Four Reasons Gold Won't Rally

PORTFOLIO POINT: Gold has come off its recent highs, and global economic factors are likely to tarnish its investment status.

Is gold a commodity or a currency, a safe haven or risk asset?

We could get all Heisenberg here and suggest it’s all of the above at the same time, but price movements over recent years suggest gold behaves differently at different times. What is likely frustrating gold investors at present is that gold does not seem to be playing by the rule book it established from 2009 into late last year.

Gold is mostly labelled as a “commodity”, yet its industrial use is barely worth noting. Some two-thirds to three quarters of the world's annual gold production is fashioned into coins or jewellery, so there is little suggestion gold is a consumable. The remainder is set aside as the collateral backing for exchange-traded fund positions, or acquired by central banks as a means of currency-backing.

On that last point we could argue that gold is more of a currency in its own right than a commodity – the “true” currency that provides value to paper currency. Since the gold standard was abandoned in the 1970s gold’s only direct connection to currency is that it is an alternative to paper, such that a devaluation of a paper (fiat) currency in turn implies a rise of the price of gold in that currency.

However that would be to imply the price of USD gold must always fall when the USD rises, yet this is not always the case. If the demand for gold exceeds this simple mathematical relationship, both the USD and USD gold can rally simultaneously.

Gold is seen as a store of wealth, and thus a hedge against inflation. This takes us back to the currency relationship, given both monetary and price-push inflation effectively devalue a paper currency. Yet, once again, gold can suddenly run the other way even when inflation becomes a threat.

Gold is also seen as a safe haven – a place to store your wealth in times of crisis when risk assets threaten to collapse in value. If this is the case, then gold should be the opposite of a risk asset, yet often it behaves like one. In the past few years when some new disaster has befallen, from Lehman to Greece, from the US downgrade to a jump in Spanish bond yields, gold’s initial reaction has been to fall in price along with stocks, commodities and other risk assets. Some safe haven.

These little gold-dumping episodes are nevertheless mostly short-lived, and typically reflect a sudden need for leveraged holders of risk assets to raise cash to cover margin calls. Gold bulls recognise such activity and tend to stand aside as they occur, waiting for a new and more valuable entry point. And at the end of the day, the price of gold now is a lot higher than it was in 2008.

If you had to identify one reason why that is the case, the answer would be money printing. Since the GFC global central banks have thrown an enormous amount of monetary stimulus into the mix, which equates to paper currency devaluation. If all currencies are being devalued simultaneously you won’t see much change in exchange rates, but you will see an increase in the value of gold. Hence, while gold has, over the past few years, exhibited some sort of multiple personality disorder in that it can be a safe haven one day and a risk asset the next, implying a currency one day and commodity the next, realistically gold has proven a net safe haven against monetary inflation over that period.

But gold has also been a lot higher in value than it is now. It traded over US$1,900/oz late last year but is wallowing in the low $1,600s at present. Its value has thus fallen over 15% in USD terms at a time when the threat of Greek exit from the euro – maybe even the complete fracturing of the eurozone – has been as great as it has ever been. As late as last week, global central banks were again declaring their readiness to start pumping fresh printed money into financial markets, were the situation to worsen. On the 2009-11 experience, gold should now be higher than it was last year. But it isn’t.

Chart 1: Spot gold price over six months
Source: www.goldprice.net

Why not? RBS precious metal analysts have offered a few reasons.

Firstly, it appears the “ever-bull” argument has finally met with historical reality. No market can go up forever (just ask American homebuyers who held such a view in 2006), and gold has been rallying consistently since the turn of the century with little in the way of interim correction. The big fall from late last year to now represents the first decent correction in that time, and this would suggest the rally’s time had finally come. But again, why now?

Well secondly, RBS suggests those wishing to establish monetary hedge positions have had plenty of time to do so are now probably done. A market can only keep rising as long as new buyers replace old buyers. If the pool of new buyers runs out, then the price cannot rise further. It won’t fall much either, because established positions will be left alone rather than liquidated. So we’ve had our big multi-year rally, and by early this year we started to run out of buyers. A correction ensued, and now we seem to have stabilised once more.

Barclays notes gold ETF positions are little changed despite the recent price fall.

Thirdly, the inflation everyone was expecting is yet to appear. If anything, global inflation numbers have been falling on financial deleveraging just as quickly as central banks have been doling out the fresh banknotes. Even China now has its price-push inflation under control. Hyperinflation? That seems very distant, if it’s going to happen. Maybe the accumulation of gold, which pays no interest, might now hold back until actual inflation does really appear.

I’ll add a fourth reason. Over the consistent 21^st century rally, every now and then gold has gotten a little ahead of itself – pulling away from the trend line before inevitably falling back again. Aside from central bank gold movements, this has reflected the price of gold jewellery occasionally running away from the spending capacity of the middle class Chinese and Indians who are the dominant buyers.

A combination of that price pullback and further runaway emerging market growth have allowed buyers to reappear after a period, thus ratcheting up the gold price over time. Right now the pace of growth of both the Chinese and Indian economies has subsided and jewellery demand has eased off.

And maybe a fifth reason why gold is not rallying right at this very point of time is that no one’s quite so sure what central banks are about to do. There’s been speculation all year about QE3 from the Fed, but yet no QE3. Maybe that will change this week, but no one’s quite sure. The ECB has just pumped money into Spain but if Greece is not exiting the euro, will it now back off too? Combine the uncertainty of whether that much more currency devaluation is in the offing with the lack of inflation argument above, and we can begin to see why gold is not quite the definitive safe haven it has been in past years.

“What exactly has changed and why it has done so is not entirely clear,” suggest Macquarie’s commodity analysts, “but as is the problem with gold, trending models tend to work until they do not. Forecasting this change in behaviour seems to be a fool’s game, as reasons for changes may be totally counterintuitive to the prevailing wisdom at the time”.

RBS believes gold could very quickly return to its safe haven position with haste, were the next crisis to be a little more ominous than the recent ones. Were a member to depart the eurozone, or were the eurozone to break up altogether, would be one possibility. If the US returned to the debt debacle of last year – which it surely must do soon given the approaching election – this, too, could send gold running.

In the meantime we await the Fed’s next move, or lack thereof. There is little clarity in Europe with regards to Greece or anyone else, so the world is a bit wait-and-see.

Greg Peel is a writer for FNArena, an online news and analysis service.

Readers should note all names are mentioned for educational and informational purposes only. Investors should always consult with a licensed professional before making investment decisions.