I’ve been asked to
talk about one of my favorite subjects: Gold . . . or, more precisely, the
global market for the metal and the factors likely to influence its future
price. In fact, gold is a subject on which I could talk for hours . . .
but I’ve been asked to keep my presentation somewhat shorter - so
I’ll try to give you some highlights and conclusions.
My comments today will be posted
on my website - NicholsOnGold.com - so, if you’re interested you can
easily check back to review my analysis and expectations.
I’ve been following gold
professionally since 1972 - when I went to work at Citibank as an
international economist and currency market analyst. My first
assignment at the bank was to write a paper on gold’s future role as an
international reserve asset.
At that time, American was
entangled in a costly and unpopular foreign war and an ambitious domestic
spending program - and the dollar was under assault in world currency
markets. Sound familiar?
Moreover, the Federal Reserve,
at that time under Chairman Arthur Burns, was financing excessive government
spending and a huge budget deficit by running its printing presses at full
blast. And, Americans were beginning to learn about stagflation.
On the gold front, the
metal’s price, which had been fixed officially at $35 an ounce in 1934,
gave way in 1968 - when the U.S. Treasury ceased supplying the world market
with ever-increasing quantities of the metal.
Since then, the market price of
gold has been free to float up and down -reflecting the metal’s own
supply/demand fundamentals and, in large measure, the attractiveness - or
lack thereof - of the U.S. dollar as a reliable store of value. And,
float up it did, rising 2400 percent to a peak price of $875 in January 1980.
So, today, here we are
again: America is once more financing costly wars abroad and massive
government spending at home. The Fed is again running the printing
presses as if there is no tomorrow. How can we not expect gold to
repeat its past performance - and rise dramatically in the years ahead?
I am sure some of the gold bears
in the audience will point to the differences between then and now:
especially the very deep synchronized global recession and decline in
business activity everywhere, the collapse in world stock markets, the burst
real-estate bubble, the destruction of personal wealth, and so on.
But, at the same time, we have
never seen a rapid increase in money supply - as that which is now underway
in the United States - that has not been followed by a period of rapid
inflation. And, as far as I know, there has never been a period of
rapid inflation in any country that has not been followed by a depreciation
of its currency and a rise in the local currency price of gold.
A Two-Sector Model
With this as background,
let’s look at some of the recent and prospective developments in the
world of gold - developments that will likely influence the metal’s
price in the months and years ahead.
In doing so, it may be
instructive to consider a two-sector model of the gold market:
In one sector gold is a
commodity where the ordinary forces of supply and demand operate. High
prices bring forth more supply and, at the same time, constrain jewelry and
industrial demand for gold.
In the other sector, gold is a
monetary and financial asset - and changes in the willingness or desire of
investors and central banks to hold more or less physical metal impact the
price. Here, demand is a function of inflation expectations, currency
stability, financial market performance, geopolitical considerations, and the
expected rate of return on holding the metal itself.
Gold as a Commodity
Let’s look first at gold
as a commodity:
On the demand side we have
jewelry consumption and industrial use (in electronics, for example), both of
which are positively correlated to growth in personal incomes and spending
and negatively correlated to the metal’s price.
On the supply side we have mine
production and the recycling of old scrap. Over the longer term and
reacting very slowing, mine output is a reflection of price versus the rising
cost of production and the difficulty in finding new deposits. Despite
the on-going development of new mines around the world, thanks to dwindling
output especially from South Africa, total world mine output is not expected
to increase much in the next few years.
On the other hand, recycling of
old scrap - mostly from jewelry - reacts quickly to changes in price beyond
certain levels that are seen by holders as attractive. We saw this
phenomenon last year. As prices rose through the $800 and $900 and
$1000 an ounce price levels, scrap supplies exploded - so much so that those
high price levels were unsustainable. Prices fell back sharply . . .
but scrap supplies remained fairly high until early this year.
Scrap recycling, which on
average runs about 1000 tons a year (about 32 million ounces) climbed to
perhaps double that rate in the fourth quarter of 2008 and the first quarter
In the current environment,
jewelry scrap has also been negatively correlated to personal incomes and the
collapse in financial asset values. Around the world, people in need of
cash or just wanting more liquidity, have scavenged their dresser drawers for
old bangles and the like to sell for immediate cash.
Today, commodity demand for gold
- reflecting the collapse in personal incomes and the rise in the price of
gold in the past couple of years - is at an extremely low level.
Jewelry demand, which typically accounts for about 70 percent of total gold
consumption, has fallen sharply . . . and, in the best of cases, seems likely
to fall throughout 2009 and possibly into next year as well.
Beyond this year, jewelry fabrication demand will undoubtedly recover, but
only very slowly - and it may be years before it regains the levels achieved
at the turn of the century.
