Summary: Falls in the gold price are not unexpected as US rate hike expectations firm. But physical demand for gold is strong as demand for jewellery in India rises and US retail investors buy coins and bars. Central banks are also accumulating gold, seeing it as a store of value as some countries print money.
Key take-out: Although the gold price is still falling, strong demand suggests a limit to how much lower gold can go.
Key beneficiaries: General investors. Category: Gold.
The US Federal Reserve is set to tighten in December, according to current market pricing. While I certainly hope they do, I’m very sceptical that they actually will. Regardless, key asset prices have reacted to the perception and heightened expectations.
Chart 1: Price of gold
As chart 1 shows, the gold price is falling in US dollar terms (blue line) and while it may get a bit of a boost following the latest terror attacks in France, the trend has been/is down. In Aussie dollar terms, the price has been much more stable and has even increased over the year as the currency tumbled.
From a market perspective, a weaker gold price isn’t unexpected. The two main reasons that gold is expected to fall as rate hike expectations firm are:
- As rate hike expectations firm, the US dollar lifts. Given that commodities are priced in US dollars, they tend to decline to keep the cross currency price reasonably steady.
- The second has to do with inflation and money as a store of value. If the Fed is printing money and destroying the value of money over time, then people buy alternative stores of value like gold, property, art etc. Conversely, if the Fed is seen as adopting a more prudent policy stance, the price of gold falls.
These relationships are all loose obviously. None are perfect but these are some of the major influences. It is what has been driving the gold price recently.
I’ve stated before that I’m a fan of gold over the long term and regard it as a good investment in any well diversified portfolio (especially in Aussie dollar terms), if just as an insurance measure and a store of value.
Understandably though, some investors, even long-term investors, may not share that view. It’s reasonable to be nervous of holding it in the face of what could be a sustained tightening cycle. Notionally that’s an incredibly bearish influence.
Two points though: Global inflation is incredibly low, it’s at a cyclical low actually. Viewed that way the gold price has held up well. Yet the fact that inflation is at a trough, driven down by temporary influences, suggests that at some point as inflation rises, gold will get additional support as an inflation hedge.
Secondly, the commencement of a tightening cycle in the US, assuming that does occur, need not see a sustained fall in gold. So if you take another look at chart 1, you’ll actually note that at the time of the last tightening cycle, back in 2004, gold pushed higher in both US and Australian dollar terms. There is a good reason for that – inflation was also pushing higher.
As you can see then, taking a view on gold is a little more complicated than noting higher rates and then assuming the gold price will fall.
That’s especially when the actual, physical demand for gold is incredibly strong.
On the latest figures, the World Gold Council report that total gold demand rose by 8 per cent in the September quarter, compared to the same time last year. That’s extraordinary growth and is at odds with the price action. Gold prices fell by about 8 per cent over the same period.
That kind of price action backs my point that the commodities market, the extent of the price falls that we’re seeing, isn’t really reflective of the fundamentals. If it was, the gold price would have increased! It’s not like supply is booming.
In some ways we are simply seeing real users of gold start to respond to weak prices. With gusto in some cases. Total jewellery demand for instance was up 6 per cent, driven by a surge in demand from India in particular.
This is important, because while jewellery demand may not be the big swing factor when it comes to the gold price (given its comparatively stable demand), jewellery is still the single biggest market or end gold user. To see such a big increase in growth reveals a perception that gold is very attractive at these levels.
Interestingly, one of the largest increases in demand came from investors. This component was up by 33 per cent – for the strongest seasonal gain in three years. It might surprise you to find out where a good chunk of that growth came from: US retail investors buying coins and bars! Demand from that sector surged by some 200 per cent – the strongest since the financial crisis hit. Otherwise, investment demand from the more traditional markets, India and China, was solid as well. Especially in China with investment demand up 70 per cent.
It’s not just consumers and investors either. According to the World Gold Council: “Central banks and other institutions accumulated an impressive 175.0t of gold in Q3 2015, the second highest quarter of net purchases on record. While this marked a 3 per cent year-on-year decline, Q3 last year was the highest on record at 179.5t.”
Now it is the developing nations driving this demand, Russia and China in particular, but this should be expected. They hold comparatively tiny holdings of gold compared to the US and many European nations. So when analysts suggest that this growth is fleeting because it is driven by developing nations, I don’t think that is quite right. If anything, the real risk is that this growth accelerates further as the per capita incomes of these nations grow.
In a world of fiat money – where the US, UK, Europe and Japan are or have been printing money, why would any country want to hold those currencies as a store of value? Gold is the prudent choice for any central bank.
The signal is clear – the idea that gold is unloved is pure tripe. Central banks, real investors and consumers still view gold very positively. Far from dumping gold or trying to reduce holdings, demand is very strong, and the signal being sent is that at its current price, gold is very attractive.
We can’t say that gold has hit the bottom. The price was still falling in the face of this very strong demand. Yet it does suggest a limit to how much lower gold can go.