Gold is in the news for all the wrong reasons at the moment. The price of the metal tumbled this month, maintaining its downward trend for the year. In fact, bullion had its worst month in over two years in July. At US$1,092, an ounce of gold is now worth what it was back in 2010.
Its future prospects, if analysts are to be believed, are worse still. A recent Bloomberg survey suggested that prices could drop to US$984 an ounce by January. That would represent a 10% decline from its present price point. A separate Bloomberg survey highlighted that over half of respondents believe gold is heading for its third consecutive annual loss in 2015.
Every investor should, in theory, have gold to safeguard their portfolio. The amount of systemic risks in the system demands that. But there’s no point droning on about the benefits of gold beyond that. If you aren’t already convinced about bullion, you’ll never be.
Instead, it’s better to question the current market sentiment in relation to gold prices.
You may have noticed that the queue of experts lining up to stick their boot in is getting longer by the day. Gold is junk and gold bugs are loonies, they say. Brian Barish, from Cambiar Investors, provides us with this gem:
‘Gold is a weird relic of antiquity. It’s not a commodity that has much fundamental demand. It’s pretty, so people use it for jewellery. But it’s unlike iron ore or oil, or copper, or corn. There’s not specific end-use for it. People just like it, so it becomes a discussion about fervour.’
I’ve picked out that comment for the scale of its condescension, but it’s by no means the only one.
What’s important is that these so-called experts are using some fundamentally untrue conclusions to explain falling gold prices.
The most commonly used one is that investors are seeing beyond the ‘illusion’ of gold. Supposedly, people are denouncing gold, choosing instead to flee to interest paying assets.
That would be an acceptable explanation if it carried any truth. But it doesn’t. Conclusions like this are not just opportunistic; they’re flatly misleading.
I think they’re smarter than that. They’re dismissive of bullion because it doesn’t return interest in the way that cash does for example. If you’re an investor that’s solely interested in returns, then you probably agree with these experts. But that’s not why most people buy gold. They do so for the purpose of protecting their wealth.
And this is where many economists get it wrong. They look at falling prices and assume that investors are abandoning gold. As I’ll explain, that couldn’t be further from the truth.
Decline in gold price doesn’t match up with basic economics
Gold prices fall based on two things; economists learn both of these in Economics 101.
The first is that low demand puts downward pressure on prices. And secondly, oversupply in a market also forces prices down. That applies to gold, as it would in any other market or industry.
But in the current bullion market, gold prices are falling without either of these conditions present. In fact, prices are falling despite increasing demand for physical gold. At the same time, supply remains limited, not overabundant as you might expect.
You might be asking yourself, ‘is that true? Is demand for gold really that robust?’ Yes! Contrary to what some will have you believe, demand for gold hasn’t bottomed out.
In the first quarter of 2015, the Shanghai Gold Exchange saw an increase in purchases by 19%. It did so because demand for bullion in China and India remains high. Moreover, in early July, purchases were equal to the annualised supply of global production.
The arguments that say demand is nosediving don’t align with market realities. What gives?
The manipulation of gold prices
With limited supply, and rising demand, it leaves us scratching our head as to why gold prices are falling. What good reason is there for gold to successfully defy basic laws of economics?
Economists Paul Craig Roberts and Dave Kranzler provide a possible answer for this. They explain:
‘Clearly the demand for physical metal is very high, and the ability to meet this demand is constrained. Yet, the prices of bullion in the futures market have consistently fallen during this entire period. The only possible explanation is manipulation’.
As they explain, gold prices are determined in futures markets. This means that bullion contracts get settled using cash, outside of ‘markets where the actual metals are bought and sold’.
In markets with cash settlements, there’s no risk to a boom in uncovered contracts. Basically, these contracts are the equivalent of someone promising to give you something that’s not currently in their possession. In this case, a seller promises to give you gold at an agreed price in the future, without holding any reserves. Where the risk? There’s none at all.
This simple, yet overlooked, fact provides a perfect framework for why gold prices are falling. With uncovered contracts, it’s simple to artificially increase supply by creating these uncovered contracts. You get a situation in which the supply of contracts is increasing, but not the supply of physical gold itself.
The end result is that gold prices go down because supply is ‘going up’. Except, of course, bullion supply isn’t going up. Gold is down because the futures markets determining today’s prices.
There is one thing that economists are right about. Gold prices are likely to fall further for the rest of the year. And it’s not just market manipulation that will keep the pressure on bullion prices. We’re also hearing more about a potential US interest rate rise coming this year.
I don’t see them raising rates this year, but in the event that they do, gold will almost certainly take another hit.
The US dollar will become even more attractive to investors once the Fed does raise rates. After all, the greenback pays interest, and gold doesn’t.
Ultimately, it doesn’t really matter whether they raise rates this year or not. What’s most important is that manipulation on futures markets continues apace. As long as that’s the case, gold prices won’t recover to their true value.
Contributor, Markets and Money
PS: Just like gold, the share market benefits from low interest rates. Both the US and Australian stock markets are continuing to push higher in 2015. Some say we’re already in the bubble of all bubbles.
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