I don’t want to dwell on
particular numbers - inexact as they are - but just to give you a sense of
magnitude, jewelry fabrication demand has averaged about 2700 tons (or 87
million ounces) annually in the decade through 2007 and has absorbed or consumed
about 80 to 85 percent of total supply from mine production and old scrap
over the years.
Last year, jewelry demand fell
about 22 percent to some 2100 tons . . . and this year we could see jewelry
fall another 20 to 25 percent to 1600 tons or less.
Some gold bears say with this
deep collapse in jewelry demand it will be impossible for gold to sustain
recent levels, much less rise to new highs in the years ahead.
Gold as a Financial
While changes in gold’s
commodity fundamentals may be huge, what’s going on in the monetary and
financial sphere for gold is absolutely overwhelming - and it is these
developments that will drive gold higher in the next few years despite the
weakness in commodity demand for gold.
First of all, the introduction
and popularity of exchange-traded funds - ETFs as they are called - has
changed the gold market in a very important structural and fundamental way .
. . and I don’t think this is yet well appreciated or understood by
most observers of the gold scene.
Gold ETFs are gold-backed
stock-market securities representing ownership in a trust designed to track
the ups and downs in the metal’s price.
Gold ETFs closely track the
market price of gold but are bought, sold, and trade just like equities on a
stock exchange - yet they avoid some of the tax, storage, and other
difficulties associated with owning physical gold.
By facilitating gold investment
for individuals and institutions, ETFs are likely to result in significantly
more investment demand than would otherwise be the case. In fact this
is already happening. At the same time, recent high prices - and the
uncertain, anxiety-ridden economic and investment environment - are
attracting more investors to gold.
Bullion held in depositories on
behalf of gold exchange-traded funds is now at record levels. At about
1650 tons (or just over 53 million ounces), these funds have just about
doubled since early last year.
Collectively, they are among the
world’s biggest holders of gold, now ranking just ahead of the central
banks of either China or Switzerland. Only the International Monetary
Fund and the central banks of the United States, Germany, France, and Italy
Importantly, the rapid growth of
gold exchange-traded funds is a two-edged sword for gold, increasing
volatility both up and down. By facilitating gold investment and
ownership by individuals and institutions they have, without a doubt, brought
significant numbers of new participants to the market and boosted buying by
veteran gold investors as well.
Just this past week, for
example, it was reported that the hedge-fund firm run by billionaire John
Paulson owned 8.7 percent - about 98 tons more or less - of the SPDR Gold
Trust. And, for sure, other hedge funds and investment institutions
also have some sizeable positions in this and other gold ETFs around the
A word of caution: The
ease of investing in gold via exchange-traded funds is matched by the ease of
disinvestment. Selling of gold by ETF investors is as simple and as fast as
selling just about any equity or mutual fund. Just as quickly as
gold-ETF depository holdings have grown so might they shrink when sentiment
changes and investors - large and small - cash out.
Indeed, gold ETFs have
contributed to the increased short-term, day-to-day, gold-price volatility
over the past couple of years . . . and they are likely to contribute to
long-term cyclical volatility as well - with gold’s ultimate cyclical
high in the next few years much higher than most analysts and observers of
the gold scene now expect.
Now, let’s turn to central
banks and changing official attitudes toward the yellow metal since these
players will also have a very big impact on the gold market in the years
On average, the central banks of
the world hold around 10 percent of their international reserves in gold.
However, the percentage of gold
in total reserves varies greatly among central banks and from region to
region. The major Euro-zone nations together hold about 58 percent of
their assets in gold. In contrast, the Asian nations as a group hold
only about 2 percent of their reserves in gold.
China, America’s biggest
creditor, has only 1.7 percent of its officially reported reserves in
gold. Japan has only 2.1 percent of its reserves in gold, and Taiwan
has about 3.8 percent of its reserve assets in gold.
Another big holder of U.S. debt
is Russia with about $330 billion in reserve assets, of which only 2.1
percent is in gold.
The big news for gold is that
central banks are now buying and adding gold to their reserves. This
follows decades of net official sales and periods when simply the threat of
sales depressed the metal’s price.
This past month marks the tenth
anniversary of Britain’s 1999 decision to sell a large portion of the
Bank of England’s official gold holdings in favor of interest-bearing
government bonds. Other European central banks - among them
Switzerland, France, Italy, Spain, Netherlands and others - followed suit,
together selling about 3,800 tons in the next ten years.
Just a few months after European
central banks began these large-scale sales, they announced to the world that
they would coordinate and limit their annual sales to roughly 400 tons and
sell no more than 2,000 tons in total over the next five years.
This became known as the first
Central Bank Gold Agreement (or CBGA-1). While the United States and
Japan were not signatories, they tacitly agreed to the limitation and neither
has sold since.
Some six months prior to the
expiration of the first Central Bank Gold Agreement, the European central
banks (with some change in country participation) signed a second five-year
agreement - CBGA-2 - this time limiting their annual sales to no more than
500 tons and their total sales over the period to no more than 2,500 tons.
