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If you own gold for investment, you need to understand what is likely to make it go down for an extended period – and when I say extended, I mean 20 years. The last time gold peaked in 1980 it was over 20 years before it regained its previous highs. That’s really too long to keep your money tied up. This article will look at current gold supply and demand and take a deeper look at what might cause a 1980’s type decline.

The World Gold Council (WGC) released their Gold Demand Trends for the 2nd Quarter and it continues to indicate gold is in a price bubble, just like the 1st quarter article. Supply is plentiful but prices keep going up anyway. The WGC has made some improvements in how they categorize data but still have what appears to be investment activity classified in the supply area, so I have re-sorted the numbers in an effort to clarify what is happening with supply and demand.

The table below tries to classify things into net physical supply and investment demand to determine if supply shortages are driving up prices. Total mine supply is growing strongly, up 4% in 2010 and 8% year on year in the 2nd quarter. Manufacturing activities (jewelry and manufacturing) grew 10% on strong growth in jewelry. Net supply available for investment was sufficient to cover investment demand with an excess of 112 metric tons in the 2nd quarter, so there was no demand restriction causing price rises. This means that the gold price rise is not caused by supply squeezes but something else.

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Gold Supply and Demand

The chart below makes it clear that investment has been maintaining demand for gold since 2001. Even the recent upturn in jewelry is based on investment as we will show below.

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Gold Usage

Jewelry use outside of the high inflation countries (China, India, et al) continues to decline, as would be expected in a price bubble. The chart shows jewelry demand declining by 1/3 since 2001. Breaking out China and India from the rest of the world makes it clear the recent spike in jewelry demand was only in India and China. Jewelry is a traditional store of value in India, and the liberalizing of gold ownership in China combined with relatively high inflation has made gold attractive to citizens of these countries. In the rest of the world gold is too expensive, which has resulted in it being out of style.

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Gold Jewelry Demand

Even though investment (some call it speculation) has increased the demand for gold, investment growth has not been great enough to cause a supply squeeze. There is some talk that gold is still in short supply and that mine production has not recovered to previous levels. The chart below shows that price increases have resulted in production increases that have brought mine production up close to its previous high. As production continues to increase, there should be downward pressure on prices.

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World Gold Production

Nevertheless, gold prices have skyrocketed. This is because gold is not like other commodities: it is also a currency reserve (not a circulating currency, but something that can be used to prove that an otherwise questionable circulating currency has value.)

Many people think this means that gold is a good hedge against inflation. It's not, at least compared to the normal creeping inflation. The chart below shows gold price compared to the consumer price index (CPI), both indexed to 1980=100. Even though inflation was continuous during this period (as showing by the upward sloping CPI line) the gold price was essentially flat until 2001 and didn’t catch up to inflation until 2010.

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Gold compared to CPI

The WCI released a report on this titled: The impact of inflation and deflation on the case for gold. While I don’t understand how they concluded that gold was a hedge against inflation (something about “time dummies” – really), there was a chart on real interest rates that supported an explanation by Brad DeLong that gold is a super Treasury bond: a very long duration asset that is or at least is perceived to be "safe"”.

The chart shown below visually proves that gold prices react to real interest rates, dropping when rates go up and increasing when they drop.

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WGC Real Interest Rates and gold

This interest rate sensitivity explains the recent spike in gold. If you chart the price of gold against the real interest rate on the 30 Year Inflation Protected Treasury Bond (a 17 year bond due 4/15/28), you can see an eerie correlation since the Lehman Brothers collapse and the subsequent flight to safety. Interest rates are inverted, so they read from lowest on the top to highest on the bottom. Note that the real interest rate according to this data from FRED of the Federal Reserve of St. Louis was 0.73% on August 1, 2011. There is not much more appreciation possible from interest rate decreases unless they go negative (people would pay money to buy a 17 year bond!)

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Gold Price compared to Real Interest Rate

Prior to 2008, the lack of price increases in gold as interest rates dropped might have been due to the manipulation that GATA was formed to fight, or perhaps more benign: the general lack of default concerns.

If gold is primarily acting like a long term bond, you can formulate that its superior performance under inflation would occur only when high inflation causes real interest rates to go negative. Gold would perform poorly under deflation because real interest rates cannot go negative because of the 0 boundary. With real interest rates almost at the 0 bound already, the likelihood of more price appreciation is very small.

In conclusion, the 3 most likely near-term scenarios for popping the gold bubble are:

  • Deflation where real interest rates rise because the 0 lower bound prevents further drops. This is a possible scenario if the economy drops into recession in the 4th quarter. It is very possible that headline inflation will be negative in the next few months due to recent drops in commodity prices.
  • Supply growth results in an obvious surplus of gold, driving down prices. This is a longer term but inevitable event. A rapid drop due to excess supply probably requires something like a revaluation upward of the Chinese renminbi, crushing demand in China as speculators there take major losses.
  • Increasing GDP growth would result in increasing interest rates and drive down gold prices, like the apparently now failing recovery did in November, 2010.

In any case, the upward movement of gold prices is very limited if it is dependent upon further decreases in real interest rates. The 1980 inflation adjusted peak of $2200 to $2400 occurred in a time of inflation which drove real interest rates negative. Inflation appears tame for at least the next 6 months.
Maybe the Fed will pull a rabbit out of its hat and drive interest rates negative in an attempt to revive the economy. We'll see.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Source: What Will Pop The Gold Bubble - Update