So far 2010 has been an interesting year as generally Gold prices have continued to trend higher and have set fresh record highs in the process. However, equities, bonds and base metals, have performed strongly too. At some stage we expect equities and base metals to move in an opposite direction to Gold. Indeed we feel Gold is reflecting the economic and financial situation more accurately than the others. There are numerous reasons to be bullish for equities and industrial commodities and continued fund interest for the long term is one such reason. Fundamental supply concerns are another. However, can equities and industrial metals out run another economic slow down? It seems as though burgeoning budget deficits will lead to austerity measures in Europe, restrictions on property speculation in China will slow growth and QE in the US will eventually debase the dollar. We think there is still a high risk of another broad market correction, probably boosting demand for safe-haven investments. Such a scenario is also likely to prompt more QE, risking debasement of the dollar and reducing confidence in fiat currencies. This is likely to boost demand for bullion and other items with intrinsic value. Gold’s moves seem measured and determined and the rally does not yet look like a bubble.
GOLD;- TREND CHANGER:-Since the rally in Gold started in 2001, Gold prices have climbed on the back of a host of issues including: the weaker dollar, increased geopolitical risk, higher oil prices, portfolio diversification, producer dehedging, falling mine production and, until recently, reliable and resilient Asian jewellery demand. However, some of these bullish underlying trends are now changing, for example producer dehedging has all but run its course, Gold production is climbing again, jewellery demand has fallen sharply and oil prices are relatively low. The one factor that has turned more positive for Gold is the reduction in official sector sales and the possibility that this sector might turn a net buyer. On balance the changes are negative for Gold’s fundamentals. However, one thing that has not changed is investors’ demand for Gold. The financial crisis and the sovereign debt crisis have increased the demand for safe-haven investments.
Given the deteriorating fundamentals, where supply is increasing and fabrication demand is falling, the bull market in Gold is in the hands of investors. In 2009, Gold supply was 4,287 tonnes, according to GFMS Ltd, and total fabrication demand plus de-hedging, totalled 2,671 tonnes. This meant that, excluding investor demand, the market was in a surplus of 1,616 tonnes. So while investors’ appetite is strong enough to absorb this surplus, the rally in Gold can continue. Going forward we feel one of the main driving influences will be the need, or otherwise, for more QE as this is likely to determine the level of confidence in fiat currencies. Indeed we feel the final stages of the bull market will happen as Gold becomes more monetised and people view Gold as the ‘must-have’ alternative to fiat currencies. As the Fed contemplates more QE there is potential for considerably more investment buying and, just as any rally can ‘run away’ on the upside, it is possible investment demand could do the same, especially given the size of the financial market and the Gold market’s small size in relationship to it. However, just as any rally can ‘go exponential’, at some stage it inevitably corrects - perhaps sharply. With large holdings of Gold in ETFs, futures, bars and coins, the market will rightly be nervous and on the look out for signs of change.
Given the deteriorating fundamentals, where supply is increasing and fabrication demand is falling, the bull market in Gold is in the hands of investors. In 2009, Gold supply was 4,287 tonnes, according to GFMS Ltd, and total fabrication demand plus de-hedging, totalled 2,671 tonnes. This meant that, excluding investor demand, the market was in a surplus of 1,616 tonnes. So while investors’ appetite is strong enough to absorb this surplus, the rally in Gold can continue. Going forward we feel one of the main driving influences will be the need, or otherwise, for more QE as this is likely to determine the level of confidence in fiat currencies. Indeed we feel the final stages of the bull market will happen as Gold becomes more monetised and people view Gold as the ‘must-have’ alternative to fiat currencies. As the Fed contemplates more QE there is potential for considerably more investment buying and, just as any rally can ‘run away’ on the upside, it is possible investment demand could do the same, especially given the size of the financial market and the Gold market’s small size in relationship to it. However, just as any rally can ‘go exponential’, at some stage it inevitably corrects - perhaps sharply. With large holdings of Gold in ETFs, futures, bars and coins, the market will rightly be nervous and on the look out for signs of change.
