Gold rally could start to tire

November 26, 2009

JaneFoley.JPGSpot gold prices are up over 40 percent year on year.  Yet, according to the World Gold Council, demand for gold in the third quarter of 2009, dropped by 34 percent year on year.  Of course, demand in the third quarter of 2008 was exceptionally high due to the financial crisis. As well, relative to the third quarter average of the five years to 2007, demand for gold in Q3 2009 was down 4 percent.

When confronted with the ferocity of the rally in gold, the fact that the third quarter demand for gold was below the seasonal average is surprising. The dynamic between price and demand suggests some fall in supply perhaps led by increased hoarding.

According to the council mining supply is fairly inelastic.

Supply of recycled gold generally helps stabilise the price, in recent years this has been 28 percent of annual supply.   Between 2003 and 2008 central bank sales represented the third biggest source of supply.

It remains unclear what the recent gold purchases from the Central Bank of India means for the demand/supply dynamic of gold going forward.

What is clear, is that the gold rally has been exacerbated by dollar weakness, but this only offers a partial explanation.  The dollar index is at 15-month lows.  In August 2008, gold traded at an average rate of $836.84.  Other factors that have chased gold prices higher include the lack of return on cash and fear of inflation.   The former will almost certainly support gold in the coming months, but the inflation argument has no legs.

Following a year packed with fiscal spending and the introduction of Quantitative Easing, Fed chief Bernanke recently said “inflation seems likely to remain subdued for some time”.  If high unemployment and rising savings rates are insufficient evidence of subdued price pressures, lessened availability of credit at a consumer level should drive home the point.

Tightening the availability of credit on Main Street has been an inevitable and necessary consequence of the subprime crisis. Not only should this ensure that consumer activity going forward stays relatively subdued but is also implies that firms will have less pricing power.

Rather the causing domestic inflation, cheap money provided by the Fed and other central banks can be linked with speculator inflows into high yielding markets.  Some asset prices in Hong Kong, China and Singapore are arguably seeing the beginnings of bubbles and this talk alone is supporting gold.

The Fed could hinder this by hiking rates so the dollar was no longer an attractive funding currency but it is unlikely to do so when its domestic economy is weak and expectations for domestic inflation are low.  Like the Bank of Japan in the 1990s, it is possible that the Fed’s ability to create inflation domestically may be lessened in the post crisis era.

While it is difficult to find signs of inflation in the US, Eurozone or UK, near zero interest rates are clearly providing a significant support for gold.  Speculation in general is being fuelled by cheap USDs but in addition, conservative and retail investors are being forced to look outside cash deposits for positive return.  Also, retail investors cannot be blamed for enjoying the intrinsic quality of gold following last year’s banking crisis.

Assuming the Fed starts to hike rates in the second half of 2010 the dollar could see a cyclical recovery on a 6 month view.  Anticipation of higher Fed rates and a stronger dollar should reverse some of this year’s flows into gold.  While this suggests that the gold rally may yet run for another 6 months , the third quarter demand data for gold implies the rally may tire as soon as the first quarter.

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