Price manipulation, limited supply, peer pressure buying, falling currencies and central bank buying are the top five factors analysts cite when discussing gold price movements. But not all these theories hold up to closer scrutiny, as gold prices in 2010 continue to push higher. See the following article from The Street for more on this.
Gold prices have risen 20% in 2010, closing Wednesday at $1,336.90 an ounce. Another round of quantitative easing from the Federal Reserve, global currency wars led by the “race to debase,” and a weakening eurozone have triggered gold’s recent surge, but those issues don’t tell the whole story.
Gold prices broke to a new record high last week of $1,424 an ounce as investors bought gold as protection against the Fed’s loose monetary policy, and as Robert Zoellick, president of the World Bank, floated the idea of a gold standard to solve exchange rate wars rocking currency markets.
Gold’s rally was fierce and short-lived. New highs failed to attract new money and momentum traders. No new money coupled with worries that China would raise key interest rates to fight inflation slaughtered prices and dragged them down 6%.
Most analysts believe the stage is set for more volatility in gold prices. Global uncertainty after the Group of 20 failed to come to an agreement on how to halt currency manipulation, of which China and the U.S. are both accused, establishes a choppy trading environment.
Gold is also at the mercy of stocks. When equities plummet, investors are often forced to sell gold for cash, but any significant dip can trigger a wave of buying as investors purchase gold at “discount” prices resulting in a strong tug of war for prices.
Prices must also contend with speculation. Some investors buy gold as protection for their portfolios and are unlikely to participate in the day-to-day market action. Traders, however, use gold as a trade, a quick way to make money, which has been aggravated recently as they must decide whether to let their December future contracts expire or pony up the cash to roll over the contract to February 2011.
Aside from recent market jitters and technical trading, there are five other fundamental factors that contribute to gold’s strong price moves.
5. Price Manipulation
Price manipulation is the most controversial theory that has circulated among gold bugs for 20 years. Some argue that gold prices have been illegally suppressed over the last two decades by central banks and governments. The Gold Anti-Trust Action Committee, or GATA, is the biggest complainant.
According to statistics from the World Gold Council, central banks reportedly have 32,000 tons of gold, with the International Monetary Fund accounting for 2,966.8 tons. Under the Washington Agreement on Gold, its members can sell a maximum of 400 tons a year, thereby restricting the amount of gold in the open marketplace.
GATA argues that central banks actually have less than 15,000 tons of gold, and that the missing gold has been secretly sold or leased into the market to prevent gold prices from rising to their actual value, which should be between $3,000 to $5,000 an ounce.
“The reasoning for the suppression is governments/bankers [look at] gold to be a barometer of the health of economies and countries. These suppressors want to kill or at the very least, greatly slow the messenger,” argues Peter Grandich, editor of Grandich Publications. The suppression theory means that global economies are in worse financial shape than investors think and that gold should be bought as the ultimate safe haven. Texas representative Ron Paul is planning to introduce a bill in Congress next year calling for an audit of U.S. gold reserves at Fort Knox.
The gold manipulation theory has been gaining traction of late after trader Brian Beatty filed lawsuits at the end of October against JPMorgan and HSBC for conspiring to “suppress and manipulate” silver prices on the Comex.
The allegations are particularly noteworthy because HSBC and JPMorgan are custodians of the physically backed exchange-traded funds like the SPDR Gold Shares(GLD_) and iShares Silver Trust(SLV_), which means the big banks are in charge of storing the metal investors are buying while being accused of manipulating the prices.
Bart Chilton, commissioner of the Commodity Futures Trading Commission, is pushing the commission to prosecute a two-year investigation into the silver market. According to reports, the CFTC is also looking into JPMorgan and possible silver manipulation trading.
The belief is that as investors realize that the precious metals market is manipulated, gold and silver prices will rise exponentially, but until then prices will suffer.
“Our complaint is that more often now they’re doing it surreptitiously as a mechanism of supporting their currencies, supporting government bonds and suppressing interest rates,” says Chris Powell, secretary and treasurer of GATA.
Powell also argues that manipulation gives the inside scoop for the investment banks who are working for the government and helping them execute their secret gold trades.
