A QE flipside for gold's lost lustre

Gold traded below $US1200 an ounce overnight – the lowest level in three years – on its way to its first annual loss this century and more than 37 per cent below its peak just over two years ago. Blame the Federal Reserve board.

It has been obvious through this year that there has been a very direct correlation between the market’s readings of the Fed’s intentions in relation to its quantitative easing program and the gold price, among other financial assets.

In April, when the minutes of the Fed’s March Open Market Committee meeting were inadvertently released early, the gold price plunged in response to the musings of committee members about the prospect of reducing the scale of the Fed’s bond and mortgage purchases before the end of this year.

Last week, of course, the Fed announced that it would begin the ‘tapering’ of those purchases – from $US85 billion a month to $US75 billion a month – in January. Not surprisingly the gold price began falling sharply, again.

The obvious explanation for the more recent sell-off is that the Fed’s move is a vote of confidence in the US economy, which is now developing discernible momentum. Moreover, that growth is occurring without any impact on US inflation, now running at a negligible 1.2 per cent.

Despite the years of pumping cheap liquidity into the US financial system in response to the global financial crisis, inflation is still not an issue and therefore gold’s role as a hedge against inflation has been undermined.

The decline in the gold price over the past two years – it peaked above $US1900 an ounce in September 2011 – might have been even more pronounced had it not been for strong demand out of China and India. With India trying to rein in a current account deficit by continuously raising import duties, and China now battling a credit crunch, those sources of demand have waned.

There may, however, be another less traditional factor at play.

When the gold price plummeted in April it coincided with – and was exacerbated by – a massive sell-off by gold exchange-traded funds. On some estimates there were net sales by ETFs of about 480 tonnes of gold – which equates to about 20 per cent of annual mine supply – in only two days.

Gold ETFs, invested by Australian Graham Tuckwell who listed the first of them in 2003, only really came to the fore in the post-GFC environment. When financial markets began their recovery in early 2009 the commodity ETFs sector also exploded.

That connection is almost certainly not a coincidence. A consequence of the Fed’s quantitative easing programs, not entirely intended, was that it drove investors out of low-yielding bonds and towards higher-returning and higher-risk assets around the globe, creating a rolling series of massive carry-trade opportunities for hedge funds and other institutional investors.

That pushed equity and commodity prices up, and gold down, as investors became less concerned about inflation or security than they were with positive returns.

Perhaps exaggerating the impact on gold were popular post-GFC trades that involved shorting the US dollar, or Japan’s yen, and going long gold. When the gold price started falling, those trades had to be abruptly unwound, amplifying the fall in the price.

The role of the ETFs in the decline can’t be precisely defined but they have sold more than 800 tonnes of gold this year. Gold used to be expensive to store and insure and to hedge the currency risk.

ETF’s, given that there are funds that have purely synthetic exposures, have provided far more liquidity to the market – and leverage – which helps explain why the price has been volatile and the fall precipitous.

With the Fed committed to maintaining US official rates at their current levels of close to zero, and still pouring $US75 billion a month into bond and mortgage markets to keep market rates low, there is no relief in sight for the gold producers who have been decimated by the severity of the fall in price, nor for investors, unless there is an unexpected surge in inflationary expectations.

The prospect of a rebound may, however, lie in the ‘flipside’ of the Fed’s policies and similar exercises in Japan and Europe.

By forcing investors to pursue positive returns by accepting more risk, there is a very real chance that the Fed and its counterparts have helped create a series of asset price bubbles. If that is the case, at some point those bubbles will have to deflate – with potentially unpleasant consequences – and that would be the point at which gold might swing back into favour.