The eurozone’s crisis can be blamed for many things but the recent sell-off in gold which saw over $250 taken off prices in the space of a month is probably not one of them. Instead, investors should look to the recovery in US stocks and the US economy in general, which seems to have had more to do with gold prices spectacularly dropping by around 22% since the beginning of the year. More intriguing still, 15% of that fall came in the space of two trading days in mid-April. It points to the end of a long love affair with gold on the part of institutional investors, and opens a big debate on gold’s future as an institutional portfolio component, and its true value in a more benign global economic environment.
“Speculative traders such as hedge funds, which tend to be quick on the trigger when changes are looming, begun losing faith back in September, from a peak net-long futures and options positions of almost 20 million ounces they started a gradual reduction that by mid-April had seen their positions dwindle to just 5.6 million ounces,” says Ole Hansen, head of commodity strategy at Saxo Bank.
Hedge funds, the nimblest market players when it comes to picking up on trend reversals, started selling their gold positions last autumn. The sell off happened as US markets were beginning to exhibit the first signs of recovery and the Dow Jones Industrial Average had begun rising steadily, with the characteristics of an ebullient macro trend, rather than its previous more erratic behaviour.
Institutional investors with large positions in gold ETFs began to realise that the tide was moving against gold after the minutes of a Federal Reserve meeting in January which clearly showed that the Fed was thinking of slowing down or entirely stopping its program of bond purchases. The implication for investors was that the US economy was doing better and that the dollar would become stronger, both of which would be bad news for gold, a safe haven asset at times of financial crisis.
The sale of gold has accelerated since then and has showed no sign of stopping. Investors have sold the equivalent of over 350 tonnes of gold in ETF holdings since the beginning of the year, of that more than 260 tonnes from the world’s largest ETF SPDR Gold Trust run by State Street Global Advisors. SPDR Gold Shares still holds about 1,023 metric tonnes of gold valued at $44.7bn.
The bulk of the sale came from large US investors. Looking at the filings submitted to the US Securities and Exchange Commission over the last few months Northern Trust, BlackRock and Soros Fund Management are among the biggest players who have been pulling out of gold ETFs. These vehicles are also popular with institutional investors like pension funds, who see them as a cost-effective way to gain exposure to commodities prices.
However, the market (that is, speculators on the price of SPDR Gold Shares) were anticipating this fall; a number of market participant bought a large number of put options on the ETF that would not have come into the money had the market not dropped so spectacularly on April 12th.
Once the selling frenzy started in the US it was replicated in Europe, just on a smaller scale. Nicholas Brooks, head of research at ETF Securities, says that the total outflow of assets from ETF Securities’ gold ETFs this year has been $1.9bn, with $14.3bn still remaining in the company’s gold ETFs. Investors have also built up positions in ETF Securities Short Gold ETFs, but much smaller ones compared with long gold positions.
Brooks notes that of the three key types of investors with positions in gold ETFs; retail investors, medium to long term investors with a strategic view of the market and tactical investors, the first two groups have mostly held on to their gold ETF positions or have added to their existing holdings. “Most of the selling came from tactical investors, asset allocators with a three to 12 month view of the market who react to changes in the market,” says Brooks. The move down was prompted by the fact that bond yields have been rising, as have stocks, and investors have started pulling out of gold and investing in higher-yielding assets.
In addition to the sale of gold ETF share, the futures markets also witnessed a spectacular fall over two trading sessions on April 12th and April 15th. On paper, the move was prompted by two factors, a downgrade of gold by Goldman Sachs analysts and the rumour that Cyprus might sell its gold reserves to repay the country’s debt. Cyprus itself was less of a worry but market participants were concerned that other Eurozone economies might follow suit. Italy alone holds 2452 tonnes of gold and in Europe only Germany has more gold reserves. A major sell off by Eurozone central banks would have serious consequences for the gold price.
Any predictions that Italy, Greece or Spain would sell their gold “are, frankly, ridiculous,” say Carsten Fritsch, analyst at Commerzbank. “If those countries are at all thinking about leaving the euro selling their gold would leave them with their hands tied behind their back because they would have fewer reserves to back their own currencies.”
Whether those were the real reasons for the bearish sentiments, and not pure speculative market play, is another matter. CME Clearing House delivery notices for COMEX gold futures around those days show that JP Morgan was behind 90% of the selling, some of it from their client account and majority from a house account. Moreover, once this one horse had bolted, the rest of the herd was not far behind.
Technical levels were breached, prompting stop-loss sales and automated selling from program-based trading schemes. “The course was set and once the 1525 USD/oz support level was reached and breached, as if it did not exist, waves of selling orders from both the spot and futures market sent the price into a tailspin,” says Saxo’s Hansen. “During the initial hour of carnage on the Friday [April 13th], almost 9m ounces of gold futures had swapped owners.”
Predictions that Italy, Greece or Spain would sell their gold “are, frankly, ridiculous,” say Carsten Fritsch, analyst at Commerzbank. “If those countries are at all thinking about leaving the euro selling their gold would leave them with their hands tied behind their back ...”
Gold then see-sawed for the rest of April, initially recovering but plunging back to $1,350/oz by mid May. In the meantime all the major banks have lowered their forecasts to an average for this year and are saying that in the short term prices are more likely to head towards $1,100/oz.
