Gold - A Perfect Storm For 2019

This article is an overview of the principal factors likely to drive the gold price in 2019. It looks at the global factors that have developed in 2018 for both gold and the dollar, how geopolitics are likely to evolve, the economic outlook and how it is worsened for the dollar by President Trump’s tariff war against China, the availability and likely demand for bullion, and the technical position in paper markets. Taken together, the outlook is bullish for gold.

2018 reprise

For gold bulls, 2018 was disappointing. From 11 December 2017, when gold made a significant bottom against the dollar at $1243, it has ended virtually unchanged today, after being 4.2% up. Gold had to struggle against a rising dollar, whose trade-weighted index rose a net 3.7% over the same period, and as much as 9.4% from its mid-February low.

Dollar strength has been driven less by trade imbalances and more by interest rate differentials. A speculating bank for its own book or for a hedge fund client can borrow 3-month Euro Libor at minus0.354% and invest it in 3-month US Treasury bills at 2.36%, for a round trip of over 2.7%. Gear this up ten times or more, either on a bank’s capital or through reverse repos for annualized returns of over 27%. To this can be added the currency gain, which at times has added enough to overall returns for an unhedged geared position to double the investment.

Not that these forex returns have been guaranteed, but you get the picture. The ECB and the Bank of Japan have been frozen into inactivity, reluctant to raise rates to correct this imbalance, and the punters have known it.

Financial commentators have routinely misunderstood the fundamental reason for the dollar’s strength, attributing it to foreigners’ desperate need for dollars. In fact, non-US holders of dollars hold it in record amounts, with over $4 trillion in deposits in correspondent bank accounts alone, and a further $930 billion in short-term debt.[i] This $5 trillion of total liquidity was the last reported position, as at end-June 2017. Speculative dollar demand since then, driven by interest rate differentials, will have added significantly to these figures. The continuing US trade deficit, currently running at close to a trillion dollars annually, is both an associated and additional source of dollar accumulation in foreign hands.

Meanwhile, the same US Government data source reveals that US residents’ holdings of foreign securities was $6.75 trillion less than the foreign ownership of US securities, and the US Treasury reports that major US market participants (i.e. the US banks and financial entities operating in the spot, forwards and futures contracts) sold a net €2.447 trillion in the first nine months of 2018. Assuming these sales were not absorbed by official intervention on the foreign exchanges or by contracting bank credit, they can only have added to foreign-owned dollar liquidity.[ii]

To summarise the point; far from there being a dollar shortage, as market participants believe, the world is awash with dollars to an extraordinary degree.

The great dollar unwind is now overhanging markets, which will remove the principal depressant on the gold price. And when it begins, as a source of supply these hot-money dollars will be seen as the continuation of escalating supply, with the prospect of future US trade and budget deficits to be discounted. These dynamics are a duplication of those that led to the failure of the London gold pool in the late-sixties, which led to the abandonment of the Bretton Woods gold-dollar relationship in 1971. And as I argue later in this article, the supply of physical liquidity in bullion markets to satisfy demand arising from dollar liquidation is extremely tight.

Geopolitics and gold in 2018

It is likely that at a future date we will look back on 2018 as a pivotal year for both geopolitics and gold. Russia has moved to a position whereby it has substantially replaced its dollar reserves with physical gold. It is now able if it should care to, to do away with the dollar entirely for its energy exports payments. It is even possible for it to link the rouble to gold.

China took the seemingly innocuous step of launching an oil contract denominated in yuan. It had prevaricated since at least 2014 before making this move, presumably conscious that it was an in-your-face threat to the monopoly of the dollar in pricing energy. 

There was an expectation that the oil-yuan futures contract would be a segway into a yuan-gold futures contract either in Hong Kong or Dubai, allowing countries such as Iran to avoid receiving dollars entirely. And indeed, a number of gold exchanges and interests in Asia have banded together to open a 1500-tonne vault in Qianhai to facilitate gold storage resulting from pan-Asian trade flows. 

These include the China Gold and Silver Exchange Society, the Hong Kong Gold Exchange, and gold market interests in Singapore, Myanmar, and Dubai. The objective is to give Hong Kong the opportunity to coordinate Asian gold markets and develop a “gold corridor” for the countries along with China’s Belt and Road initiative. Therefore, both private and public sectors will be able to accumulate the oldest form of money as a backstop to local currencies, as an alternative to accumulating those of their trading partners. 

Geopolitics evolved from fighting proxy wars in the Middle East and Ukraine, which were effectively won by Russia, to the less obvious war of trade tariffs. President Trump has styled himself as “A Tariff Man”. We have presumed that he is ignorant of economics, but that is no longer the point. Tariffs have evolved from a policy to make America great again to bankrupting China. China is seen as the greatest economic threat to America, and in this duel, tariffs are Trump’s weapon of choice.

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Disclaimer: The views and opinions expressed in this article are those of the author(s) and do not reflect those of Goldmoney, unless expressly stated. The article is for general information ...

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