GOLD WILL CONTINUE TO BE DRIVEN BY UNCERTAINTY
EVEN as euro-dollar traded around its lowest level in 22 months, global stock indices managed to stage a small rally last week. Although it is wise not to read too much into this divergence, it marks a break from the positive correlation between the single currency and stocks to which we have grown accustomed. One explanation for this could be the expectation of further intervention from the European Central Bank (ECB). Anything which raises euro liquidity will hurt the currency while supporting risk assets. Of course, gold should also benefit should investors convince themselves that additional central bank stimulus is on its way.
After a strong start at the beginning of the year, gold has fallen sharply over the past few months. Equities have too, of course, but gold has fallen around 15 per cent from its February high while the S&P 500 is down a more modest 7 per cent from this year’s best levels back in March. In both cases, prices rose as the full impact of the ECB’s initial Long-Term Refinancing Operation (LTRO) was absorbed. But now it feels as if gold and equities have further to fall in the absence of further central bank intervention.
Of course, central banks also buy and sell gold, and their changing behaviour is one of the biggest fundamental drivers for future price action. For over 20 years, central banks were net sellers of bullion, but became net buyers in 2009. The central banks of developed economies, which hold significant proportions of their reserves in gold, stopped selling. Meanwhile, emerging market central banks, which typically have only a small percentage of their foreign exchange reserves in gold, are rebalancing their reserves in gold’s favour. Noting the persistent budget deficits that the US and other developed countries are running, there is a wish to diversify out of dollars as well as other fiat currencies.
If central banks continue to be net buyers, then gold should find strong support, at least as far as the physical market is concerned. However, the paper (futures and forwards) markets dwarf the physical in terms of the outright number of ounces traded each day. In the short-term, the movements in the gold price correlates closely with those of other risk assets. Leveraged investors, such as fund managers and speculators, use the futures market and exchange-traded funds (ETF). These instruments are typically traded on margin. Consequently, if equity markets experience a sell-off, there is usually a rush to liquidate all margined position to raise cash and limit future losses. Gold has been caught up in these sell-offs before, and it is likely to happen again. On the other hand, physical buyers tend to be long-term holders who have made the decision to own gold because it offers a method of wealth preservation. They view it as a store of value and a medium of exchange. It cannot be devalued as it cannot be created by the press of a button as currency and debt instruments can. It therefore makes up an important part of many investment portfolios.
Many analysts believe that gold was in a bubble which has now popped. They argue that it is an unproductive asset as it yields nothing and pays no dividend. But others say that gold is nowhere close to bubble territory. They note that when adjusted for inflation, the previous record high of $850 achieved back in 1980 would price gold at around $2,400 today. Gold bulls also argue that it is destined to rise much further than this, as the default reaction by developed world central banks is to inject liquidity into the markets through quantitative easing and asset purchase programmes. In addition, as every country seems intent on boosting growth by cheapening their currency to encourage exports, this simultaneous devaluation of fiat currencies can only boost gold’s appeal. Yet one thing is for certain – gold will remain volatile for as long as economic uncertainty continues to grow.