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By Eric Schaefer of American Independence Financial Services

A curious event occurred on Monday, April 15th: the price of gold went into a tailspin, falling from $1,548 (on the Friday prior) to $1,416 per troy ounce (oz), a decline for the day of almost 9%. The rout continued on Tuesday and Wednesday before prices stabilized just above $1,400 per oz. The question on investors' minds is, is this the beginning of the end of gold's ascent? Or, just a pause before new heights are attained?

Certainly evidence abounds to support both views. On the one hand, newly converted gold bears argue that inflation has been the dog that has not barked. Despite the ballooning of central bank balance sheets (to stimulate the global economy), not just in the U.S. but elsewhere as well, inflationary pressures have been subdued. Furthermore with precious metal prices (including silver, platinum and palladium) reaching record highs in 2012, anxiety was bound to set in with some investors itching to sell. And, finally, the bears suggest central bank demand (534 metric tons in 2012 or 12% of total demand) has peaked, with some banks (most notably Cyprus) expected to become sellers of the yellow metal.

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Gold bulls, however, are not bereft of convincing reasons to suggest the decline will prove a mere blip on an otherwise unstoppable ascent. The fact that inflationary pressures, at home and abroad, are tepid should not be taken as evidence that inflation will not accelerate in the future. The thought goes that the Federal Reserve (nor the European Central Bank, the ECB, for that matter) cannot be counted to protect purchasing power. After all, the Fed, according to this view, has been complicit in a massive, unprecedented transfer of wealth from savers to borrowers. Savings, by definition, represents a reservoir of future purchasing power. What further evidence is needed to convince holdouts who persist in placing their faith in the wisdom of central bankers?

Then, there is the continuing growth in demand from China, India and the Middle East. In 2010, jewelry, gold bar and coin demand by citizens of China and India was approximately 1,570 metric tons; or, just under 38% of aggregate global demand for all uses. Higher spot prices might crimp demand from the man on the street in Mumbai or Shanghai. But, consider their other options. They are few. Both India and China have banking systems viewed by outsiders as shaky. Both nations also have equity markets considered less than transparent. And, in the case of China, any local investor worried about a gold bubble is also equally concerned about a residential property bubble. Given the alternatives, precious metals, even at current high prices, may seem the safer bet.

Our view? Well, we suspect all of the usual suspects — central banks, hedge funds, sovereign wealth funds or the man on the street — but, central banks have perhaps the most to gain from a decline in the price of gold. In 2012, we estimate worldwide demand for gold was on the order of $236 Billion. Versus world production of $83 Trillion, aggregate gold demand accounts for only a fraction of global economic activity. This analysis is at the margin for the new supply. But, if we consider all of the gold held worldwide (estimated in excess of 165,000 metric tons), a $100 increase in price translates into paper wealth gains of $530 Billion. Compared to aggregate global economic activity in recent years, this number begins to loom large. So, an $800 per oz. gain over the past five years begins to look alarming.

Why would central banks be concerned by this? Because it suggests that a fair amount of the liquidity central banks have been pumping into the financial system is being siphoned off. Furthermore, the spot price of gold is a barometer of financial pessimism. Even at $1,414 per oz. — down from its high of $1,790 per oz. — gold's price suggests investors are none too optimistic. Pushing the price down may instill confidence.

Whoever started swatting at the gold bugs proliferating worldwide may find the infestation none too easy to control.


Notes on Sources and Methods:

London morning gold fixing prices quoted in dollar per troy ounce. Prices obtained from Kitco Metals Inc. The London fixings (morning and evenings) are widely quoted measure of gold and other precious metal prices. It is the price for settling contracts between members of the London bullion market.

All prices are in troy ounces. Weights are in metric tons. There is 32,150 troy ounces in a metric ton.

(Sources: Kitco Metals; World Gold Council; AIFS estimates.)

Important Disclosures

The views expressed in this document are based on political, market, economic and other conditions subject to change at any time. Data are acquired from sources believed to be reliable. But no warranties are made to the accuracy, completeness or timeliness of the data and information presented. Opinions expressed are those of the author unless indicated to the contrary. Nothing in this document should be construed or taken as financial or investment advice. Please consult with your financial advisor to discuss how the subject of this research report may impact your unique, individual circumstances.

Certain indices, yields, exchange rates and other market and economic statistics may be quoted or mentioned in this report. You can not invest directly in an index; nor can you obtain many of the other yields or rates quoted. Please bear in mind such indices and other statistics do not include many of the expenses associated with investing in securities including (but not limited to) trading costs, custodial fees and management fees. All index results cited in this document reflect returns including the impact of re-invested dividend or interest payments expressed in US Dollar terms unless noted to the contrary.

Investors should understand and consider these and other risks they may face by investing in the Funds. These risks are discussed more fully in the Funds' prospectus. Investors are encouraged to read the prospectus.

Source: An Infestation Of Gold Bugs