In actuality, gold sales by this
group of nations proved to be far below the allowable limits . . . and sales
by the Agreement Signatories this year could total no more than 150 tons.
With this Agreement set to
expire later this year on the 26th of September, many observers believe that
a third agreement will be announced in the next few months, possibly with the
inclusion of the IMF, either as a signatory or tacitly incorporating
prospective IMF sales into the group limitations.
The IMF Board of Governors has
already stated its desire to sell 403.3 tons as part of its plan to cover the
organization’s operating deficit. More recently, leaders of the
Group of Twenty, including President Barak Obama, said that revenue from
these sales would be used to help the world’s poorest countries.
Although IMF sales now seem very likely over the next few years approval by
member nations is still required. (Importantly, U.S. approval - which
by dint of America’s large voting position in the Fund is necessary -requires
In any event - and of great
significance - it looks like the official sector is now turning from a net
seller to a net buyer of gold, regardless of another Agreement and even
allowing for IMF sales of 403 tons spread out over the next few years.
For one thing, the pattern of
sales in recent years suggests that the Europeans have exhausted pent up
supply. For another, with the rise in the gold price over the past
decade, many of these central banks have been embarrassed by their poor sense
of timing and huge paper loses on their gold disposals.
Meanwhile, a number of other
countries have become gold buyers, most notably China, which has recently
acknowledged the transfer of 454 tons to its central bank, the People’s
Bank of China.
It is important to recognize
that this metal was actually acquired over several years by the State
Administration of Foreign Exchange (SAFE) from domestic gold-mine production
but only recently transferred to the central bank for inclusion in its
official reserves. It is very possible that SAFE or other government
agencies still hold significant quantities of gold that have not been
transferred to the central bank and are not yet counted as official reserves.
Moreover, with much talk in
official circles about China’s need to diversify its official central
bank reserves, it seems likely that the central bank or other government
agencies will continue to buy significant quantities of gold from domestic
mine production - perhaps totaling 100 to 200 tons a year - in the next few
Russia, like China, has also
begun buying gold for official reserves from its own growing domestic mine
production. Prime Minister Putin has said that Russia should hold 10
percent of its official reserves in gold bullion - and recent reports
indicate the country has added some 90 tons to official reserves so far this
A few other countries not
usually considered key players in either international monetary affairs or
the gold market have recently emerged as gold buyers: Ecuador has doubled
its official gold reserves, buying some 28 tons (900,000 ounces) so far this
year; Venezuela has bought 7.5 tons (240,000 ounces). There’s
some talk that an unnamed European central bankh as also bought gold this
year and suggestions that others - including the Arabian Gulf states, Brazil,
and even India - are considering purchases.
One can imagine, especially with
today’s world economic and geopolitical situation, that the central
banks of countries with relatively large U.S. dollar holdings might like to
diversify to reduce risk their U.S. dollar risk.
So, if European sales do
continue under a new Central Bank Gold Agreement . . . or if the IMF actually
begins selling . . . it seems to me that some of these countries - like
China, Russia, Japan, India or others with relatively low gold
positions and relatively high U.S. dollar reserves will use these gold sales
as occasions to buy without disrupting the market.
When all is said and done, when
we’ve examined all the supply/demand data and all of the economic and
political influences, one crucial fact remains most important to
understanding - and predicting - the future price of gold:
We have never in the history of
money seen such an expansion in its supply as that now underway - in the United
States and globally - without experiencing, after a period of time, a rapid
deterioration in the value of money - in other words, without a rapid
increase in the overall price level.
More than any other factor
influencing the gold market, it is the inevitable devaluation of money and
the corresponding rise in price inflation that will propel gold skyward in
the next few years.
As sure as night follows day,
today’s reflationary monetary policies - however necessary - have
long-term implications for global inflation. Typically, monetary
creation affects price inflation with a lag of six months to a couple of
years - and, in the current environment, the lag could be still longer . . .
so it may be some time before inflation is recognized as a serious problem.
But gold prices have shorter lags and could begin moving up before rising
inflation becomes apparent or worrisome.
Longer term, gold-price
prospects remain as bright as ever - and I firmly believe we will see record
high prices in the next few years.
With the right confluence of
economic and geopolitical developments we should see gold break through
$1500, then $2000, and possibly still higher round numbers in the next few
years - particularly if we get the type of buying frenzy or mania that often
occurs late in the price cycles of financial and commodity markets.
Ladies and Gentlemen:
Thank you very much for your kind attention . . . and now I would welcome any
questions or comments from the audience.
all the other articles published by Jeffrey Nichols
Jeffrey Nichols, Managing
Director of American Precious Metals Advisors, has been a leading gold and
precious metals economist for over 25 years. His clients have included
central banks, mining companies, national mints, investment funds, trading
firms, jewelry manufacturers and others with an interest in precious metals
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