Investment demand for gold fell last year for the first time since 2007, as Chinese demand stagnated and western investors began to question the sustainability of gold's decade-long rally. Prices are struggling near six-month lows at $1,643 a troy ounce. Billionaire investors George Soros and Louis Moore Bacon have cut their stakes in gold ETPs last quarter, while John Paulson has maintained his position. The cycle for gold prices, which climbed for 12 straight years, has probably turned as the recovery in the U.S. economy gathers momentum and investment holdings collapse. Goldman Sachs (NYSE:GS) cut its three-month target to $1,615 an ounce from $1,825 and lowered the six- and 12-month forecasts to $1,600 and $1,550 from $1,805 and $1,800. In this article we will look into three reasons that could support higher gold prices.
1. Gold's increased role as a reserve asset
According to OMFIF, the world could head towards a regime of durable multi-currency reserve system, where the U.S. dollar would share its pivotal role with a range of other currencies. Neither Germany nor Japan want their currencies to become significant reserve currencies. By contrast, the Chinese authorities have made it clear that they want the renminbi ultimately to become a reserve currency. As China aspires to take the lead politically and economically, it is unlikely to be satisfied with storing its wealth simply in liabilities of other countries.
The role of gold during and after a move to a multi-currency reserve system is an important issue. Gold will probably play a greater role during the transition period. This is likely to be a period of substantial fluctuation in currency values as market actors attempt to find a new equilibrium. That is where the attraction of gold, an asset which is nobody's liability should stand out: investing would denote no political bias, which should minimize foreign exchange fluctuations. For central banks, concerned with preserving value and naturally politically cautious, gold is likely to prove a haven from currency storms.
2. Currency War means use of gold as an FX hedge
Currencies have increasingly become part of the global monetary policy debate. The Japanese yen (JPY) would be the most obvious case and the sharp weakening of the JPY (NYSEARCA:FXY) could have broader global policy implications. The new Japanese government looks committed to propel the economy out of deflation, given the range and extent of measures employed. A weaker yen is a key strategy for Japan to revive its export-oriented economy. Japan has fired the first round of shots on this front, which could result in a major confrontation from other countries as well. The Fed, ECB and BoE (which have their own QE programs to stimulate growth), along with other emerging markets could follow with verbal interventions, capital controls and interest rate cuts. Under the current scenario, the weakening JPY should not be viewed as a short-term event, but as a prolonged, sustainable strategy spread over many years.
I have written in detail about a looming currency war similar to those of 1930s in my previous articIe "Is Japan Prompting A 1930s-Like Currency War?" Finally if weaker yen remains the core of Japan's plans to revive its export market, risk of currency war looms higher. With anemic global growth and sluggish demand, any revival of Japan's export market would be at the loss of market share for other countries.
Competitive devaluations have been one of the major reasons to be bullish on gold. Over the years, countries across the world have used gold and other precious metals to protect their purchasing power against currency depreciation
3. China Gold ETF could lead to additional demand
The much-anticipated launch of gold ETFs in China has become a reality, which could trigger a new wave of demand for the precious metal. These Gold ETFs have been successful elsewhere in the world, contributing to a surge in gold prices since their launch in 2003. This event could signal the step in the liberalization of China's bullion market, which has seen investment demand surge to 274 tonnes last year (vs. 15 tonnes in 2006).
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.