Gold: The Metal That Central Banks Love To Hate

by: Andrew Hecht


Gold has been telling us something in 2016.

Central banks continue to be the biggest holders in the world.

Talking down the dollar?

Why they love the shiny metal and why they hate it - a balancing act.

Gold is a report card, and it is giving those bankers a D-.

Gold is the one means of exchange that has outlived all others. Each and every paper currency that exists today, backed by the full faith and credit of the governments that print the bills and mint the coins, is relatively new compared to gold. Gold has been around for thousands of years.

There are a growing number of people on the planet that invest in and hold gold for security and wealth preservation. The argument for gold is that it is the best hedge for inflation. Paper money, or currency, has been cheap around the globe as low interest rate and quantitative easing policies by the world's central banks in the wake of the global financial crisis of 2008 have decreased interest yields and the cost of borrowing. The theory behind these policies is that economic stimulus comes from spending and borrowing rather than savings. Many people who buy and hoard gold do so out of a basic distrust of central bank policy. The irony in that is central banks are the largest holders of gold in the world, holding over 30% of all the gold ever produced in the history of the world.

Gold has been telling us something in 2016

2016 has started with a bang across all asset classes. Volatility has picked up in equities, debt, and currency and commodity markets. Meanwhile, one of the strongest markets out there this year is gold and historical volatility is actually declining - the rally has been a slow and steady affair.

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The daily COMEX gold futures chart highlights that the yellow metal has appreciated by over 10.7% so far in 2016. At the same time, daily historical volatility has dropped from over 20% in late December to its current level of around 11.01%. This makes gold not only the best performer in 2016 but also a stable alternative to cash, which has been king this year. Gold is looking good. There are signs that both investment and speculative demand is returning to the market. Open interest, the total number of open long and short positions on COMEX gold futures, initially fell in 2016. At the end of 2015, there were 415,220 open futures contracts; by January 26 this metric fell to 373,434. While rising price and falling open interest is not a bullish signal for a futures market, in the case of gold, it represents that shorts in the market threw in the towel and closed positions given the strength in the yellow metal. Recently, open interest has begun to pick up and now stands at 391,899 contracts as of Friday, February 5, 2016. The wave of volatility that is sweeping across all markets has resulted in a flight to quality and gold has been a big beneficiary. Expect this to continue if gold continues to march higher; it will pick up believers with each tick higher. Since the middle of January, the gold market has been a one-way ride up.

Central banks continue to be the biggest holders in the world

Central banks around the world hold huge quantities of gold as part of their foreign currency reserves. The U.S. is the world's largest holder of the yellow metal with 8,133.50 tons, according World Official Gold Holdings reported by the World Gold Council. This translates to 261,492,025 ounces with a value of around $307 billion at a price of $1175 per ounce. This is a drop in the bucket when compared to the current level of the national debt but still a significant asset.

While there are always questions about the whereabouts and actual number of tons of U.S. holdings, this reported number has remained steady for decades. The next four largest governmental holdings of gold in order are Germany with 3,381 tons; the IMF with 2,814 tons; Italy with 2,451.8 tons and France that holds 2,435.6 tons. All of these holdings have remained stable from February 2015 to February 2016 with the exception of Germany whose reserves fell by only 3.2 tons or about 100,000 ounces over the course of the year. In the cases of all of the nations in the top five (with the exception of the IMF), their gold holdings represent more than 60% of the total national reserves. The big changes in gold holdings came in terms of the sixth and seventh holders of the metal.

In 2015, Russia was the sixth largest holder of gold and China was seventh. The two nations switched places by February 2016, but both increased reserves dramatically. In 2015, China held 1,054.1 tons; they now own 1,762.3 tons - an increase of over 67%. In 2015, Russia held 1,208.2 tons; this February their holdings were up to 1,382.9 tons - an increase of over 12.5%. While Russian holding represents 13% of total national reserves, the Chinese gold only represents 1.8% of their reserves. Even though both nations are experiencing economic hardship, they continue to add to gold reserves.

On a year-on-year basis, world central bank holdings rose by 761.6 tons of gold or almost 24.5 million ounces. While China and Russia increased holdings by a combined 882.9 tons, all other central banks only sold a net of 121.3 tons. The bottom line is that central banks of the world covet their gold.

Talking down the dollar?

Central bank activity in the post 2008 years has reached a new level of intervention. Quantitative easing and low interest rates are tools at the disposal of these institutions as they attempt to manage economies around the world. While QE has ended in the U.S. and short-term interest rates rose at the hand of the Fed for the first time in nine years in December, QE remains in force in Europe under the direction of the European Central Bank. In China, six interest rate cuts in 2015 and intervention to devalue the yuan have been tools used in an attempt to stimulate the slowing Chinese economy.

The U.S. dollar had been strong prior to last Wednesday. The greenback was pushing up against the 100 level on the March dollar index futures contract. As the U.S. is one of the only countries growing at a moderate pace and in light of the interest rate hike in December of 2015, the dollar has been strong. However, a strong dollar presents a problem for the U.S. central bank for a number of reasons.

