Precious metals have been weak for the year of 2012 and investor sentiment is nearing an all time bottom, but I believe we haven't reached bubble territory yet.
When roaming the precious metals forums, I found out that Brazil doubled its gold holdings in two months time (added 17.2 tonnes in October 2012 and 14.7 tonnes in November 2012. Total holdings now 67.2 tonnes), and I just wanted to see if central bank gold buying correlated with the gold price.
And surprisingly, there is a correlation (Charts 1 and 2)! If you look very carefully, you will see that the price of gold goes up when central banks buy gold. For example, from 1970 till 1976 we see a net positive buying of gold by central banks. That period was also bullish for the gold price. The same can be said for 1980. Then came a period where central banks slowly got rid of their gold from 1980 till 2002 and that's a period where gold declined in price. And from 2003 onwards, central banks have slowly shifted from net sellers to net buyers again today.
The basic conclusion is: as long as central banks are net buyers of gold, the gold price will be strong.
|Chart 1: Central Bank Gold Buying|
I know you would think that the gold price will come down soon because central banks will eventually become net sellers again. But I believe central banks will keep on buying gold at least for another 5 years. This is evidenced on chart 3 which presents the total central bank gold reserves in the world.
As you can see, central banks have always been adding to their gold reserves since 1845. 1965 marks the ultimate top of world gold reserves and since then, central banks have been selling gold until 2008. If central banks want their gold reserves to go back to their high of 1965, they need to aggressively buy gold for at least another 5 years, especially when gold becomes a Tier 1 asset from January 2013 onwards. I believe this will support the gold price and I didn't even count in the massive inflationary policies of central banks by increasing their balance sheets.
As you know, when a central bank increases its balance sheet, it also needs to increase its gold reserves as I pointed out here. In that article I referred to James Turk's Gold Money Index where it says that the gold price needs to be on par with the forex reserves of the central banks. As forex reserves (Chart 4) are still rapidly increasing (especially in China because of their U.S. bond purchases), mainly due to the expansion of the balance sheets of the ECB and the Federal Reserve (Quantitative Easing), I'm sure that the gold price has still a long way to go before reaching bubble territory.
Disclosure: I am long PSLV, AGQ. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.