The opposition, however, believes that claims of price suppression are completely unfounded. “There’s no vested interest on anybody’s parts to suppress prices here,” says Jon Nadler, senior analyst at Kitco.com. “The allegations remain at that level, simply allegations.”
Nadler argues that despite the rumored price manipulation, prices have still quintupled in value over the 20 years. “If this is suppression, I think it’s completely ineffectual, and let me have more of it,” Nadler says.
4. Supply and Demand
The supply and demand factor is pivotal in determining the price of gold.
Many analysts argue there isn’t enough gold being produced to satisfy rising demand. The above-ground stock of gold is around 160,000 metric tons and grows about 2,400 tons a year, which is only 1.75% ,while demand keeps expanding.
In the World Gold Council’s recent Gold Demand Trend report, gold mine supply rose 3% in the third quarter from a year ago compared to a 12% rise in total global identifiable gold demand. Mine production grew to 702 tons while demand popped to 921.8 tons.
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Although mine supply only grew 3%, total supply grew 18% to 1,028 tons more than enough to cover demand. The amount of recycled gold in circulation grew 41% as consumers took advantage of high gold prices to cash in on their gold. The WGC says that another price surge, however, is needed to trigger more selling and that for now sellers appear to be tiring out, which would further limit gold supply.
From 2005 to 2009, the gold industry received 59% of its supply from mining production, 31% from recycled or scrap gold and 10% from central bank sales.
Juan Carlos Artigas, investment research manager at the World Gold Council, says that as central banks become buyers instead of sellers the supply picture loses 10% of its gold while simultaneously grappling with gold-producing countries that have exhausted their resources.
For example, South Africa produced 74% in the beginning of the decade but is now down to 19%. “What we’ve seen is that there’s a strong demand going on at the same time that the supply picture is shifting,” says Artigas. Weak gold grades in the third quarter also contributed to deteriorating supply from mines in Peru and Indonesia. Helping mitigate some of these losses were better grades and more gold from mines in Australia, Argentina and the U.S. run by Newmont Mining(NEM) and Barrick Gold(ABX). But the supply picture is still pretty much a mining and production crap shoot.
One factor that could perpetuate a supply and demand imbalance and higher gold prices is the advent of physically backed gold ETFs. Along with the GLD, the iShares Comex Gold Trust(IAU_) and ETFS Physical Swiss Gold Shares(SGOL_) hold more than 1,400 tons of gold, over half of annual gold production.
Over the past three years, cumulative supply has grown 59% while demand has surged 62%. According to Artigas, this imbalance has “created a fundamental support in the development of the gold market and, consequently, an environment of rising gold prices.”
This upward trend is expected to continue as investors seek ways to diversify their portfolio. “While there are many factors that affect the price of gold at any given point, the overall trend has been underpinned by the dynamics of supply and demand.”
One wild card that has the opportunity to reshape the supply and demand landscape is the end of big producer de-hedging. Producers are often required to hedge, lock in gold sales at a certain price, in order to secure project financing.
In order to get out of this obligation, the producer must buy back its hedges, literally buy gold. As big miners quickly tried to de-hedge as the gold price soared, massive tons of gold were literally taken out of the market.
In October, AngloGold Ashanti(AU_) announced the elimination of its last remaining 95 tons of hedges. The biggest hedger now is Avocet Mining with just 12 tons and it isn’t expected to buy back the hedges.
Without big gold companies frantically buying massive tons of gold, prices could lose a key support factor. Matthew Piggott, metals analyst at GFMS, says AngloGold’s action will force “the [gold] market [to] look to other areas of demand (such as investment) to make up the difference in the absence of price support from de-hedging activity.”
Jon Nadler, senior analyst at Kitco.com, who sees a top in the gold market within a year, says if the gold market had “not had that de-hedging component … we would be around $900 in gold [today].”
3. Safe Haven and Peer Pressure Buying
Traditionally, gold investing was reserved for gold bugs — those who thought global wealth would be eradicated and gold would be the only currency left standing.
However, as the financial crisis rocked global markets at the end of 2008, a trend started to develop of regular investors allocating a certain amount of their portfolios into gold. The GLD held 614 tons the Friday before Lehman Brothers declared bankruptcy and how holds 1,290 tons.
