The World Gold Council released the Gold Demand Trends report for the 1st quarter 2012 Thursday and it continues to show increasing supply and decreasing basic demand. More importantly, gold may have just had what I'll call a reverse Hotelling Moment when investor confidence that gold will continue to go higher is shattered. I'll go over the details below and you can decide.
The chart below highlights the decreasing annual demand for gold in everything except investment (or speculation, your choice). Gold price appreciation flattened out from the end of 2011 to the 1st quarter 2012 but jewelry and technology use continued to drop.
I've left central bank (AKA Official Sector) sales and purchasing off the above chart as the wild swings from selling to buying distort what the private market is doing. The World Gold Council has finally recognized that central bank purchases and sales are not part of supply and made it a special category in demand. Central bank motivations are a mystery as banking theory does not have a strong rationale for using gold as a reserve instead of other currencies. In typical contrary fashion, central banks have sold heavily as the price of gold went up and started purchasing as the price of gold topped out.
To help clarify whether gold's price rise is demand or speculation based, I've re-sorted the World Gold Council data into 2 categories: New and Net Supply, and Investment Demand.
The New and Net Supply category shows whether there is price pressure because basic manufacturing (jewelry and technology) demand is not being met by new mine supply. In fact, gold is plentiful with mine supply growing at a 3% rate, while manufacturing demand is dropping precipitously, down 10% in the most recent quarter, resulting in an addition of 55 metric tons to new stock. Adding in recycled gold resulted in significantly more gold available for investment in the 1st quarter than last year.
Private investment demand grew 13% in the 1st quarter but was still not enough to absorb all supply without official sector (central bank) purchases. Central bank purchases dropped over 40% so perhaps they have decide buying high is a bad strategy. Net, total investment demand was slightly greater than supply resulting in a continued drawdown in OTC stocks.
The big issue here is whether central banks are going to continue to purchase gold? If central bank purchases continue there's a possibility of supply shortages which could push prices up, possibly with spikes like in September. Central banks will only buy gold if they think it will continue to go up so we get to our "Hotelling" Moment question.
Harold Hotelling was an economist who developed Hotelling's rule which showed that as long as the price of a commodity was believe to be going up, the value would go up or down with changes in the cost of storage, that is, the real interest rate (interest less inflation). While this rule doesn't necessarily apply in all cases, it has been very good at predicting the price of gold since 2008. The chart below shows the strong relationship of the price of gold charted against the inverse of the real interest rate, represented by the 5 year constant maturity Treasury Inflation Protected Security (TIPS).
A Hotelling Moment would be when investors/speculators become so convinced that gold will go up that they buy as much as they can afford and the price moves up or down primarily with the cost of storage (interest rates for investors). This is what appears to have happened in December '08 shortly after the Lehman Brothers blowup as shown on the chart below. A Reverse Hotelling Moment occurs when speculators become uncertain that price appreciation will continue. At this point, price changes become disconnected with drops in interest rates. This appears to have happened on February 28 when gold started to drop while interest rates remained low. With interest rates at current levels, gold should be between $1750-1800/oz if Hotelling's rule was still working. (Note that gold will still go down if real interest rate go up as increasing costs of storage make remaining investors less able to hold gold.)
So the current demand situation for gold is a basic oversupply but with investment/speculation demand that continues to absorb available supply. The inverse relationship with interest rates drops may have broken down because investors are no longer confident gold will continue to go higher. If gold does not relatively quickly return to a price of $1750 per ounce or higher, the gold bubble has been punctured and we can expect it to slowly deflate. Because real interest rates are anticipated to remain low through 2014, there should not be rapid price deflation so gold is probably still not a short.
Flight to safety seems to have broken down as a driver for gold (if it ever was) as investors are rolling into the dollar for safety and relative appreciation. US Treasuries are being sold at record negative interest rates. In the Euro currency crisis, the dollar is the direct play and gold is a secondary play which requires a lack of trust in the dollar. With the budget deficit actually shrinking in the USA (the wrong policy but what gold bugs recommend), end of the world gold bugs don't have a strong rationale for recommending short term gold purchases.
The wildcard is what do central banks do? If they abandon gold as a poor idea (which technically it is for a central bank) then gold will be in significant oversupply and we could have relatively rapid drops in price.
Given the reaction of gold pricing to lower interest rates, it is unlikely that gold will exceed previous highs and is probably at the start of a long, slow decline - a leak of the bubble. I'm continuing my April 16 recommend of rolling on rallies into other metals such as platinum (which is cheap compared to gold) to achieve diversification and better appreciation potential. More cautious investors should not wait for rallies to exit gold for platinum given the much better performance year to date and stronger fundamentals for platinum .