-off has added weight to the view that a theoretical floor of around $1,300 an oz (£855 an oz) has been established for the metal. That's obviously a highly contentious proposition, but it is supported by the changing cost profile of the industry, while the continued rise in demand from the world's reserve banks must give even the most sceptical investor cause to reflect.

In common with a lot of metals, a steady fall in ore grades has pushed up average cash costs across the industry to $727 an oz. Add in the ancillary costs linked to processing, replacement capital expenditure and environmental restitution and you will be lucky to get much headroom below around $1,200 an oz. The fact that gold producers now have less room to manoeuvre not only means they have less leeway when it comes to paying dividends, but it effectively reduces the marginal profit incentive to increase output. And if miners are less inclined to seek out virgin deposits, or ramp up production at existing facilities, it stands to reason that prices would eventually respond if demand ticked up.

Certainly it seems unlikely that we will see a significant ramp up in gold production in the years ahead, not least because gold miners' output has ramped up so significantly in recent years. Annual gold production has rebounded to around 2,700 tonnes for the past three years, but exponents of the 'peak gold' theory suggest falling ore grades and rising production costs mean this figure is unlikely to rise substantially higher.