Seeking Alpha
Research analyst, CFA, portfolio strategy, gold
Profile| Send Message|
( followers)  

Back in 2008 I went to my then boss and told him to throw out the text book, and that many of the classical correlations were going to be reversed. We were no longer going to be reverting to the mean from above, we were going to be reverting to the mean from below. We were no longer in an environment where our biggest threat was too strong economic growth and inflation, our greatest threat was going to be recession and deflation. The thesis was that the 2008 crisis was a game changer, and that it would force macro changes that would distort many historic relationships and understandings.

The most counterintuitive concept is that inflation will likely hurt the price of gold, not help it. Unlike the past, inflation will not be good for gold going forward, at least not until Central Banks run out of gold to sell.

The reason gold will be hurt by inflation, at least inflation overseas, is because of who owns the gold and why. During the post-2008 crisis, many Central Banks went on a gold buying spree. China started to diversify away from the US Dollar, as did many other Central Banks, and the diversification asset of choice was gold. Central Banks own astronomical amounts of gold.

Russia will cross the 1,000 tonnes mark by May. With gold production of its own, and the desire of Russia to continue adding to its influence and power as a financial center, it should be expected that central bank buying will continue regardless of the price swings in gold.

Analysts make a lot out of retail gold buying in India and China, but that demand is a relatively small percentage of the total world supply of gold. New production is enough to fulfill that demand, and more, lifting pressure off gold prices. Retail buying doesn't make up for Central Bank's reduced demand.

But India's appetite appears insatiable. According to the World Gold Council, India consumed 963 tons of gold in 2010, amounting to one-third of global demand. In the financial year ending March 31, 2012, India imported $58 billion of gold compared with $38 billion over the previous 12 months. In 2013, India imported 1,017 tons, up from 471 tons in 2000-01.

Gold ETFs alone hold enough gold to supply India for over a year.

According to data from State Street (SPDRs) and BlackRock (iShares), GLD and IAU held over 1,550 tons of gold earlier this year, an all-time high.

Analysts support the theory that the demand for China and India won't be enough to support gold.

Demand for physical gold bullion, especially in China, will remain strong in 2014, but it could lose its ability to support prices in the first quarter, said an Australian analyst. Victor Thianpiriya, commodity strategist from Australian New Zealand Bank (ANZ), said China and India to continue to dominate the physical market in 2014. China, in particular, has a long way to go before the desire to own the yellow metal is abated.

"The sky is the limit for retail demand in China," he said.

Unfortunately, although physical demand helps to support the market, Thianpiriya expects it is only a matter of time before prices drop below the yearly low established in June around $1,180.

The reason I say inflation is going to be bad for gold is because of who owns the gold and why. Central Banks have been buying gold as part of their monetary policy, and during a period of monetary expansion they have been buying a lot.

according to The World Gold Council's most recent report on global central bank holdings. These six nations have purchased large amounts of gold so far in 2013 or throughout 2012. And if their buying continues, their gold demand could offset some of selling pressure (which has driven gold price to below $1,400) in the future. Some nations may indeed continue buying because of central bank or currency issues.

Monetary Policy 101:

The US Federal Reserve, the Central Bank of the largest economy in the world, owns no gold.

Although the Federal Reserve does not own any gold, the Federal Reserve Bank of New York acts as the custodian of gold owned by account holders such as the U.S. government, foreign governments, other central banks, and official international organizations. No individuals or private sector entities are permitted to store gold in the vault of the Federal Reserve Bank of New York or at any Federal Reserve Bank.

Under our system the Federal Reserve buys and sells Treasury Bonds through its Federal Open Market Committee or FOMC. When the FOMC buys bonds they print money and buy bonds on the open market. That increases demand for bonds, driving up bond prices and driving down yields. It also puts new money into circulation. No longer is someone holding an illiquid government bond, they are holding highly liquid cash. The Fed then holds the newly purchased bonds as essentially collateral against the newly printed cash that was put into circulation.

That is how the Fed "injects" liquidity into the markets. The result is that bond prices increase with monetary expansion. The key is that expansionary monetary policy drives bond prices higher.

The Fed does the exact opposite when they want to contract the money supply. To shrink the money supply and take liquidity out of the market the Fed would sell the illiquid bond and receive the highly liquid cash. The result would be that bond prices would drop, and yields would increase. The amount of currency in circulation would also shrink.

That is how the Fed removes liquidity from the markets. The result is that bond prices fall with monetary contraction. The key is that contractionary monetary policy drives bond prices lower.

That's wonderful, but what does that have to do with the price of gold? In a word, everything.

While here in the US the Central Bank uses bonds to implement monetary policy, in many other countries they use gold. Just replace the word gold with the word bond in the above monetary policy explanation and you will see why inflation is bad for gold. More specifically, inflation in Nations that use gold to implement monetary policy. To make matters worse, some of those Nations were expanding their money supply when gold was $1,900/oz. To contract their money supply by $1,900, they will need to sell more than one oz of gold, and the selling will likely drive gold prices down even lower, compounding the situation. If the price goes low enough, the Nations may not have enough gold to fully implement the needed monetary contraction.

