Why the Gold Market Action is Not What You Think

It's been a tumultuous month or two for gold - and the world's financial media has taken note. The yellow metal was headline news as its price moved swiftly upward in late August and early September to reach a new all-time high of $1,923.70 on Sept. 6 in New York intraday trading. Since then, the decline has been even swifter with the price falling at one point on Monday, Sept. 26, by more than $120 an ounce to $1,580 in Asian trading.

The magnitude of gold's decline - about $344 an ounce from its September historic peak to its recent low point - seems stunning in absolute value terms. But, in percentage terms, it has lost "only" 18%, which historically speaking is not so unusual. At the time of the Lehman Brothers bankruptcy in 2008, gold fell more than 20% and, in the 1970s, gold corrected several times by 15% to 20% and once by some 30% in the midst of a great bull market that took the metal from one historic high to the next.

Gold's latest rout has been attributed by pundits and headline writers to a number of factors:

  • Some claim gold lost ground so quick as investors, seeking liquidity and a safe haven, rushed into US dollars as investors sought liquidity and a safe haven. And we all know that gold should move inversely with the greenback, right?
  • Others say the metal's price dropped as investors liquidated gold to cover losses and meet margin calls in world stock and bond markets.
  • Meanwhile, the uncertainty and political stalemate in Europe, as Greece moved closer and closer to declaring bankruptcy, received some of the blame for the sharp drop in world stock markets and, by extension, gold.
  • Similarly, a number of analysts pointed to the failure of Congress and the administration to deal effectively with America's Federal deficit and debt crisis . . . or to the outcome of the last Federal Reserve policy-setting meeting and the Fed's expressed concern that the economy is at risk.

I think these are mostly lame and somewhat timeworn excuses, the sort of analytical thinking that we hear whenever gold suffers anything from a minor one-day setback to a sharp price correction lasting weeks or months.

In fact, there was no widespread selling of gold, physical gold that is, by investors around the world -- just the opposite. Private investors in Europe, North America, India, China, and elsewhere were net buyers of gold over the past several weeks of gold-price weakness.

We have had almost daily reports from our well-placed gold-market friends in key world markets that demand for small bars and coins has remained fairly firm as buyers were attracted by lower price levels. Confirming a persistence of demand and the tightness of the gold market has been the high price premium for both large and small bars in the key Asian centers.

Driving Asian investment demand - in India, China, and elsewhere - has been the continuing rise in household incomes in tandem with worrisome inflation - and this pro-gold combination is unlikely to change in the foreseeable future.

Meanwhile, gold exchange-traded funds, a popular gold investment medium for some Western investors, both retail and institutional, have lost only about half a million ounces in the past few weeks, not much compared to the buying of physical gold and not as much as some feared or predicted in view of the "bad" press gold has gotten lately.

In addition, and very importantly, it is likely that central banks in the aggregate were also significant net buyers of gold in recent weeks, especially each time the price took a tumble. I believe that a few central banks - central banks that have been fairly regular buyers including Russia and China (which does not report or publicize its purchases) have stepped up their purchases in reaction to the lower, more attractive, price levels now prevailing.

So, who then, is responsible for gold's swift loss? It hasn't been retail and institutional investors selling physical gold in world markets. It hasn't been central banks selling their official reserve holdings.

Now - rather than any dramatic reversal in world physical markets - it looks like the precipitous price decline in the last few weeks can be blamed entirely on institutional speculators (including some prominent hedge funds, commodity funds, and the trading desks of the big Wall Street banks) who, as a group, sold or reversed their previous "long" bets that had contributed to gold's swift and steep ascent recently on the way up.

These institutional speculators trade in such large and leveraged volumes in futures, over-the-counter, and other derivative markets, utilizing momentum and other "black box" trading algorithms, that their collective actions can, for a time, simply overwhelm the actual ebb and flow of physical gold in world markets.

However, what governs the price of gold over the long term are the market's real-world supply and demand fundamentals - and these have been decidedly bullish and are becoming even more so.

Nothing that has occurred in the past few days in any way diminishes my long-term enthusiasm about gold-price prospects.

The same bullish gold-market fundamentals, macroeconomic trends, and other recent-year institutional and structural changes in the gold market per se (such as the introduction and growth of gold exchange-traded funds or the legalization of private gold investment in China) that we have been discussing for many years remain firmly in place and promise significantly higher gold prices over the next five years or longer.

Indeed, US and European economic prospects continue to deteriorate, suggesting we will see still more desperate monetary stimulus from the Fed and the European Central Bank (the ECB) before the end of this year.

Here in the United States, the Fed will be facing continued signs of renewed recession or recession-like business and employment conditions and their policy response is likely to be a third round of quantitative easing (QE3) or other program of monetary stimulus, possibly announced in early November following the Fed's FOMC monetary policy setting meeting.

Across the Atlantic, the ECB will still be struggling to prevent the approaching Greek sovereign debt default and the insolvency of some European banks holding Greek sovereign debt. Some fear this would be a catastrophe far worse than the Lehman Brothers bankruptcy - with dire consequences for the world economy.

Importantly, to the gold-price outlook, today's buyers, both private investors and central banks, are likely to be long-term holders. Much of this gold, once bought, is unlikely to be resold any time soon even at much higher price levels. For central banks, the holding period will be measured in decades if not longer. This promises less liquidity, more volatility, and much higher prices in the years ahead.

Jeffrey Nichols, managing director of American Precious Metals Advisors and senior economic advisor to Rosland Capital, has been a precious metals economist for over 25 years.

About the Author
Jeffrey Nichols

Jeffrey Nichols, managing director of American Precious Metals Advisors and senior economic advisor to Rosland Capital, has been a precious metals economist for over 25 years.

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