In summary, the big picture outlook remains bullish in the medium term. Although there seems to be a degree of optimism that the worst is over and that an economic recovery is underway (albeit slower than originally thought), we are not so sure. Indeed, with Gold prices setting record highs there are obviously others who feel differently and we would be in that camp. Overall, we fear that the rebound off the 2009 lows may have run its course and it may be in the process of stalling. The measures governments have taken over the past two years have bought some time, but the legacy of their actions are likely to have created even bigger global problems and these could emerge if markets get more worried about the level of debt. If people and creditors start to lose faith in the dollar and other hard currencies, then a dollar crisis could unfold and that would likely impact all markets, creating further turmoil, uncertainty and fear in the process, all of which is likely to boost the appeal of Gold
FACTORS DRIVING GOLD PRICES:-
The dollar:- – As the financial crisis took hold in mid-2008, the dollar found some support as safe-haven buying into US Treasuries led to dollar buying too. However, the irony is that the US’s reliance on QE in effect threatens to debase the dollar, turning it even more into a fiat currency. Indeed, there is a fear that debt levels could get so high that governments’ only hope of repaying the debt would be to allow inflation to reduce its value. When inflation takes off in a country the currency weakens as it devalues against other currencies. However, when two or more currencies devalue at the same time their exchange rates may not register much change, but the buying power of these currencies is reduced. This is one reason why we expect Gold prices to continue to rise. As Europe, Japan and the US take measures, such as QE, to underpin their economic growth and fend off deflation, they risk debasing their currencies, so it is not surprising that Gold prices have been rising across these currencies. Because competitive devaluation is impacting many of the currencies that make up the dollar index (which includes the euro, the yen, the pound, the Swiss franc and the Swedish krona) the extent of weakness in the dollar might not be showing up in the index. However, a look at the dollar vs the Swiss franc, clearly shows the down trend in the dollar continues, see chart opposite. During the sovereign debt scares in Europe in the first half 2010, the inverse relationship between the dollar and Gold has been sporadic with both often rising at the same time, which highlights both are seen as safe-havens. However, more recently the dollar has been falling and Gold has been rising.
The dollar:- – As the financial crisis took hold in mid-2008, the dollar found some support as safe-haven buying into US Treasuries led to dollar buying too. However, the irony is that the US’s reliance on QE in effect threatens to debase the dollar, turning it even more into a fiat currency. Indeed, there is a fear that debt levels could get so high that governments’ only hope of repaying the debt would be to allow inflation to reduce its value. When inflation takes off in a country the currency weakens as it devalues against other currencies. However, when two or more currencies devalue at the same time their exchange rates may not register much change, but the buying power of these currencies is reduced. This is one reason why we expect Gold prices to continue to rise. As Europe, Japan and the US take measures, such as QE, to underpin their economic growth and fend off deflation, they risk debasing their currencies, so it is not surprising that Gold prices have been rising across these currencies. Because competitive devaluation is impacting many of the currencies that make up the dollar index (which includes the euro, the yen, the pound, the Swiss franc and the Swedish krona) the extent of weakness in the dollar might not be showing up in the index. However, a look at the dollar vs the Swiss franc, clearly shows the down trend in the dollar continues, see chart opposite. During the sovereign debt scares in Europe in the first half 2010, the inverse relationship between the dollar and Gold has been sporadic with both often rising at the same time, which highlights both are seen as safe-havens. However, more recently the dollar has been falling and Gold has been rising.
