Sleep easier on gold's currency cushion

Buying a fistful of US dollars is one way to hedge against what many investment analysts see as the inevitable fall in the value of the Australian dollar, although there is an easier way that also eliminates country risk: buy gold.

Even investors with a deep-seated dislike for gold are forced to acknowledge its role as a universal currency. It is a status recognised by most of the world’s central banks, which not only hold much of the world’s gold but continue to buy it.

The latest central bank gold buying, as monitored by the World Gold Council, shows a diverse range of countries prepared to allocate part of their financial reserves to the acquisition of more gold. These include Russia, which snapped up 12.2 tonnes in January, and South Korea, which bought 20 tonnes last month.

Perhaps even more interesting was the lack of selling by the International Monetary Fund and a group of European central banks, which had cut their gold exposure in the 1990s. This was until they entered into an agreement to only sell 400 tonnes a year during fixed five-year terms, with the latest sales window running from 2009 to 2014.

In the first year of the current “selling season” the IMF and several European governments sold 136.2 tonnes of the agreed 400 tonnes, but over the next three years sales volumes dropped away sharply, from 53.3 tonnes in 2010 to 5.9 tonnes in 2011, 4.2 tonnes in 2012, and nothing so far this year. And the gold sales agreement is not cumulative, meaning it’s a maximum of 400 tonnes in any year with no roll-over effect.

The fact that the world’s central bankers have faith in gold as an investment is an interesting comment on how they structure their portfolios. The banks also have been adding Australian dollars to their assets, and while Australian investors have local dollars in abundance they also ought to be considering broadening their investment spread to include assets such as gold ahead of a substantial exchange-rate correction, especially against the US dollar.

That’s when gold comes into its own, because it is widely traded in US dollars and might even be seen as a proxy for the American currency. It is also an asset that is widely available, highly liquid and beyond the reach of government interference.

So, if well-credentialed market observers such as Eureka Report’s Adam Carr can see the Australian dollar neither rising nor falling sharply (see today’s article The dollar’s medium-term comfort zone), but destined to depreciate against the US dollar once that country’s central bank starts to raise interest rates, then gold comes into its own as a useful hedge against currency loss – even if the gold price itself loses some of its gloss.

This was a theme I examined before Christmas (Gold warning bells chime), and as recently as last month (Gold meltdown comes with a currency chaser), when pointing out that gold was in trouble as the global economy continued to show signs of a sustainable recovery.

That argument has been tested over the past few days as Europe’s recession shows signs of morphing into a depression and investors in that region, especially Cyprus where a raid has been launched on bank deposits, are shifting their funds out of the euro into US dollars, gold, and possibly even the Australian dollar, which remains stuck around $US1.03.

Playing a daily currency game is not the best way to see gold, which is really a long-term insurance policy against the type of short-term fluctuations that are affecting all government-issued currencies.

That’s why Australian investors who hold gold (such as me) are relaxed about the outlook for the metal, because it is behaving as a perfect hedge against the day the Australian dollar drops.

Today, with the gold price back up to $US1,606 an ounce, and the Australian dollar at $US1.0368, the Australian gold price is $A1,549/oz.

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A fall-back by the Australian dollar to parity with its US cousin (and these calculations are easy to make) boosts the Australian gold price to $1,606, a 3.7% increase in value as the “gold insurance policy” kicks in.

A significant drop in the Australian currency against the US dollar produces even more interesting numbers, with the local gold price at an exchange rate of US95c translating in $A1,690/oz, while US90c boosts the local gold price to $A1,784/oz, a 15% increase on the current level.

At an exchange rate of US80c, the Australian gold price does something even more eye-catching. It scales the $A2,000/oz mark, with today’s gold price of $US1,606 translating into $A2,007.50, a 29.6% increase on the current local price.

It is possible that both the Australian dollar and gold will fall at the same time, when (rather than if) the US eventually starts to increase interest rates. But in that situation it is likely that an Australian investor holding gold will be cushioned by the common decline. It is the cushioning effect that underlines the key point about gold.

In the current climate of ongoing economic uncertainty gold is behaving as an insurance policy against unpredictable government policies, such as the savings account raid being mounted on Cypriot bank accounts. This is an event which could accelerate a shift by European investors into alternative asset classes beyond the reach of government – such as gold.