COMMENT – Gold’s dramatic spike is shining a light on some uncomfortable truths

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Gold is now at an all time high of $1,922 – a level last seen on September 6 2011. This rise has been complemented by strength (at last) in silver, up 39% in the last few weeks, and by bitcoin which breached the important $10,000 level. Still, gold remains the ultimate hedge against uncertainty.

The rally in gold actually pre-dates the coronavirus epidemic and can be traced back to the middle of last year. Gold at the time was unable to breach monumental seven-year gold resistance at $1,360, failing to do so on 12 occasions. It was in the doldrums.  

Then the US 10-year treasury yield collapsed, reshaping the dynamics of the bullion market.  

The 10-year bond has been on a downward trajectory since 1980, when you would have secured a yield of 16% on your investment. Today it offers less than 0.6% in nominal terms or a negative yield in real terms. 

The move in treasuries yields has a 93% negative correlation co-efficiency with gold, and it shifted sentiment. The decline also prompted a reversal by futures traders, who covered a rare 300 tonne net short position in late 2018 to a net long position of about 1140 tonnes. 

Meanwhile, central banks were acquiring gold at the fastest rate since 1971 (what did they know that everyone else did not?). Still, it was moves by “fast money” speculators that took gold smartly through $1,360.

Stop orders were triggered and prices climbed further as the “smart money”, institutional and wealth sectors, joined in. Only in the retail sector, ever the laggard, did gold continue to languish at a 12-year low – until the virus hit. 

Gains in 2019

In 2019, gold saw a 19% gain in USD terms, marking the first year of what is typically an eight to ten-year bull run. Arguably, equities were already in a bubble as expressed by the price/earnings ratio, and again there were deepening uncertainties about whether records in the stock market could be sustained. 

The immediate response to the coronavirus pandemic by governments in the form of liquidity injections was large and impressive. However, the second order effect has been a significant increase in the money supply, with the unintended consequence of over-reviving the equity market after its price correction.

 Equity prices are now effectively disconnected from the real economy. These factors all point to immediate deflation due to a brewing supply shock, followed by significant future inflation – which makes gold an attractive prospect. 

Admittedly, lockdown also disrupted gold supply chains, which meant the metal was not able to get to where it was needed in the form required. The levelling of global prices that is called “arbitrage” was just not able to do its job.  

The difference between spot prices and futures blew out to a 7% differential. Bid/offer spreads in the professional market were similarly wide. Meanwhile, physical metal became hard to source as refineries closed and aircraft parked. These problems proved expensive for those on the wrong side of the trades, but markets have since settled down. 

Since then, the critical trend for gold over the last few months has been the contrasting collapse in demand from the traditionally very price-sensitive Asia, versus the massive buying spree by Western institutions.

 As things stand the latter has more than offset the former. ETF demand, with only half a year gone, is already at a record annual high. Year to date, western institutions have bought 880 tonnes of gold (worth $230 bn) in ETFs – about half of global mine production.  

Gold, Asia and the dollar

The impact of rising gold prices in USD in Asia was magnified by the firm dollar, which made buying in local currencies prohibitively expensive. We are now seeing some recovery in Asian demand (reflected in local prices rising from a discount to a small premium compared to loco London), which should provide some downside support to prices. 

The market has arguably overextended itself in the short term and gold is clearly overbought. It is due a period of consolidation which would confer longer term strength in the price. That is assuming gold behaves in its normal, rational and sober manner.  

Our modern sensibilities instinctively interpret the crossing of stellar paths as just a happy but natural coincidence with no deeper significance. The Ancients saw it differently, with a primal knowledge of the stars and a primal appreciation for gold – the latter at least may be making a comeback.  

Concerns about systemic risk, solvency of major institutions, and the threat to the faith system that we call fiat currency is more real now than for many generations. To navigate through these critical issues requires an investor to engage both his or her intellect as well as a gut-feeling in seeking wealth protection.

(Donald Bradley is commodities and equity index analyst)

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