An enigma, wrapped in a puzzle, wrapped in gold

Gold is a mystery, though price setting has come a long way since Franklin Roosevelt's lucky numbers. And bugs are set up for disappointment in the near future.

A clever fund manager in the City of London says he will have a go at anything, except gold. “No one knows how it works,” he explains. The chairman of the US Federal Reserve, Ben Bernanke, is in the same boat: “I don’t pretend to understand gold,” he says. But for true believers in gold – known as gold bugs – it is the most lustrous of financial instruments. It is no surprise, therefore, that gold is a volatile market that encourages wildly contrasting expectations.

Presently the price is $1310 an ounce. The bears say the price is falling, and may go as low as $1000 an ounce. The gold bugs believe gold is seriously undervalued, and expect it to bounce back to $2400 an ounce in 2014. In real terms, that would be a record, beating the $2337 an ounce set over 30 years ago in 1980.

I was allowed to see the gold in the vaults of the New York Federal Reserve then, and I think I might have seen more money in one place than anyone since Croesus minted the first gold coin in the 4th century BC. (There is plenty of gold in the vaults of the Bank of England too, but they prohibit access to casual visitors such as me; indeed Mervyn King confessed that he himself found it difficult to get a look, and he was the Governor.) By 2001, however, the price had fallen to the other extreme at $352 an ounce.

Over time, various methods have been used to price gold. When President Franklin Roosevelt wanted to devalue the dollar in 1933 by increasing the price of gold, he would meet his closest advisors over a breakfast of boiled eggs in the White House to decide randomly by how much the price would increase that day. FDR was fond of raising it by 21 cents because three times seven is a lucky number.

A less random method of setting the price is the London Gold Fixing, which has been operating, with stoppages for war and the odd market crisis, since 1919. Initially, Rothschild’s, the Bank of England bullion dealer chaired the fixing along with four specialist bullion dealers in the City of London, but by the end of the century none had enough capital to finance sophisticated developments in mining finance.

Now the fix is operated by big banks: Barclays Capital and HSBC, Deutsche Bank, Societe Generale and Scotiabank. Until 2005, they met at Rothschild’s twice a day; but now the banks talk on a secure conference call. They reveal whether they are in the market to buy or to sell, how much they have on offer, and at what price. The balance sets the gold price.

Miners still produce the best part of two-thirds of the gold that comes on to the market (2455 metric tonnes in 2012). Despite rising prices in the past five years, gold-mining remains a precarious business. Many of the largest mines are on their last legs, and grades of fineness are falling. Gold towns like Kalgoorlie are accustomed to boom and bust. Good times and miners buy vineyards; in bad times, it’s back to tinnies.

The other third of the supply comes from scrap gold. Since 2009, as the price rose steadily this has been growing faster than mine production. Consumption has fallen since 2008, but still no less than 44 per cent of the gold supply in 2012 went into the jewellery business. Dentists still plug 40 tonnes of gold into the world’s mouths each year; and industry absorbs 400 tonnes.

But demand for gold as an investment is the single factor that most influences the price. The flow has more than doubled in the past decade, and for 20 years there has been a strong correlation between investment demand and the gold price. In 2008, the banking collapse had a direct impact on the rising price; it created uncertainty at a time when interest rates stayed very low and quantitative easing in London and Washington was inflating the prices of assets such as gold. India and China were also keen players in the market.

With prices rising steadily, it was a wonderful time to be a gold bug. But in April this year, the price plunged by $200 in two days, which was described, extravagantly perhaps, as the most extreme fall in bullion prices in 5000 years. The bugs suspected they were the victims of a conspiracy, arguing that industry-bodies like the World Gold Council were deliberately understating the total gold supply by as much as 3000 tonnes a year.

They are clutching at straws. Long-term analysis of the gold market suggests that what counts most is the trend in real US interest rates. During the fall in interest rates between 2008 and 2012 the gold price rose by 167 per cent. Last April the economic indicators in the US perked up; bond yields improved and liquidity got tighter; and the price slumped.

If the analysts have correctly read the runes, this means that a gold price of $1000 an ounce is more likely than a record $2400 an ounce. The smart advice in the City is to stick with the bears for a while, and hope that the bulls may be back in 18 months or so. Of course, it might be smarter still not to pretend to understand gold at all, and to stay away.