To put it all into perspective, Gordon Brown sold a portion of UK gold reserves in 1999 for $275/oz. Though it may look shockingly low now, this was a reasonable price at the time. Throughout the last decade prices have climbed steadily, reaching an all-time high of $1,920/oz in 2011. Mining output of gold has not significantly changed over the last decade and although there is an argument that it became more expensive, an increase in labour costs, electricity and transport still doesn’t explain an eight-fold rise in prices.
The price of gold started rising when first gold ETFs were launched in the early noughties and then accelerated during the financial crisis as gold ETFs became the safe-haven investment option. Initially, institutional money started flowing into commodity ETFs because of interest in the convenient way they offered access to commodities market diversification opportunities, and the strong case being made by commodities bulls. Subsequently, with the onset of the financial crisis, there were also considerable fears about inflation and precious metals holdings were viewed as one of the principal means for institutions to hedge against this threat.
While inflation in the UK and other developed markets has declined in recent months, from a global perspective it still remains a key consideration for long term investors, who will be less keen to reduce gold exposure. For major growing economies like Brazil for example, inflation has remained a key theme in the last six months.
Analysts have now almost universally lowered their gold price forecasts for the year to around $1,550-$1500/oz. Even so, the game has not been played through yet. It is becoming increasingly obvious that when trying to assess what the gold price will do next, the main movement to gauge is that of ETF investors. This is the case, even though cheaper prices will make the metal much more attractive to retail buyers who either buy jewellery, as is mainly the case in China and India, or bars and coins, as in Europe, the US and Australia.
In fact, since gold prices fell to around $1,400/oz or at times below that level there has been massive buying in China and India. Indian buyers have enthusiastically come back into the market particularly because late last year gold prices reached historically high levels in rupees terms; now that prices have dropped, several hundred dollars for gold is considered relatively cheap. It should also not be forgotten that both China and India are home to a large and increasingly affluent middle class demographic, and their buying will have more impact on the price at the cheaper end of the chart than ten years ago. Similarly, gold bars and coins remain a favourite investment among more affluent Europeans, particularly in Germany, where gold is still regarded as a solid store of value.
In the latest issue of its paper Gold Demand Trends the World Gold Council noted that the net outflows from ETFs obscured the strong rise in investment for gold bars and coins in the first quarter this year which stood at 377 metric tonnes, up from 342t last year in the same period last year, and gold jewellery buying which rose to 551t from 491t in the same quarter last year. This could create a fairly solid floor for the gold price, despite the insti-tutional selling.
According to Saxo Bank, while the technical picture for gold points towards a target of $1,150/oz, “we look for support to emerge towards $1,300/oz while any recovery from here will be met with fierce resistance at the old floor of $1,525oz,” says Hansen.
For the active investor, the sudden price moves represent a range of opportunities. For example, Société Générale’s Patrick Legland says that investors could sell a one year call option with a $1,800 strike and use the received premium to buy a one year gold put with a $1,440 strike. An alternative zero net premium option structure would be too short a one year gold call at a $1,700 strike and buy a one year put at a $1,550 strike.
The bottom line is that after all these moves the gold market is unstable. Most analysts expect that prices will initially drop some more before starting to recover later in the year, an expectation based on the fact that stock markets have moved up too far too fast and on the fact that the US has not yet left its economic problems behind.
“Tactical investors will remain bearish on gold until the interest rate cycle has peaked and the dollar has stopped rising. However, the underlying economic situation in the US has not dramatically changed, the US still has fiscal and debt problems and some investors may have over-anticipated a recovery,” says Brooks. Unlike tactical investors, other longer term investors are likely to stick with gold under those circumstances, he adds.
Also, there is currently a large build-up of hedge fund short positions in the market at present. All it would take is another sovereign debt crisis and the gold market would move against them. This is likely to keep the market volatile and without a clear trend in the near future, but unlikely to continue declining over the three-to-six month horizon.
|Diverse global demand for gold|
|The latest World Gold Council Gold Demand Trends report, which reports on the period January-March 2013, shows a market driven by diverse global demand, though overall total global demand for gold in the quarter was 963t, down 19% from Q4 2012, though in value terms demand fell 23% to $15bn. The average gold price over the period fell 3% to $1,632/oz.|
Demand for gold in China and India led trends, with demand related to jewellery up 12% for the quarter year on year. In addition there was a notable increase in bar and coin sales, which rose 22% year-on-year in China and 52% in India. Central banks remained significant acquirers of gold, making purchases in excess of 100t (109t) for the seventh consecutive quarter. In the US demand for bars and coins was up 43% compared with the same quarter in 2012. Globally, bar investment was up 8% while official coins (such as American Eagles and Canadian Maple Leafs) were up 18%. Gold held by gold-backed ETFs, which in 2012 accounted for 6% of the world’s gold demand, fell by 177t. That fall pushed the sum of ETF and total bar and coin demand to just below 201t. Total investment demand was 320t in Q1 2013, flat compared with a year ago. “Gold-backed ETFs, which made up 6% of gold demand in 2012, have seen some holders, primarily in the US, collect profits and move into equities. While gold ETF holdings are down, this has been balanced by 378t of investment in bars and coins, an increase of 10% on the same period last year, and up 12% on Q4 2012,” explains Marcus Grubb, managing director, Investment at the World Gold Council.
“The price drop in April, fuelled by non-physical moves in the market, proved to be the catalyst for a surge of buying that has left many retailers short of stock and refineries introducing waiting lists for deliveries. Putting this into context, sales of bars and coins, jewellery and consumption in the technology sector still make up 81% of the market,” says Grubb.