Dollar strength makes U.S. exports less attractive to the rest of the world. This results in problems for corporate profits, the labor market and overall economic growth in the United States. The dollar is the reserve currency of the world, just as other nations hold gold, they also hold dollars as part of their foreign currency reserves. Therefore, the pricing mechanism for commodities around the world is the U.S. currency. The Fed has a hard target for inflation in terms of future rate hikes in the current interest rate cycle. A strong dollar has been an important factor depressing the prices of raw materials. Thus, inflation has been far short of the Fed's 2% target.

Last Wednesday, NY Fed President Dudley said a stronger dollar could have "significant consequences" for the U.S. economy. In other words, the expected rate hikes may not be forthcoming if the dollar continues to rally. This dovish statement by an important member of the U.S. central bank sent the dollar reeling.

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The U.S. dollar index fell by over 2,400 points or 2.4% Wednesday and Thursday of last week. On Friday, the dollar index bounced back rallying just under 600 points on the session. In response, many commodity prices rose on Wednesday and Thursday. Gold rose by more than $30 in response to the weaker dollar on those two days, and it rose another $16 on Friday when the dollar strengthened.

Central banks use tools to manage markets and economies. Sometimes the best tool is their bully pulpit. It is highly probable that Dudley's statements were purposeful. The statement surely cleared the way for another rate rise since commodities appreciated taking the inflation rate closer to the Fed target and the dollar fell leaving lots of room for a rebound the next time the Fed acts.

A lower dollar was in the best interest of the U.S. central bank as it approached 100 and the key technical resistance level at 100.70, the December 3 highs. Jaw boning or talking down the dollar is a method of intervention that turned out to be highly effective, in this case.

Central banks have many tools at their disposal when it comes to managing monetary policy; one of the tools that they rarely talk publicly about is gold.

Why they love the shiny metal and why they hate it - a balancing act

Central bankers love to hate gold. They love it and a testament to that fact is the addition of just under $29 billion worth of the yellow metal to their coffers over the past 12 months. Every major country in the world owns gold as a significant part of their foreign currency reserves. In the U.S., gold represents over 72% of the national reserves. However, rarely if ever will you hear the Fed Chairperson or any members of the FOMC whisper a word about gold. They talk about the dollar, oil prices, equity prices and other assets but gold is almost a taboo subject. When it comes up, Fed leaders avoid the topic.

When Congress questioned former Fed Chair Bernanke about the precious metal, he told the legislators that he really does not understand gold as it is an "unusual asset." The ECB rarely talks about it nor do the Chinese or any other major governments. They just hold it and over the past year, they added to their aggregate holdings. Therefore, it is fair to say that these central banks both respect and love the shiny and lustrous metal. They also hate it with a passion.

When central bankers do their jobs well, the price of gold is stable and it tends to move lower. That is because fiat currencies derive their value from the full faith and credit of governments that issue the paper and coins and the central banks that manage economies. When faith in government monetary policies declines, gold tells it like it is. In 2016, gold is not very happy with the job that central bankers are doing. Sure, they can manage a rising gold market by selling some reserves into the market to depress the price. The problem with that is what happens if they sell it and it keeps rising? For central bankers, gold is a blessing and a curse at the same time, a catch-22 and a yellow metal that they love to hate.

Gold is a report card, and it is giving those bankers a D-

With gold and high-quality bonds rising in 2016, the markets are telling us two things. Expectations are for a continuation of low interest rates, QE and management of economies by the central banks of the world. That is why U.S. treasuries are rising, for now. The market perceives a put option under the market for government debt. When things go wrong, the central bank will step in with another round of dovish tools to lower rates, causing bonds to rally in their quest to stick another finger in a leaking hole in the financial dam by providing yet another round of stimulus.

Gold is rallying because faith is slipping in terms of the monetary authorities' ability to control a global economy awash in cheap money and markets that are bucking like wild broncos. The appreciation of gold thus far in 2016 amounts to a report card for the central banks of the world. When the dollar was strong, the price of gold was falling in dollar terms but it was more stable in other major currencies. In weak currencies like the ruble, Brazilian real, South African rand, Australian dollar and others, gold moved appreciably higher last year. At that time, gold gave the central banks and economies of those nations a failing grade. In 2016, gold is eyeing the U.S. central bank and so far, it looks to me like the Fed is looking at a grade of D- from the yellow metal.

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The monthly chart for gold tells us that in dollar terms, the final exam could be coming soon. Gold has been making lower highs and lower lows since the price rose above $1900 in 2011.

The true test for gold comes at $1200 per ounce. At that level, it will break out of the almost five-year bearish trend. Will it break the cycle of lower lows and lower highs since 2011 - we will find out soon; we are only $25 away. Janet Yellen and company are about to face the ultimate arbiter in terms of their policies over recent years.

More rate hikes will support the dollar and will likely cause gold to fall back into its bearish trading pattern. If this does not happen and gold breaks out to the upside, it will tell us something significant about the U.S. and global economies. From a macro perspective, remember that gold in dollar terms has rallied in the aftermath of the first interest rate hike in the U.S. in nine years. There is a price to pay for low interest rates, debt and lots of cheap money flowing around the world. That price is inflation - gold's best friend and the worst enemy of central bankers. A battle between the two could be on the horizon.

As a bonus, I have prepared a video on my website Commodix that provides a more in-depth and detailed analysis on gold to illustrate the real value implications and opportunities.

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

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: The author always holds part of his portfolio in precious metals, that percentage varies with market conditions.