At presentations at worldwide mining events in the last few years, my favourite topic is to counter the myth on gold to be a monetary instrument  having the reputation to be the ultimate investment of choice, particularly in periods of a financial crisis and more specifically a hedge against the dollar.

This public opinion could be easily tested since the beginning of the 2008/2009 financial crisis, followed by the euro zone crisis this year.

While in the early stage of the financial crisis, on March 19, 2008, the gold price showed a high of $ 1,030.80 against a low of the dollar of $ 1.58 against the euro, since then, during the course of the financial crisis culminating into a credibility crisis, gold and the dollar followed a separate course.

Gold, expected to show a strong performance and limited volatility, and to protect investors in periods of culminating financial and economic turbulence, fell back 33% to a low of $ 692.50 on October 24, 2008, while during the same 5-month period the dollar was strengthening to $ 1.26, being preferred as a safe haven to gold.

When Lehman Brothers collapsed on September 15, 2008, it was striking to see that in the course of 2009 when the financial crisis looked to be under control supported by growing optimism on the 2010 outlook for the world economy, the gold price did not fully recover only but reached an all time high of $ 1,226.10 on December 26, 2009.

During this period, which took almost a year, the dollar weakened to $ 1.51 against the euro and it looked like the correlation with the dollar was restored. However, then the Greek crisis started to take its toll, also affecting financial markets of the other so-called pigs-countries, urging the European Union and the IMF to create a $ 750 billion rescue plan to prevent a collapse of the euro and threatening a  break-up of the euro zone.

With the euro crisis accelerating in concert with the euro loosing 17% since the beginning of 2010, resulting in a low of $ 1.17 against the dollar on June 7, the strong dollar didn’t hit the gold price but changed its course by becoming a hedge against the weakening euro in stead.

Compared with worldwide rescue packages to a total of US$ 2,000 billion in the last quarter of 2008 and first quarter of 2009 to attack the financial and economic crisis, this time the € 750 billion euro zone rescue plan followed by Europe’s bank stress test, have to restore confidence in the financial markets.

With the euro having recovered to $ 1.30 preceding expected positive results from the stress tests, confirmed  by only seven lenders out of ninety-one banks having failed the test, the threat of  the euro zone to collapse looks to be prevented just in time.
It shouldn’t be ignored however that the test applied only to assets held on trading books and ignored banking books where the bulk of sovereign exposure lies, including $ 2,000 billion of loans to be refinanced in 2012.

In the meantime, the US economy is showing a stronger recovery than the euro zone, as a result of which it looks like the Fed will tighten its monetary policy earlier than the European Central Bank. This will have a positive effect on the dollar.
A more positive scenario on economic growth implies that risk investment will increase, resulting in equity markets to recover, which will be at the expense of investing in treasury bonds and gold bullion.

Negative for gold is its fading monetary position. Against Western central banks and the IMF selling gold, only Russia and India have been buyers of importance in 2009/2010 to date. India has bought 200 tonnes off the market from the IMF which offered a total 403 tonnes for sale. Against expectations, China held off buying gold from the IMF.

Forced by the euro crisis, I expect further sales from the IMF and ECB gold holdings in an attempt to strengthen  to save the euro and expect that the deposited gold of the recently announced 382 tonnes BIS gold swap will not flow back to the countries being involved in the swap.

The recent intervenance of the IMF and BIS to sell and swap gold, respectively, underpins my view that the pure monetary function of gold has become replaced by an economic function as a bridge financing to bail out financial institutions in countries facing serious economic troubles.

Gold has already lost its monetary function since it doesn’t represent a realistic option to replace paper money as a reserve currency due to the value of the relatively small size of gold holdings compared with the value of dollars circulating. Also, Asia, led by China, is neglecting gold as a reserve currency and holds two-thirds of its monetary reserves totalling $ 2,450 billion in dollars. China’s priority is to secure the country’s economic growth by safeguarding the future supply of industrial commodities.
In summary, it is wishful thinking to believe that the current monetary position of gold justifies significant higher gold prices than the current $ 1,200 level.

Primarily, one should look at the investment merits of gold from a fundamental point of view based on demand and supply. Although retail demand has increased substantially since last year, its represents approximately 20% of total primary demand only, compared to approximately 50% related to jewellery demand, which has shown a strong decline in 2009, particularly in India, the world’s leading gold consumer.

A misconception is that the strong increase of the gold price since 2001, when it was quoted around $ 252, was fully driven by growing investment demand. The truth is that the impact of dehedging over the last ten years had a bigger impact  With the hedge books of major producers almost closed now, this will have a negative impact on demand, which has to be compensated for by ongoing investment demand, particularly of ETFs.

On the supply side it is a misconception to believe that consistently declining gold production will support a higher gold price. Actually, since emerging countries, led by China, are producing more gold than traditional countries since last year, world gold production has reversed its modestly declining trend.

Thereby it has also to be taken into account that the top-10 gold producers representing approximately 45% of total world gold production hold an average of 17 years of reserves related to their actual annual production. Reserves are valued at an average of $ 800-850 per ounce, leaving a strong margin for increasing the value of reserves, including upgrading of resources into reserves.

With margins at a gold price of $ 400 having risen from $ 150 in 2004 to more than $ 400 at today’s gold price of around $ 1,200, selective investment in the gold equity markets and particularly in near term producers and advanced developers, in my view, offer substantially higher investment rewards than gold bullion.

Since gold having appreciated 50% in value since the end of 2008, I would be happy to see the current trading range between $ 1,180 – 1,220 to be maintained.

Marino G. Pieterse

Editor, Gold Letter International

Marino G. Pieterse has been an independent financial analyst and gold specialist for more than 25 years. He is the chief-editor of Goldletter International, the only gold investment market letter in English in Europe focusing on emerging gold regions in the world, as well as reports on individually featured companies and special reports on other metals, including uranium. You can receive Gold Letter International’s reports for free by clicking on the “Subscribe” button.