Deflation - Inflation :-- At present, the prospects of deflation seem to be a bigger cause for concern than inflation, although the inflation / deflation risk has now become more of a geographical issue. Asia and rapidly developing economies face inflation, while developed economies are worried about deflation and with interest rates already as low as they can be, governments are using QE in an attempt to avoid deflation. As QE debases a currency, we feel Gold will remain in demand even during a period of deflation. One argument against strong Gold prices during periods of deflation is that deflation is likely to see more demand for US Treasuries and in turn that is likely to underpin the dollar; but as we have already experienced the dollar and Gold can rise in tandem. Once sustainable economic growth is seen again, we expect inflation to take hold in the West, either as governments allow it to, in an effort to reduce the value of their debt mountains, or because they end up being slow to tighten monetary policy. This may happen if growth returns while unemployment remains high, or the housing market remains fragile. So even though inflation is unlikely to be an issue in the West in the medium term, it is a longer term threat, especially given all the QE.
Stagflation – Given there is a degree of unknown consequences in the measures central banks are applying in their effort to prompt growth and avoid deflation, there is a risk that they could be creating the conditions for stagflation. Indeed although official inflation in the West is low, asset prices are already rising strongly and they are not doing so on the back of a strong pick-up in demand. So it would appear that one of the consequences of QE is that liquidity is pumping into equity and commodity markets and is chasing prices higher. As such, we are getting high prices, but little economic growth and as growth remains subdued unemployment is remains high. In this situation governments are likely to refrain from raising interest rates and in turn that is likely to lead to inflation.
Central Bank Official Sales – For many years central banks have been net sellers of Gold but that may now be about to change. As the first year of the third Central Bank Gold Agreement (CBGA-III), which allows for sales of 400 tonnes of Gold per annum, comes to an end, it appears as though EU central banks have reported sales of less than 3 tonnes; the IMF has sold 222 tonnes to central banks (India 200 tonnes, Mauritius 2 tonnes, Sri Lanka 10 tonnes and Bangladesh 10 tonnes) and 88.3 tonnes on the open the market, so collectively official sales look to be in order of some 333 tonnes. Outside their acceptance of IMF sales, European central banks would appear to have had a significant change of heart as their sales have been minimal whereas under CBGA-II annual sales averaged 377 tonnes. Other countries have been adding to their Gold reserves; between January and the end of April IMF data shows official holdings increased 43 tonnes, with Russia and Venezuela the two main buyers. Other reports also suggest that Russia has continued to build up its Gold reserves and at the end of July reportedly held some 726 tonnes, up 13.6 percent so far this year. With limited IMF sales next year, (they still have an estimated 92.7 tonnes to sell) and with European central banks perhaps refraining from selling, we would not be surprised to see central banks become net buyers in 2011. As of the end of July 2010, central banks still held 30,520 tonnes of Gold – this is worth remembering when we worry about sovereign debt as if the situation did become critical then central banks could turn to their Gold reserves to bail themselves out. Note how the Bank of International Settlements, BIS, completed a 346 tonne Gold swap in July with various commercial banks, whereby it lent them money and took Gold as collateral.
Stagflation – Given there is a degree of unknown consequences in the measures central banks are applying in their effort to prompt growth and avoid deflation, there is a risk that they could be creating the conditions for stagflation. Indeed although official inflation in the West is low, asset prices are already rising strongly and they are not doing so on the back of a strong pick-up in demand. So it would appear that one of the consequences of QE is that liquidity is pumping into equity and commodity markets and is chasing prices higher. As such, we are getting high prices, but little economic growth and as growth remains subdued unemployment is remains high. In this situation governments are likely to refrain from raising interest rates and in turn that is likely to lead to inflation.
