Gold - A Perfect Storm For 2019

 Admittedly, issuers have different gold-to-currency ratios, but overall this suggests the gold price would be far higher if a sustainable level of currency convertibility is to return.

The reason we must consider this relationship is that in the light of all the foregoing, the gulf between the two quantities is set to accelerate from the currency side.

In the early 1930s, dollar prices of raw materials and commodities fell heavily, bankrupting farmers and miners worldwide. The purchasing power of the dollar rose, because it acted like a gold substitute. Today there is no convertibility between the dollar and gold at all, so the effect of a global economic depression is bound to see the gulf between the dollar and gold widen, as central banks expand the quantity of money in an attempt to fight recession and keep their governments solvent. There can be no doubt the policy response from the Fed and all the other welfare-state central banks will be neo-Keynesian, exploiting all the freedoms of unsound money.

In fact, the increase in the money quantity is not new, dating from the Lehman crisis. This is shown in the chart below, of the fiat money quantity, compared with its long-term pre-Lehman growth path.

(Click on image to enlarge)

13 dec 1

FMQ is basically the sum of true (Austrian) money supply and commercial bank reserves held at the Fed. Even though its growth has recently stalled, the gap between the pre-Lehman crisis growth path still stands at $5.55 trillion.

Now imagine what will happen when the global economy stalls. The Fed, along with other central banks, will be forced to make yet more currency available to support the banks, finance government spending and encourage consumption. The injection in the US last time was roughly $10 trillion, or 55% of GDP. Next time, with interest rates needing to be maintained in order to support the currency, it will almost certainly require more aggressive quantitative easing, with central banks substantially increasing their purchases of government bonds.

Gold is already close to all-time lows, relative to the money quantity. This is shown in the next chart.

(Click on image to enlarge)

13 Dec 2

It was from similar indexed levels that gold bottomed in the late sixties. A return to the level set by President Roosevelt in January 1934 implies a price of $53,250 today. This is not a forecast, and its only relevance is to illustrate the potential for an upward adjustment in the gold price, based on the degradation of the dollar since 1934.

Physical factors

Demand for physical gold consistently exceeds mine supply. Central banks are accumulating bullion, adding 425 tonnes in the year to September 2018. Chinese private sector demand continues at a steady pace, which measured by withdrawals from the Shanghai Gold Exchange, is running at a 1,900-tonne annualized rate. India’s total gold imports were 919 tonnes in the year to end-September (according to the World Gold Council), so adding identified central bank demand to private sector demand from India and China, these three sources account for 3,344 tonnes annually, which is the same as global mine supply.

The supply/demand balance is more complicated than these figures suggest. Some of the mine supply is not available to markets. For example, China, which is the largest mine supplier by far, severely restricts gold exports. Official reserves at central banks are only what are declared and include gold out on lease or swapped, and therefore not in possession of the central bank. They are therefore short of actual possession, exposing them to potential counterparty and price risk.

Net demand from the rest of the world and from unrecorded categories is satisfied with the existing above-ground stock of bullion, which we estimate to be about 175,000 tonnes. Only an unknowable fraction of this is available for market liquidity. The most identifiable swing-factor is ETF demand, which saw outflows of 103 tonnes in the three months to September[iv]. Looking back over recent years, another substantial ETF outflow was in 2016 Q4, when the gold price bottomed, and in 2015 Q2 to Q4 saw net outflows every quarter. It appears that ETF demand is acting as a contrary indicator of future price trends.

This fits in with market theory, which based on investor psychology predicts investors are at best trend-chasers, investing most heavily at market tops and liquidating positions at price lows. The peak of net ETF liquidation in 2018 was in June and August. In June the gold price breached the psychologically important $1300 level, and in August the market turned higher at $1160. ETF net selling tells us, therefore, the gold price may have recently indicated a turning point.

Supply from ETFs at market lows satisfies demand from those that have a continuing demand. We have seen the pattern of central banks increasing their buying on lower prices, but there is also some evidence commercial banks are accumulating bullion for their own books, possibly for risk purposes.

Under the new Basel III standard, physical gold held on an allocated basis is now classified as cash and has the advantage of zero risk weighting, compared with a 15% haircut under Basel II. Besides physical cash notes (which in practice banks try to minimize in their branches), the only other alternative to cash is balances held on the bank’s account at a central bank. The ECB and the Bank of Japan charge negative interest rates on these balances, which for commercial banks in the EU and Japan leaves only physical gold as an alternative.

For the thinking banker, it makes sense to hedge fiat currency exposure (which is the entirety of his business) with some physical bullion. The opportunity cost in the form of lost interest is not a factor, with overnight money-market rates in euros and yen negative. And the regulatory cost of holding gold is being removed.

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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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