The recommended percentage is typically between 5%-20% depending on how aggressive the investor wants to be or just how much he needs to diversify against other assets. Most retail investors still don’t own gold, which is one of the fundamental reasons gold bulls think the price will skyrocket.
“We’re going to go into a period like the high tech market where there is a mania,” says Rob McEwen, CEO of U.S. Gold, who thinks the market is about half of the way there.
“Your curve is like any other area of the market that suddenly people wake up to and say I have to have it and it goes parabolic … at some point up there gold is going to achieve a point where its relative purchasing power relative to other assets is going to be at its zenith and that’s when you want to start thinking about trading out.”
This recent shift of gold as a trading tool as well as an investment was underscored by gold purchases from big-name investors who had profited off of the subprime crisis by betting against mortgage-backed securities.
In the fourth-quarter of 2009, legendary investor George Soros almost tripled his gold holdings in the GLD ETF from 2.5 million shares to 6.2 million as gold prices hit a then-record high of $1,227 an ounce. Sorossold over 547,689 shares in the third quarter of 2010 but is still the eighth-largest holder of the GLD and initiated a new position in IAU of 5 million shares.
The largest holder remains Paulson & Co., run by investor John Paulson. Paulson’s fund currently owns 31.5 million shares, which it has held for more than a year.
During the third quarter, large investment banks like Bank of America(BAC_) and JPMorgan(JPM_) loaded up on precious metal ETFs. JPMorgan doubled its holdings in the GLD to 10.3 million shares and increased its shares in the IAU by 3.8 million. Bank of America added 1.3 million shares to its GLD position and become the largest holder and biggest buyer of the silver ETF, the SLV, by adding 4.6 million shares bringing its total position to 12.3 million.
Big-name buyers like Soros and Paulson are significant as they can trigger peer pressure buying. When gold prices pop double digits on high volume, retail investors typcially will jump into the trade for fear of missing the opportunity.
Scott Carter, executive vice president of Goldline International, a seller of precious metals, says that “when there’s a spike in the price of gold, it’s somewhat counter-intuitive, but you see buyers increase into the markets. So it’s almost like the train is leaving the station … if gold goes up 1%, 2% in a day we’ll see a dramatic increase in the interest.”
On the flip side, when profit-takers sell gold for cash or the crisis premium decreases, momentum buying also slows as investors don’t want to be left holding “cheap” gold.
The advent of physically backed gold ETFs over the past six years has given investors an easy way of speculating on gold. One share of the GLD is equal to one-tenth an ounce of gold. If investors start piling into the ETFs, the funds must add more gold, taking more gold out of the open market and triggering higher prices. But the reverse is also true. If investors sell gold ETF shares en masse and there are no buyers, there will be inflows of gold into the market, which will weigh on prices.
Large swings in the gold price can also point to buy orders or sell stops. When the gold prices sinks to or rises to a certain level, a trader will be forced to sell or buy gold. This trading restriction is set up to protect the trader from losses and to protect gains, but often can accelerate sell-offs and rallies.
2. Currency Debasement
The most popular reason to own gold is as a hedge against inflation. The theory is as paper currency loses value, gold will retain its purchasing power, making it a safe place to preserve one’s wealth.
Historically, gold has traded in opposition to the dollar. A stronger dollar makes dollar-backed commodities like gold more expensive to buy in other currencies, which weakens demand.
Times of real market panic have altered the dollar/gold inverse relationship as both are bought as safe havens, an alternative to stocks and “riskier” currencies like the euro.
The Federal Reserve’s recent announcement of a $600 billion bond buying program, which kicked off Friday, led to an initial dollar selloff as investors dumped the currency to buy gold to protect themselves against the Fed’s printing presses. But this trade has been crimped recently as eurozone issues and contagion worries have weighed on the euro and pushed the U.S. dollar higher.
Investors were acting like the EU debt problems ended with Greece, but Ireland and Portugal are finding themselves on the chopping block with both countries having to defend themselves against bailout rumors.
The EU is trying to pressure Ireland into taking €80 billion in aid and Portugal is warning of a possible bailout risk as well. If the euro keeps sinking as investors dump the currency, the dollar will keep rising and keep putting pressure on gold prices.
Over the longer term, however, many investors expect the dollar to come under strain as the Fed’s printing presses debase the currency.