Central Bank Official Sales – For many years central banks have been net sellers of Gold but that may now be about to change. As the first year of the third Central Bank Gold Agreement (CBGA-III), which allows for sales of 400 tonnes of Gold per annum, comes to an end, it appears as though EU central banks have reported sales of less than 3 tonnes; the IMF has sold 222 tonnes to central banks (India 200 tonnes, Mauritius 2 tonnes, Sri Lanka 10 tonnes and Bangladesh 10 tonnes) and 88.3 tonnes on the open the market, so collectively official sales look to be in order of some 333 tonnes. Outside their acceptance of IMF sales, European central banks would appear to have had a significant change of heart as their sales have been minimal whereas under CBGA-II annual sales averaged 377 tonnes. Other countries have been adding to their Gold reserves; between January and the end of April IMF data shows official holdings increased 43 tonnes, with Russia and Venezuela the two main buyers. Other reports also suggest that Russia has continued to build up its Gold reserves and at the end of July reportedly held some 726 tonnes, up 13.6 percent so far this year. With limited IMF sales next year, (they still have an estimated 92.7 tonnes to sell) and with European central banks perhaps refraining from selling, we would not be surprised to see central banks become net buyers in 2011. As of the end of July 2010, central banks still held 30,520 tonnes of Gold – this is worth remembering when we worry about sovereign debt as if the situation did become critical then central banks could turn to their Gold reserves to bail themselves out. Note how the Bank of International Settlements, BIS, completed a 346 tonne Gold swap in July with various commercial banks, whereby it lent them money and took Gold as collateral.
Central Bank diversification;-
Although the US dollar is likely to remain the World’s reserve currency for the foreseeable future, there are definite moves afoot by some countries to diversify their reserves. Leading the move is China, which has cut its holdings of US Treasuries and is buying Japanese bonds. At the end of June, China held $843.7 billion of US debt, down from the $938.3 billion peak seen in September 2009. China bought the equivalent of $20 billion worth of Japanese debt in H1’10 and officials suggest China may buy debt from its other Asian trading partners. China has often said that it is not looking to diversify into Goldas the Gold market is too small, however they could increase their holdings by buying a proportion of the country’s mine output. Even if China does not increase its Gold reserves, it does look as though other Asia countries are doing so and we would expect this trend to continue and perhaps spread to the oil producers too. China, Japan and Saudi Arabia only have 2% to 3% of their reserves in Gold compared to 62% in the Euro area.
Investment demand:-
Exchange traded funds (ETFs) have become a highly popular investment vehicle and are used across the spectrum of the investment community from retail investors, pension funds, to hedge funds and sovereign wealth funds. Interestingly as the chart shows, there have been few instances of large redemptions and the overall trend in the amount of metal held in the ETFs has been up. The financial crisis in 2008 saw a rapid increase in the size of the ETFs as did the sovereign debt crisis early this year. The amount of Gold held peaked in mid-July 2010 at 2,095 tonnes, redemptions during the recent rally in equities saw holdings drop to 2,046 tonnes, but then as fears rose in early August about a possible double-dip recession and the dollar started to weaken in September, the buying returned and holdings set a new peak at 2,106 tonnes. Investor interest is not just confined to ETFs, in recent years there have been unprecedented levels of investment in Gold bars and coins. In 2008, retail investment demand in Europe and North America jumped to 327 tonnes and climbed to 414 tonnes in 2009. By comparison the average level of buying in 2006 and 2007 was 50 tonnes. In early 2010, demand slipped as the fear factor in the markets subsided, but it picked up again once the sovereign debt crisis escalated. Sales of American Gold Eagle coins averaged 82,875 oz in the first four months of 2010, they jumped to 190,000 oz in May and averaged 164,500 oz in May, June and July, before dropping back to 41,500 oz in August.At some stage, once recovery is underway and the threat of inflation subsides, investors are likely to reduce their exposure to Gold in all forms and when that happens the Gold price is likely to correct significantly. However, this is unlikely to be an issue in the medium term as the risks of double-dipped recession, dollar devaluation and inflation, are still present.
The Futures market;-
The net long fund position has been climbing steeply since 20th July 2010 when the position stood at 178,307 contracts, it has since climbed 44% to 257,649 contracts as of late September. The downward sloping line joining previous peaks shows that the net long fund position has broken higher again. The two previous highs where at 244,725 contracts in late June 2010 and 262,331 contracts on 24th November 2009. What is noteworthy is that recent periods of long liquidation have not been particularly severe with the net fund position only dropping to around 170,000 contracts, avoiding the steep declines seen in early years of the bull market when the net fund long position would drop to around the 50,000 contracts. We think the market may be able to sustain an even larger fund long position as there is still a high chance that more QE will be seen and in turn that is likely to see more competitive currency devaluation.
