Gold: Drivers For A Price Growth

Includes: GLD, UUP
by: Vision Capital M.

After oscillating around the $1,600 level for the summer, gold prices took a leap last week and advanced by more than 3% to finish at $1,669. The increase was sparked by several events, but the big question now relates to how long this price appreciation will continue. Are we at the start of a new longer-term uptrend in gold prices?

In order to find an answer, we should analyze the possible drivers of such a growth in gold prices. Usually it all comes down to supply and demand, including the quantum of money supply.

The demand for gold

The recent gold demand trends report of the World Gold Council summarizes the situation as:

"Gold demand for the second quarter of 2012 measured 990 tonnes, 7% below year-earlier levels. Weaker demand from the jewellery, investment and technology sectors was offset to some extend by a surge in buying by the official sector. The supply of gold declined 6% year-on-year, mainly due to lower levels of recycling… Looking at the first half of 2012, gold demand of 2090.8 tonnes was a 5% down on the previous year and 14% above the five-year H1 average of 1828.7 tonnes."

The report states also that China and India accounted for about 45% of the global consumer demand for gold in Q2 of 2012. The economic slowdown in China and the lack of a clearer trend in the gold price weighed on buying decisions in the country. The strong depreciation of the Indian rupee against the U.S. dollar in the March-July 2012 period (almost 14%) hampered demand in India, as the gold price in local currency surpassed the psychological level of Rs 30,000/10g. Currently, it trades at Rs 29805/10g. There are expectations that the demand will grow in the second half of 2012, as the wedding and festival season in the country approaches.

For the last two months, however, the Indian rupee's exchange rate against the U.S. dollar seems to be stabilized. Given the dollar continues to depreciate against most of the world currencies in the near term, this could be supportive for the rupee and the demand for gold in India, respectively.

Investment demand for gold during the recent quarter fell most notably in China, India and the U.S., while it grew in Hong Kong, Taiwan, Japan, the Middle Eastern countries and Europe, with Germany accounting for almost a 51% increase in the year-on-year volume of purchased gold.

The decline in the retail and investment demand was partially offset by increased purchases of the central banks and other official entities. The gold reserves of those institutions increased by 254.2 tonnes in H1 of 2012, compared with 203.2 tonnes in the first half of 2011 (marking a 25% rise). The quarterly increase of 157.5 tonnes was a record, since the sector became a net buyer in 2009. Supposedly the biggest reason for this record could be the need for banks to diversify their foreign exchange holdings. In the light of more monetary easing programs that could be ahead, such a need is not expected to decrease soon. This would mean that even a further decline in retail demand could be met successfully by purchases of the official sector and the price would consolidate for a longer period.

Large investments

Despite the overall statistics that show that investment demand in the world slowed during the second quarter of 2012, a recent Bloomberg article showed that two large investors increased their gold holdings during that period. John Paulson, who runs a New York hedge fund with more than $21 billion assets under management, increased the fund's share in the SPDR Gold Trust ETF (NYSEARCA:GLD) by 26% in Q2 of 2012. Soros Fund Management LLC more that doubled its holding in GLD to 884,400 shares.

History has many instances of great investors who failed. Hence simply copying another one's strategy is not a good option but keeping in mind what bigger players do could prove to be worthy sometimes. Often investors should have a broader look at the markets and "connect the dots" to make their own conclusions on which they could subsequently act.

FOMC minutes

Another dot in the gold price trajectory appeared last week, as the FOMC minutes were released. The participants in the meeting agreed that growth in the U.S. for the period was slower than previously expected. Some of them lowered their near-term forecasts mostly because of the weaker-than-expected increases in consumer spending and employment. The members were concerned about possible "strains in financial markets stemming from the sovereign debt and banking situation in Europe as well as the potential for a significant slowdown in global economic growth and for a sharper-than-anticipated fiscal contraction in the United States."

Still the participants' inflation expectations remained unchanged as the recent increase in energy prices is expected to be restrained by a weaker global demand and higher inventory levels. Concerning the continuation of the accommodative monetary policy for an extended period of time, a few of the participants shared their view that this could erode the stability of inflation expectations and lead to an upside pressure on inflation outlook.

At the end, the FOMC issued a statement in which it assured the markets that "the Committee will closely monitor the incoming information on economic and financial developments and will provide additional accommodation as needed to promote a stronger economic recovery and sustained improvement in labor market conditions in a context of a price stability." The FOMC next meeting is scheduled for September 12-13, 2012.

From the minutes, we see that further monetary easing in the U.S. could be expected sooner, rather than later, given that global and U.S. growth continues to drag and especially if the fiscal constraints on U.S. growth increase. In a previous article of mine on the possible depreciation of the U.S. dollar against the euro, I talk about the possibility of the U.S. hitting the debt ceiling before the end of the year. Part of the reasons for this would be the current payroll tax cut, which was extended to the end of 2012. A possible discontinuation of it in 2013 would weigh further on consumer spending, as noted by the FOMC members.

Another round of monetary easing, as mentioned by some members of the FOMC, could change the long-term inflation expectations - which would be supportive for gold prices, as gold is considered by many to be a hedge against a loss in the value of money.

As mentioned in another article of mine, the end date (September 8, 2012) for banks and other financial institutions in the U.S. to give their comments on the proposed regulatory changes concerning the risk weight of gold is approaching. Those changes, if accepted, could have a significant impact on the longer-term institutional demand and supply of gold - which would be positive for gold prices.

Bullishness of gold analysts

According to a Bloomberg article on Friday, 29 of 35 analysts surveyed by the media expect gold prices to rise this week. Two potential problems with this sentiment concerning long-term gold price appreciation are worth noting.

The first one is that it is a very short-term view for a more sustainable strategy. They could also have the same sentiment for the week after the next and so on, but this is about to be ascertained in future.

The second problem is that bullishness should be supported by fundamental factors to last longer. Most of them were mentioned above, including the continuing demand from central banks and the expected further monetary easing in the U.S. On the other end, stands the slowing consumer demand in China and India. If the current tendencies in those big demand providers continue in the same direction this would not act as a supportive factor for a longer-term increase in gold prices, given it is not completely offset by increases in demand elsewhere.

So an answer to the question asked in the beginning would be that we could be facing the start of an uptrend, but such a trend is not confirmed yet. There are reasons why the price would advance and there are those who would try to depress it. As a result, a further consolidation could be under way for at least as long as the price of the U.S. dollar has not changed completely its direction.

Investors willing to gain exposure to any possible increase in gold prices could use the SPDR Gold Trust ETF, GLD. GLD is an ETF that tracks the spot price of gold bullion and the fund's only holding is physical gold bullion. The fund has an expense ratio of .40%.

Keeping in mind, however, that the trend in gold prices is not completely clear yet, protection of a long investment in GLD could be appropriate. This could be done using an ETF with a negative correlation to the price of GLD, such as the PowerShares DB USD Bull ETF (NYSEARCA:UUP). This ETF tracks the performance of being long in the U.S. dollar against six major currencies and has an expense ratio of .50%. The correlation for the last five years between UUP and GLD is -0.72, but for the last year it increased to -0.85.

Disclosure: I 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.