Earlier we presented one view on why gold is about to plunge. While that perspective was somewhat truncated, a report recently issued by Bank Of America's commodities team presents the case for gold at $1,500/ounce. As BACMLCFC observes, and agrees with other observations presented on Zero Hedge by both SocGen and by Jim Grant, "[d]uring the last decade we found that three variables alone could explain the fluctuations in the price of gold: risk, currency and commodity prices. In a nutshell, our analysis showed that gold is sometimes a currency, sometimes a commodity and sometimes a store of value. Of course, the elusive question will always be figuring out which market gold will track next." In essence, a detailed if longwinded report (get a cup of coffee now) to confirm that Paulson and Ackman will soon be much richer.
Gold Prices Continue To Move Towards $1,500/oz
The three stages of gold price appreciation
Departing from this analytic framework, we argued back in October 2008 that gold prices would move up to $1500/oz in three steps. The outburst of the credit crisis in August 2007 marked the start of the first stage where gold started to reflect the rising risk premia, rising from $650/oz to about $950/oz. The second stage of gold price appreciation, we argued well over a year ago, would primarily be about USD weakness and lack of confidence in fiat currencies. We argued that gold could break through $1200/oz in this second stage and strengthen against all currency crosses. The third and final stage will be driven, in our view, by a strong cyclical recovery in energy and commodity prices.
A weak dollar is now driving investors into gold
Our analysis shows that the recent rally in gold prices that started in April this year has mainly been about currency weakness, matching the second stage described in our October 2008 piece. Of course, many observers will argue that investor and central bank demand has been the main driver of gold prices for
some time (Chart 2). But this is the old traders’ truism: prices go up because there are more buyers than sellers. The more critical question to understand whether a trend is sustainable is what drives that investor demand. In that sense, gold prices have rallied this year on the back of a weaker trade-weighted
USD (Chart 3).
The 2nd stage of higher gold prices is about USD weakness
Why are investors piling into gold? First and foremost, money is flowing into gold as investors seek to protect themselves from USD currency risk. Looking at daily gold spot returns and decomposing them into factors, we find that USD depreciation and currency risk have been important contributors to higher gold
prices (Table 4). Secondly, our analysis also suggests that changes in gold prices have been leading indicators of changes in 5Y breakeven inflation rates and in the USD yield curve slope (10Y-2Y) since April, suggesting that gold is really moving ahead of inflation expectations.
Decomposing the FX driven gold rally of 2009
In the most recent rally, some currencies have shown high correlation and high beta relative to gold prices since April (Chart 4). More specifically, EUR and CAD have shown the highest beta and correlation to gold, while KRW and JPY show some of the lowest in the last 8 months. But even those currencies that have not
been correlated with gold have tended to be more correlated in the more recent period when using forward looking measures like implied volatility in the options markets (Chart 5).
When EURUSD drops, gold tends to hold its value
So what is driving the correlation between gold and the various currencies? Our analysis suggests that the correlation of gold returns to EURUSD is a lot higher on the upside that it is on the downside (Chart 6). This is a rather interesting development that it is also present in other currency crosses. The simple explanation, in our opinion, is that the supply of money in all currency areas is increasing a lot faster than the supply gold. So the weaker dollar is contributing to push gold prices higher in USD, but the increase in money supply in all countries is driving gold prices in every currency.
Compared to the expansion in the money supply …
In our view, the massive expansion in money supply observed in 2008 represents a competitive debasement of fiat currencies relative to gold (Chart 7). With the exception of the JPY, broad money in local currency expanded at rates between 8.5% for the EUR and nearly 25% for the TRY, compared to an expansion in the global stock of gold of 1.18%. For the time being, however, the rapid increase in real money has not been accompanied by a broad-based increase in consumer prices as the credit multiplier has remained rather muted in most countries.
…there is just not enough gold to go around
Top holders of currency reserves like China, Russia or India will likely need to increase their exposure to gold over the coming months and years (Chart 8) as the value of fiat currency reserve holdings like the USD or the EUR comes into question. The obvious problem with Emerging Market Central Bank (EM CB) diversification is that there is simply not enough gold to go round. Official sector holdings of gold have moved from 29.1 to 28.7 thousand tons from 2004 to 2008 (Chart 9) despite the higher prices. Net, gold held by the official sector has declined by 1.27% in the period, according to GFMS.