For example, imagine a Nation that has a money supply of $4,000, and that money supply was created when gold was $2,000/oz (yes I know it didn't make it to $2,000). That means that the Central Bank has a balance sheet of $4,000 in circulation backed by 2 oz of gold. Imagine gold drops to $500/oz. The Nation now has $4,000 in circulation, but only $1,000 in assets backing it. If the Nation wanted to cut its money supply in 1/2 to battle inflation, the most they could do would be to cut the money supply by 1/4 or $1,000. Most likely it would be less than $1,000 because the selling of the 2oz of gold would likely drive the price of gold lower. Because inflation in a relatively small Nation isn't likely to alter the world price of gold, the above scenario is a very real possibility.

a major market concern is that Cyprus is now likely a gold reserve seller. The World Gold Council shows that Cyprus's 2013 gold reserve is only 13.9 tonnes, which is 61.9% of the small nation's total foreign reserves. Concerns about selling from Cyprus are compounded by worries that larger troubled nations, including Italy, Portugal and Spain, may start selling gold to either raise capital or because of the existing Central Bank Gold Agreement sale programs.

To make matters worse, the US may not want to play along. Imagine the US likes cheap Russian imports, and those cheap imports are driving up the inflation rate in Russia. Russia wants to battle inflation, so it sells its gold to drive up the Ruble vs the US Dollar, and slow domestic demand and inflation. The US wants to continue to import cheap vodka so it implements a contractionary monetary policy to strengthen the US Dollar vs the Ruble. The stronger US Dollar will impact the world price of gold by driving it lower.

One other point is that I don't buy the arguement that lower gold prices will severely impact gold production, at least not anytime soon. Depending on what "sustained" means, this quote may or may not support my position.

If gold dips below $1,200 per ounce for a "sustained" period, serious production cutbacks are likely, World Gold Council representatives warned Monday.

The average industry cost of production is $1,200 per ounce, according to the council, which cited recent Thomson Reuters data. About 30 percent of the gold mining industry becomes unprofitable if prices fall below that threshold, the council estimates.

Gold mines are like Airlines and have a cost structure heavily weighted towards fixed costs. That kind of cost structure often results in producers producing well below their average cost. That in fact is what happened in the natural gas industry over the past few years. Companies with large fixed costs will continue to produce even it they are losing money, as long as they cover their variable costs. Depreciation isn't a cash flow expense, and depreciation is a big cost in mining. Mines may take 20 years to build and get operating, and I doubt they will let a short-term price drop shut them down.

Gold mines can take years to come online, up 20 years after deposits are first discovered, so the industry may take a long-term view on prices. The industry is also reportedly beset by a shortage of qualified mining engineers. The World Gold Council is an industry trade lobby whose members include major gold miners.

The other issue is hedging. If these miners were smart and hedged when gold was $1,900 they could care less what happens to the price of gold. No matter what happens to the price of gold they get to sell their newly mined gold for $1,900 until they deliver on all their contracts.

Miners unwound hedging activity in 2013, or "de-hedged," to the tune of 49 metric tons, according to GFMS. Still, there has been fresh hedging activity worth 11 tons, an activity which recalls strategies not seen widely for years.

In conclusion; the crisis of 2008, which inspired many Nations to move away from relying on US Dollar backed assets like T-Bills towards gold, has greatly altered the dynamics of gold. Market supply and demand are no longer the only factors that determine the price of gold. Central Bank monetary policy now plays a key role. Central Banks were instrumental in bidding the price of gold up to $1,900/oz, greatly expanding their money supplies as they built their inventories of gold. Those inventories of gold however are not earrings stashed in a jewelry box, those inventories are assets that back currency in circulation. Once inflation hits those Nations, they will be forced to sell their gold holdings. Because gold is now part of the monetary policy of these Nations, inflation will trigger gold selling, not buying. Because the US has a trade deficit with almost every Nation, the US has a currency that is relatively strong to most Nations. That means that inflation will likely develop in our trading partners long before it develops in the US. If that happens, foreign Central Banks will sell their gold, and drive its price down well in advance of inflation developing in the US. If and when unwanted inflation does develop in the US gold prices will increase, but before that happens gold must go lower before it goes higher. As long as Central Banks are holding gold that backs currency in circulation, inflation in those Nations will trigger gold selling, not buying, and that is the paradox that exists today.

Disclaimer: This article is not an investment recommendation or solicitation. 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. Full Disclaimer and Disclosure Click Here.

Source: The Golden Paradox; Expect Inflation To Hurt Gold, Not Help It

Additional disclosure: I also own calls on GLL