How Central Banks Are Pushing Gold Prices Higher

|
 |  Includes: GLD, IAU, NGD
by: Amine Bouchentouf

Central banks around the world are major players in the gold market and they influence gold prices both directly and indirectly.

Money Supply and Gold Prices

Central banks control the spigot of money available in the world. It's no secret that central banks - particularly those in Western economies - have been following an extremely loose monetary policy, and thereby increasing the amount of paper money.

What is less-known is that there's a direct relationship between all this money printing and the actual price of gold. The World Gold Council published an excellent analysis of how gold prices react to movements in the global money supply.

The analysis, based on a multiple regression model, shows that there's a direct relationship between the money supply and gold prices. When the Federal Reserve increases money supply by 1%, gold prices increase by 0.94%. Of course, not all central banks are created equal and what the Fed does has much more influence on gold prices than, say, the central bank of Turkey. The results of the study are included below:

Source: World Gold Council

This relationship between the actions of the Federal Reserve and the price of gold are further captured by the chart below, which isolates the US money supply vis-a-vis gold prices (click to enlarge images):

Click to enlarge

Source: IMF, World Gold Council

As you can see, the increase in the US Monetary Base is clearly linked to the rise of gold prices we've experienced in the last decade. Since this relationship is not 1:1, I qualify it as an indirect relationship, although the actions of the Fed's monetary policy has an undeniable effect on the gold markets.

Central Banks Get Physical

Countries have been using gold as a currency ever since written records are available. And the world's central banks have one thing in common: The vast majority own direct physical gold bullion, which they store in vaults as a currency alternative. Central bank purchases of gold have a direct impact on the price of bullion.

The Bank of England Gold Vault

For those who doubt gold's monetary status, let us ask the following question: If gold isn't money, then why do central banks hold over 20% of above-ground gold reserves?

Let us go further and ask this same group: If gold isn't money, then why does the Federal Reserve hold over 75% of its currency reserves in gold?

The fact of the matter is that gold - for a number of different reasons - acts as a monetary asset and that central banks play a crucial role in determining bullion prices. Central banks view gold as a monetary asset and have a policy in place to acquire this asset through physical purchase programs. Currently, the largest holders of gold bullion are the United States, the Eurozone, Germany and the IMF.

In addition, these holders have the overwhelming majority of their foreign exchange reserves in gold. The Federal Reserve has 75% of its forex reserves in gold; 72% of the German central bank's foreign reserves are held in gold bullion. The following table shows the largest central bank holders of gold:

Rank Country/Organization↓ Gold

(tonnes)

Gold's share

of national forex

reserves

- European Union Eurozone 10,792.6 60.7%
1 United States USA 8,133.5 74.7%
2 Germany Germany 3,401.0 71.7%
3 IMF 2,846.7 -
4 Italy Italy 2,451.8 71.4%
5 France France 2,435.4 66.1%
6 People China 1,054.1 1.7%
7 Switzerland Switzerland 1,040.1 16.4%
8 Qatar Qatar 950.3 7.1%
9 Russia Russia 775.2 6.7%
10 Japan Japan 765.2 3.0%
Click to enlarge
Source: The World Gold Council. Data as of Dec 2010

Central Bank Gold Purchases on Overdrive

Central banks around the world are stepping up their purchases of gold bullion. Year to date purchases of gold by central banks is up 168%. South Korea, Mexico, Russia and Thailand have all made large purchases of bullion this year. I expect this trend to continue, especially among the emerging market central banks.

For those who doubt that central banks have the ability to increase their gold holdings, here's one thing you need to keep in mind: while the European and American central banks hold over 70% of their reserves in gold, emerging market central banks hold less than 5% in bullion. Consider the following:

Total Reserves in gold, percentage:

  • Brazil: 0.5%
  • Russia: 8.2%
  • India: 8.5%
  • China: 1.6%
  • Japan: 3%
What do you think would happen to the price of gold if the BRIC central banks were to increase their percentage of gold holdings to the level of the North Atlantic central banks? And we're already seeing signs that the Chinese central bank is making an aggressive move to diversify from Euros and Dollars and into gold.

The bottom line is that central banks have a direct influence on gold prices since they're such large holders of bullion; and their activities in the physical market will continue having a major impact on gold prices going forward. If you believe that central banks will continue buying gold then it's not too late to jump in gold.

Owning physical bullion can be beneficial in and of itself, although you have extra costs related to storage, transportation and insurance. Another alternative is the ETFs:

  • SPDR Gold Shares (NYSEArca: GLD)
  • iShares Gold Trust (NYSEArca: IAU)
The ETFs are an easy alternative although there are fees associated with them, and the tracking of physical gold prices is not 100%. Another option is gold equities, especially junior miners which can offer a lot more upside due to their low extraction costs and the industry's M&A.

I highlighted the benefits of owning a junior miner such as New Gold (NYSEMKT:NGD) in a previous article. Either way, if you're bullish on gold - and central bank activities provide another support for future price increases - it's important to be appropriately positioned in a way to benefit from rising prices.

Disclosure: I am long NGD.