Gold supply trails the expansion in global nominal GDP
In effect, the increase in the global stock of gold is roughly equivalent to the increased mined output every year. In 2009 and 2010 we estimate this figure to be 2,350 and 2,300 tons, or roughly 1.5% of the current global above-ground stock of gold. With governments around the world loosening up monetary policy
to stimulate the economy, not enough gold is mined out of the ground relative to other goods in the economy (Chart 10).
The risk of waves of competitive G10 FX depreciation…
In the meantime, with G10 fiat currencies suffering from a credibility problem, a move towards hard assets like gold by investors and CBs appears likely. If the US prints money to fight off deflation and a soaring public sector deficit, Europe will have to follow or suffer from a USD competitive depreciation. Political and central bank discomfort over USD weakness is mounting within G10. Few, if any, G10 nations are willing to embrace further currency appreciation given the current valuation levels. The problem is that every country with a floating currency is in the same situation, creating a vicious cycle, where a USD competitive depreciation leads to a GBP competitive depreciation, which in turn leads to a EUR competitive depreciation and so on. Because the public finances of the US, Japan, Britain and the Eurozone are in such dire straits (Chart 11), it is hard to envision how these countries will return to trend economic growth without robust
foreign demand, suggesting that this dynamic could go on for a while.
…is forcing EM CBs to turn to gold instead of G-7 bonds
Any given EM CB cannot hedge against further USD weakness by buying EUR or GBP. This is because there is a significant probability that the ECB and the BOE will have to follow any monetary policy moves by the Fed, as it became apparent during the financial crisis. Then again, if EM CBs come to the conclusion that gold
is better value than EUR, the problem of reserve diversification becomes one of game theory. In recent weeks, India made a first move by snapping up half of the IMF gold for sale in one go. With 203 tons of IMF gold still up for sale this year, every other EM central bank must be wondering who will move next and how fast . In the light of the experience of the last 10 years, more diversification out of G10 currency accumulation into gold seems like an attractive proposition.
Simply, beggar-thy-neighbour policies have natural limits…
Effectively, as the USD or the GBP weaken against the AUD, the NOK, the JPY or the EUR, these currency areas also lose competitiveness against Britain and the United States. In turn, this means that the diversification benefit for a nation’s FX reserves from buying EUR or GBP rather than USD is limited. A point that we have made over and over is that monetary policy is contagious (Chart 12). Large economies like the
Eurozone, the US or Britain may have different objectives when it comes to inflation or economic growth, but their central banks cannot operate independently of each other because their economic cycles are closely interlinked (Chart 13). More importantly, with the EURUSD touching 1.50 it is hard to argue for further dollar weakness against the European currency purely on fundamental grounds.
…because further USD weakness requires a CNY revaluation
Because there are natural limits to floating G10 currency appreciation against the USD, our EM Fixed Income and FX Strategy team has been arguing for EM FX appreciation against G10 currencies (and against the USD). But most floating EM FX currencies have already surged tremendously in recent months. In the case of
the commodity exporters, the risk of catching the “Dutch disease” is increasing very rapidly1. In our view, further weakness in the trade-weighted dollar would require a CNY revaluation. In turn, as EM CBs can not accumulate CNY, the only practical way to avoid adding EUR at these levels to EM CB portfolios is to buy gold.
The point of fiat currencies is to debase them as needed
While some investors remain concerned that lax monetary policy could end up resulting in inflation sometime down the road, we would argue instead that the whole point of having a fiat currency is to be able to debase it when the economic conditions require it (Chart 14). As the combination of monetary and fiscal policy measures help create an upswing in economic activity over the next two years, cyclical pressures will come back into the system, likely resulting in a lot more money chasing the same oil barrels. As we expect gold to maintain its long-run relationship with other commodities, we see a third stage of gold price appreciation where prices push above $1500/oz on the back of higher oil and commodity prices (Chart 15).
Our view is, as always, not without risks
There is a clear case to be made for stronger gold prices, but our view is not without risk. Our positive gold view could come under pressure if EM central banks decide to shun gold in favour or USD or EUR denominated bonds (Chart 16). A move to diversify away from all G-10 currencies at the same time would
hurt the USD most given the higher USD weight in FX reserves. Meanwhile, a more aggressive shift out of fresh USD inflows into both EUR and gold by CBs could bring about the dynamic observed in recent months (Chart 17), but the valuation and performance of the EUR during the crisis argues against this and we believe the share of gold will likely continue to increase.