Technical Outlook:-
Gold’s bull run continues, prices have just set new highs at around $1,387/oz and all thoughts are now on where the next peak is likely to be. This weekly chart shows the up trend line is strong and is shadowed by the 40 week moving average. However, the stochastic indicators, having been very strong, now look tired and therefore some consolidation seems likely in the short term. This would tie in with the spike up through the overhead resistance line connecting the 2008 and late-2009 peaks at around $1,322/oz – as such, we would not be surprised to see some consolidation in the $1,320-$1,360/oz range for a while. Since October 2008, the up trend line has provided support so over the medium term we would look for dips to run into support around the up trend line, which is last at around $1,215/oz and was last touched in late July. Further support should be available lower down at the 40 week moving average level around $1,190/oz. If a significant sell-off got underway (while the overall bullish picture remained intact), then we would expect solid support around the $1,050-$1,100/oz level. As for where the next peak is likely to lie, we would point to $1,440/oz as this is where the upper resistance line is currently at. Projecting that line forward would suggest prices could be up around $1,620/oz in twelve months time. As such, in the year ahead, we would be looking for a trading range between $1,050-$1,600/oz
Forecast & Conclusion;-
There are a multitude of factors influencing the Gold price, but one of the main reasons driving the bull market is all the uncertainty over the economic recovery and the legacy of the massive governments’ stimulus packages and bailouts mainly paid for with borrowed and printedmoney. At present this is reflected by the weakening dollar. So far despite all the governments’ efforts the recoveries in the US and Europe look fragile and are likely to need more government support in the months ahead. There is already talk that the Fed may be looking to inject another trillion dollars of QE. One of the concerns is that the actions being taken are debasing the dollar and encouraging competitive currency devaluation. As former ‘hard’ currencies tend towards losing value, faith in these fiat currencies is falling and as a result people are swapping out of fiat currencies and into Gold and other commodities with intrinsic value. Indeed this might be a reason why industrial metals are doing well even when the economic outlook is uncertain.
Overall, we do not think we are near the peak in Gold yet as we think the world’s financial problems are not over. However, the higher the Gold price goes the more volatile trading is likely to become and the more nervous investors and funds are likely to be. Another broad market sell-off could lead to a sell-off in Gold – possibly down to the $1,050/oz area, but again the increased fear of the consequences of another broad based sell-off could then see Gold prices shoot higher – indeed Gold could still become a bubble, either because of a deterioration in the economic, financial and fiscal climate, or because recovery gets going and that prompts fears of inflation as the governments around the world delay the start of monetary tightening.
We fondly hope that, at some stage, the problems facing the global economy (and the West in particular) will be solved and normality will return. When that process begins, safe-haven assets are likely to be sold, producers are likely, once again, to increase hedge selling and a good deal of the stock that has built up in allocated accounts at banks and in ETFs may flood back into the market. One can imagine what prices will do under such circumstances. There may well be some scares along the way that the end of the bull market is unfolding and sharp sell-offs are likely to be seen, but overall until robust private sector sustainable growth is seen we expect Gold’s bull market to continue. In the months ahead we expect increased volatility in Gold prices. Once real confidence returns and sustainable economic growth looks in place to the extent that governments’ finances will improve, we would expect rotation out of safe-havens and more appetite for risk, mainly through equities. Given that there are still some concerns over the possibility of a doubled dipped recession, that unemployment remains stubbornly high and house prices are still depressed, and there is still talk of more QE, we feel it is too early to think the worst maybe behind us. If we are in the eye of the financial storm then the next part of the storm may well be the one that leads to the end-spike up in Gold prices. There seems little point forecasting how high prices might go but we would not be surprised to see prices trading in the $1,500/oz -1,600/oz range, possibly spiking higher. That said, we would also think there is a chance that prices could be trading well below current levels in twelve months time
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