Gold has marched steadily higher over the past ten years, with only the reasons behind investors’ demand for the yellow metal changing along the way. Looking ahead however, mounting fundamental and technical evidence suggests that a sharp downturn lies around the corner.
Real Gold Supply, Demand Pressure Prices Lower
The trends in real demand look decidedly lackluster, with gold for the manufacture of jewelry as well for industrial and dental use clearly tracking lower (the former for over a decade and the latter for at least three years).
Meanwhile, supply seems to be picking up. Indeed, mine production has snapped a multi-year downtrend with output rising for the first time in close to seven years. Further, gold scrap such as jewelry melted down for its metal content is on the rise as well.
Reasonably enough, if real factors were the only forces driving the market, falling demand and rising supply suggest the price of gold ought to have declined over recent years.
Investment Demand is the Top Driver of the Gold Rally
Naturally, reality has proven to be quite different from what real supply and demand would suggest, with gold prices hitting all time highs this year. In fact, it appears investment demand lies behind the metal’s spectacular performance, with retail buyers doing a fair bit of the heavy lifting in pushing prices higher.
The patterns behind investment demand and its interaction with the spot price suggest the rally witnessed over the past ten years is becoming increasingly vulnerable. Exchange-traded funds (ETFs) have become an increasingly attractive vehicle for gold exposure given their ease of use compared to physically buying bullion, with “soft” investment now on pace to overtake its counterpart for the first time ever. However, while ETFs make buying gold comparatively easier, they equally make liquidating the investment easier as well, making for a far more violent downturn than would otherwise be the case should traders’ sentiment reverse.
More worrying still, it appears that gold’s appreciation has become the impetus for demand, the precise opposite of how an asset is normally expected to behave. Indeed, linear regression studies suggest that a whopping 89 percent of the variance in the spot gold price is explained by variance in the holdings of the SPDR Goldshares ETF (GLD), the leading exchange-traded fund tracking the metal.
Gold: A Bubble on the Verge of Bursting?
With real supply/demand conditions pressuring prices lower, it seems clear that robust growth in investment interest is the only way for gold to continue to advance. However, the rally has become a self-fulfilling prophecy, with gold’s appeal to investors dependent upon its continued gains. This leaves the door open for a sharp reversal at the first hint of a meaningful setback, an outcome that promises to look all the more dramatic because of the proliferation of ETFs as a vehicle for gold investment.
Where might such a setback come from? Looking at the most recent headline explanation behind gold’s appeal, it seems the story begins with inflation expectations. Throughout 2009, the price of gold tracked intimately with US breakeven rates – the spread between yields on regular and inflation-indexed 10-year US Treasuries that is used as a gauge of investors’ price growth expectations – amid concerns that quantitative easing would debauch paper currency. Ever the standby store of value, the metal proved attractive as central banks around the world resorted to effectively “printing” money, a policy that many feared would engineer a period of runaway inflation.
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The likelihood of such an outcome seems resoundingly unlikely, however. Looking at the US as a benchmark test case, the amount of money actually created by the Federal Reserve’s liquidity injections is a function of the money multiplier, a ratio measuring the total impact of a deposit into the banking system after it expands through lending and borrowing while cycling through the banking system. Data compiled by the Fed’s St. Louis branch reveals that currently, the money multiplier is hovering near 0.8, the lowest levels in over 25 years. This means that for every Dollar created via quantitative easing, only 80 cents actually makes it into circulation. Going further, a Fed measure of the velocity of money (the speed with which it changes hands) has also fallen multi-decade lows.
While some of this can surely be attributed to sluggish economic activity, that doesn’t tell the entire story. The unprecedented scale of the 2008 credit crunch has engineered a major shift in consumer behavior, with personal saving among heretofore famously spendthrift US households sharply outstripping borrowing. Put simply, Americans have become keener to save than borrow. It is small wonder then, that the money injected into the system translates into smaller final amount than would normally be the case, and does so at a slower pace: in order for the fractional reserve banking system to multiply deposits, people must be willing to take out loans. On balance, this means that despite the Fed’s “artificial” creation of liquidity, a catastrophic period of inflation is unlikely because the mechanisms of monetary policy transmission are not operating as they should. As this becomes apparent, gold is increasingly likely to lose its appeal as an inflation hedge.
More recently, price action noted since the end of the first quarter has seen gold take up the role of a safe-haven asset, with spot showing a strong inverse correlation with the S&P 500 benchmark stock index. While the festering EU debt fiasco and its ominous implications for the global economic recovery hint that further risk aversion is likely ahead in the near term, it seems only a matter of time before the fallout from the crisis is priced into the market and loses its ability to meaningfully shock investors. On balance, this suggests gold may move higher in the near term but also that these gains are inherently limited, offering another likely stumbling block that threatens to undo the rally.
Ilya Spivak, Currency Strategist
Sumit Roy, DailyFX Research
