Why central banks are loading up on gold

Summary: Gold has been flat for some time, but that hasn’t stopped heavy buying activity.

Key take-out: The metal is being seen as a hedge against the US dollar, but price forecasts are mixed.

Heavy selling by investors has knocked $US150 an ounce off the price of gold since mid-April, though who’s actually buying gold at a time of rising US interest rates is perhaps more interesting than who’s selling.

The big buyers, who snapped up 193.3 tonnes of gold in the first six month of the year, are the world’s central banks, led by Russia, Turkey and Kazakhstan, with help from India, Thailand and Egypt.

Central banks, according to the World Gold Council, now hold $US1.36 trillion worth of gold, roughly 10 per cent of global foreign currency reserves.

That central banks hold a large amount of gold is well known, but the fact that they’re still buying sends a powerful signal to the rest of the investing world that it’s important to have a diversified portfolio.

What the banks have been doing is to put a little more distance between their reserve capital and the currency which dominates global trade, the US dollar.

The banks are, in effect, increasing their hedge against a future possible fall in the value of the US dollar, an event which can’t be accurately predicted but is one that looks likely sometime next year, if only because the dollar has been exceptionally strong this year.

For the average investor the benefit of exposure to gold might be marginal, but for anyone thinking of putting a currency-hedge in place, a policy of following the central banks is not a bad one.

Follow the money?

Several years ago, Mark Creasy, a man who made the first part of his substantial fortune by exploring for and discovering gold, gave a valuable piece of investment advice when asked when was the right time to buy gold.

“Follow the central banks,” Creasy said, a comment based on the same principle of knowing when is a good time to buy property – follow the people who already own a lot of property.

The theory is that anyone with deep exposure to a particular asset class almost certainly knows more about that asset than anyone else, which means they buy when the price looks low and sell when the price looks high.

In the case of gold, the price trend has been down for the past seven years during which it has tumbled from $US1821/ounce to its current $US1194/oz. The biggest influence during that time has been the value of the US dollar or, more specifically, official US interest rates.

When US rates fell to near zero it made as much sense to own gold, which does not pay interest when held in its bullion form, as it did to own US Government issued Treasury Bonds.

But, as US interest rates rose, a switch became attractive, and is becoming more attractive as the US central bank “normalises” interest rates via a series of well-telegraphed increases.

In theory, now is a time when owners of gold should be selling, which many are, but that’s not the case with the biggest owners of gold, the central banks. They work on a different time scale to most investors and appear to be looking through current trends to what lies ahead.

Goldmining companies also appear to be using this year’s downturn in the gold price to start building for the future, with the $US18 billion merger of international gold majors, Barrick Gold and Randgold Resources, just one example of a significant increase in corporate activity in the gold sector.

Locally, there have been expansion moves by Ramelius Resources, which is bidding for Explaurum, and Regis Resources proposing a share-swap takeover of Capricorn Metals. Before that there was a major international expansion move by Northern Star, which acquired the big Pogo goldmine in Alaska from its Japanese owners.

Mixed gold forecasts

Investment banks are divided on the gold question. Citi has cut its forecast near-term gold price by 6 per cent, but still sees a price recovery from its current $US1194/oz to $US1270/oz next year. The Australian gold price is tipped to rise further to $1794/oz, thanks to the effect of a decline in the value of the Australian dollar.

Morgan Stanley also believes gold and silver will rise next year “as the period of US dollar and equity market strength comes to an end, prompting capital flows back into precious metals”.

Macquarie sees the current downward pressure on the gold price as much to do with a surplus of gold in the global market as the strength of the US dollar, but it has identified one “unambiguously bullish signal for gold” – the hefty pace of central bank buying.

As well as noting continued buying by Russia, Macquarie saw significance in the growing list of other central banks buying gold.

“We looked at what this means, and concluded that the more aggressive US government might be making foes and friends question their reliance on the US dollar,” Macquarie said.

Whatever the reason behind the current state of the gold market, it is perhaps significant that the metal hasn’t fallen further than it already has as the US interest rate cycle normalises.

What happens next is the interesting phase of the gold market and it seems that central banks believe the low price today makes for good buying ahead of a potential price rise as the US dollar runs out of steam next year.