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Recently I wrote an article highlighting how the stars were aligning against gold. In it I pointed out that one of the reasons gold bulls used to support their position was that central bank buying of gold was at a 50-year high:

Philip Silverman, managing director of Kingsview Management in New York, advised investors not to bet against gold last month because central bank demand remains strong. According to the World Gold Council, central banks' gold purchases in 2012 were the highest for nearly 50 years, as banks sought to diversify their reserves.

'You don't fight the stock markets when the Fed is easing, so you wouldn't want to fight the central banks when they're buying gold, because they have deep pockets,' Silverman said.

Central bank buying of gold in my opinion isn't necessarily a good thing for gold, and in fact has done very little to support the price of gold, which peaked prior to 2012. The reason central bank buying isn't a good thing for gold investors is that central banks aren't gold investors. They don't buy gold as an investment, or at least they shouldn't. Central banks buy gold as a way to implement their monetary policy, not as a way to make money. Their motives are not the same as a gold investor.

Central banks use gold is a manner similar to the way our Federal Reserve uses treasury bonds. Under our system, the Fed purchases treasury bonds through the FOMC (Federal Open Market Committee). If the FOMC wants to expand the money supply, they buy bonds on the open market. Money is transferred from the Fed into the hands of the previous bond owner's account. The previous bond holder gets dollars for their bond. On their balance sheet, their illiquid non-current asset in the form of a bond is re-categorized as a liquid current asset in the form of cash. In reality, the Fed doesn't "print money out of thin air;" they covert illiquid bonds into liquid cash under "normal operations." The cash they use is already on their books, simply not in circulation. That is why they describe the Fed action as "adding liquidity" to the market. On the Fed's balance sheet, they reduce their holding of liquid cash and increase their holdings of illiquid bonds. No money is "printed out of thin air;" it is simply put into circulation in a more liquid form. When the Fed wants to pull money out of circulation, to remove liquidity, they simply reverse the process and sell bonds.

Now I'm going to contradict myself. Under QE, the Fed does actually "print money out of thin air" and they "expand their balance sheet." QE isn't a "normal operation." In fact, I think this is the first time they've done it in my lifetime. So, yes, the Fed can "print money out of thin air," but what they usually do is buy and sell bonds, adding and subtracting liquidity to the market. The important point being, however, that when a central bank expands or contracts their money supply, they have an asset backing the transaction that can be later used to reverse the situation. That is true even with QE. During periods of hyperinflation like the Weimar Republic, money is simply printed and used, with no asset held in reserve to reverse the process. The German government would print money, buy goods, and hand the goods over to France for war reparations.

Why this is bad for gold is that if the central banks already own gold, that means the currency is already out in circulation. We are most likely closer to the end of easing than the start. That means that central banks are more likely to be wanting to slow or even reverse their monetary expansion going forward. If that is the case, central bank buying has most likely reached a peak, and we are likely headed to a period where the central banks may actually start selling gold. More importantly, as gold falls in price, the central bank may have more currency outstanding than assets held on their balance sheet. That is a huge incentive for the central bank to sell gold before it falls any further.

The end of easing is only one reason a central bank may sell its gold. Another is that it has no choice. Gold is down over $80 as I write this, breaking through the significant technical level on $1,500/oz. The reason being given is that Cyprus may have to sell its gold holding as part of a "bail out." If Cyprus can drive gold down over 5%, you can imagine what a large country could do.

The impact Cyprus is having on gold also demonstrates the impact central banks can have on asset prices. As I mentioned above, our Federal Reserve mostly holds Treasury and other bonds. When the Fed reverses policy they won't be selling gold, they will be selling bonds. The likely impact will be lower bond prices and higher interest rates.

In conclusion, central bank buying of gold is a double-edged sword. Central bank buying most likely helped get gold and SPDR Gold (GLD) to its current lofty level, but as central bank policies turn from monetary expansion and stimulus to a neutral or even contractionary policy, the support gold has gotten from central bank buying will be reversed. Investors in long-term treasuries can learn from gold as to what is likely to happen to the value of their bond holdings. When central banks shift from monetary expansion to contraction, both bonds and gold are likely to suffer.

Disclaimer: This article is not an investment recommendation. Any analysis presented in this article is illustrative in nature, is based on an incomplete set of information and has limitations to its accuracy, and is not meant to be relied upon for investment decisions. Please consult a qualified investment advisor. The information upon which this material is based was obtained from sources believed to be reliable, but has not been independently verified. Therefore, the author cannot guarantee its accuracy. Any opinions or estimates constitute the author's best judgment as of the date of publication, and are subject to change without notice.

Source: Central Bank Buying Of Gold Is A Double-Edged Sword