Squashing the gold bugs

The steepness of gold’s decline has taken investors by surprise, but there’s still plenty of potential overhang in the yellow metal's market.

Over the past fortnight the gold price has had its second precipitous fall this year, taking its decline since the start of April towards 25 per cent. As is now the case across most financial markets, the blame lies with the Fed.

The price first plunged in early April, diving from around $US1600 an ounce to around $US130 an ounce. After stabilising around the $US1400 an ounce level, over the past fortnight it has tumbled again, this time to below $US1250 an ounce.

The explanation for the direction of the price, if not the complete explanation for its magnitude, is obvious.

It was in early April that the markets detected a strengthening of the language being used by the members of the US Federal Reserve Board’s Open Market Committee when discussing an eventual exit from their QEIII quantitative easing program. The second wave of selling – and not just of gold – hit this month when it became clear, and was subsequently broadly confirmed, that the “tapering” of the program would begin later this year.

The market’s pre-emption of that tapering of the $US85 billion a month program of bond and mortgage purchases by the Fed has caused US bond rates to rise, equity markets to fall – and the dollar to strengthen.

There are direct and self-reinforcing correlations between the US dollar, US rates and the gold price. The rise in US bond yields amid signs of a strengthening US economic recovery pushes up bond yields and the dollar, which impacts negatively on the gold price.

It is the steepness of the decline in the gold price rather than its direction, however, that appears to have taken the markets by surprise.

After the April sell-off the gold market had settled as physical buyers returned. In the latest downward spiral, which has taken the price to three-year lows, there hasn’t been much evidence of physical demand.

That could be because central bankers aren’t adding to their reserves and the emerging pressures within China’s economy and other developing economies has impacted that demand.

On the sell side, in April there were massive outflows of funds from gold exchange-traded funds in line with a more general exodus of investors from commodity exchange traded funds.

Even after the gold price peaked at around $US1900 in September 2011 those funds had continued to increase their gold holdings until late last year, when they held about 85 million ounces before a relatively gentle slide that turned into a rout in April.

It would appear that the most recent sell-off is again due to ETFs and wealthy investors dumping their holdings in response to the Fed’s outlining the framework for a tapering of the QEIII program and then an eventual exit from it next year.

Gold has traditionally been used as a hedge against inflation and currency devaluations.

There is nothing to suggest that inflation is on the horizon – the Fed and the Europeans appear more concerned about deflation than inflation – but the US dollar is, as US interest rates have started to climb, on the rise and therefore the traditional supports for the price have been withdrawn.

The extent and rate of the falls is probably due to the extent of the ETF holdings but more broadly to the appetite for risk, and the leverage that was associated with it, when official interest rates in the US and Europe were close to zero and the central banks were pumping trillions of dollars a year of very cheap liquidity into the global financial system.

With rates rising and the prospect that the pumps will slow soon the markets have responded by attempting to pre-emptively, and almost instantly, unwind all the exposures to risk that have been built during the post-crisis period, when central banks have effectively injected about $US10 trillion of liquidity into the system.

With less than 20 per cent of the holdings of  gold ETF’s turning over so far this year there is potentially still a considerable over-hang in that market and presumably not dissimilar positions in other risk assets.

The good/bad news for gold bugs is that the fall in the gold price has had a leveraged impact on the share prices of gold miners, which have been smashed. The response of companies like Barrick and Newcrest has been to try to cut costs, stop loss-making or marginal production and reign in capital; expenditures.

At the margin supply will be more constrained than it was, which help in establishing some kind of eventual floor under the price, although it should be noted that five years ago the price was around $US800 an ounce, or about 35 per cent lower than it is today.

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