Inflation is currently low. The core Consumer Price Index was unchanged in October leaving inflation up 1.1% year over year, well below the Fed’s modest 2% target rate. If inflation stays low, the Fed could come under pressure to print more money to spur growth. Any moves like that would buoy gold as a safe-haven asset.
In the meantime, high inflation in other countries like China have investors worried that central banks will follow South Korea and raise interest rates. Any signs that governments will fight growing inflation will be a negative for gold, which is what triggered gold’s double digit sell-off on Tuesday.
The more pressing currency issue, at least in the U.S., is deflation as high unemployment is forcing consumers to save more, spend less and wait for prices to fall. Some experts say that gold will perform well even in a deflationary environment.
“If we have a severe bout of deflation, gold might actually, while falling, become a very decent reverse hedge,” says Nadler. “[That is] it could fall less than other asset classes would in such a situation. Let’s say stocks, and bonds and real estate.”
Whether deflation or inflation, the U.S. is currently more than $13 trillion in debt with $224 billion in interest payments due in fiscal year 2010 fueling rumors among doomsayers that the dollar will eventually be worth zero.
“Intrinsically, the dollar is worth nothing. It’s a dream painted on a piece of paper,” says Rick Rule founder of Global Resource Investments. Rule predicts higher gold prices in the future because the U.S. dollar will eventually depreciate in value. “There’s no particular reason why you, despite the fact that you live in the U.S., need to be a prisoner of the dollar … use gold money, export your capital.”
Recent talk of currency wars have also highlighted the fragility of the paper market. Countries like Brazil and Japan have been watching their currencies rise in value as speculative money looks for currencies with high yields. However, the downside is that these countries’ exports are more expensive to buy elsewhere which crimps their growth.
Other nations like the U.S. and China have been accused of forcing their currency lower to help their export growth. At the recent Group of 20 meeting in South Korea, countries agreed to promote global growth and avoid competitive currency debasement but couldn’t agree on any specifics.
Talk of currency and trade wars only boost investors’ lack of faith in paper money which will shine a light on gold’s appeal as a safe haven asset.
1. Central Bank Buying
Huge double-digit price movements in gold could mean that there are big buyers and sellers in the market like central banks.
“There has been a fundamental shift in the behavior of central banks over the past few quarters,” says Natalie Dempster, head of investment for the World Gold Council. “Central banks on the whole have been net sellers of gold for the past two decades.”
Since the second quarter of 2009, however, central banks from emerging market countries have transitioned into net buyers. The Reserve Bank of India has been actively buying gold from the IMF . India now holds 7.5% in gold reserves, which is still considerably lower than the 20% of gold reserves it held in 1994.
One of the biggest buyers is China. Over the past five years, the country secretly increased its gold holdings from 600 tons to 1,054 tons. China currently holds only 1.6% of its reserves in gold. Dempster says that if the continent were to reallocate its holdings to 3%, it would need to buy 1,000 tons of gold. Compare this with the U.S. and Portugal, which hold 70% and 80% of their reserves in gold, respectively.
China has said that it will not be buying anymore gold for its reserves, but is encouraging its citizens to buy and is opening up the gold trading market to spur demand. China, however, is unlikely to announce if they are buying gold for risk of triggering a rally in the price.
“Some banks like India,” says Dempster, “have been rebalancing as the percentage of gold in total reserves has fallen over time. Others are looking to diversify away from dollar-based assets, and with sovereign debt concerns continuing to grow around the world, gold’s attractiveness as a reserve asset that bears no credit risk continues to grow.”
In the third quarter, purchases by central banks outweighed sales by 21.9 tons according to the World Gold Council. Eurozone banks held on to their gold while Russia bought 46.2 tons, Philippines bought 4.2 tons, Thailand added 15.6 tons to its reserves and Sri Lanka increased its holdings by 6.9 tons.
Central banks in general regard reserve allocation as an ongoing government policy. Although the governments consider fundamentals like dollar weakness and the sustainability of gold as money, they don’t trade gold; they buy it as an investment. They will buy gold when they feel gold reserves are too low when compared to its other holdings.
Central banks tend to be price agnostic, but are heavy buyers and sellers.
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