Back on the 13th of May I took a look at the gold price and gold market and gave some thoughts on the subject. Since then the price of gold has remained reasonably firm and as of yesterdays close the front month for Comex gold futures closed at US $1205. There is a lot of debate over why this is so and there have been some new interventions in the debate that I think are worthy of note. It is of course a subject that often leads to passionate debate as you could almost summarise the debate as you either love it or hate it and both extreme camps tend to view the other as simpletons and fools!
Some time ago the Sage of Omaha gave his view on gold.
“Gold gets dug out of the ground in Africa, or someplace,” he said. “Then we melt it down, dig another hole, bury it again and pay people to stand around guarding it. It has no utility. Anyone watching from Mars would be scratching their head.”
So I think that we can safely assume he is not a fan.
A Ponzi Scheme?
An article in the Wall Street Journal recently advanced the view that the gold market operates as follows. Over the past decade or so the price of gold has risen approximately fivefold. This rise has been because there have been more buyers than sellers. But according to data from the World Gold Council, an industry body, there is no shortage of gold at all.Over the last decade the world has produced—or, more accurately, recovered—far more gold than anyone actually wanted to use. Since 2002, for example, total demand for gold from goldsmiths and jewelers, and dentists, and general industry, has come to about 22,500 tonnes. But during the same period, more than 29,000 tonnes has come on to the market. So there has been a surplus of 6500 tonnes of gold since 2002,according to these figures.
Most of the new supply has come from mine production. Some, though a dwindling amount, has come from central banks. And a growing amount has come from recycling with old jewelry and the like being melted down for scrap. So if supply has consistently exceeded user demand, how come the price of gold has still been rising? In a word, hoarding. Gold investors, or hoarders, have made up all the difference. They are the only reason total “demand” has exceeded supply. Lots of people have been buying gold in the hope it would rise. But the only way it can rise is if still more people buy it, hoping it will rise still further. And so on.
What do we call an investment scheme where current members’ returns depend entirely on new money brought in by new members? A Ponzi scheme.
The argument is actually quite seductive but I feel that there are some points which are relevant.
1. Over the past few years has seen a reduction in investors faith in fiat money. It would appear that the main central banks of the world are willing to engage in Quantitative Easing (which many people other than gold bugs see as printing money) on a scale which is unprecedented and only recently the European Central Bank has started on this road. So there are genuine fears of inflation should such action be repeated or carried on.
2. I am always cautious about statistics and wonder how accurate the numbers from the World Gold Council actually are.
3. Calling holders of gold “hoarders” may be inaccurate after all many seem to believe it has value and may have no intention to sell in these times. Only time will tell if it proves to be a better store of value in this century than the last one.
What is actually occurring?
Well the various mints around the world are seeing an increase in orders. Back when I wrote my previous article on gold there was talk of a lot of gold buying from Germany and Austria. It turned out that the Austrian Mint sold 238,000 ounces of its Vienna Philharmonic coin last month, six times the volume in May 2009. In another example The US Mint sold 190,000 one-ounce American Eagle coins in May which was nearly treble the sales of a year before, and the highest since January 1999, when gold was trading at less than a quarter of its current price. This demand has carried on as the Rand refinery in South Africa, which produces the world’s most popular gold coin, the krugerrand last week increased production by 50 per cent to keep up with demand. Whilst consumption of coins and small bars makes up a relatively small part of overall gold demand, it is clearly showing signs of being a leading indicator of investor sentiment.
Central Bank Sales and Brown’s bottom
Over the past decade central banks particularly European ones have been sellers of gold. Exact figures have been hard to find and I even heard a story of a journalist being fired from his job for trying too hard to track down the numbers but in the end these things always leak. Anyway it is estimated that central banks in France, Spain, the Netherlands, and Portugal followed the UK’s 1999 example and sold large chunks of their gold reserves when gold prices were around US$280. They sold around 3,800 tonnes of gold for around $56 billion, according to estimates in the FT. If they’d kept those gold reserves and not bought government bonds with the proceeds, those banks would be $40 billion better off.
The example which they followed was when Gordon Brown back in 1999 decided to sell off some of the United Kingdom’s gold reserves. He sold 395 tonnes at an average price of US $275. He then reinvested the money in foreign currencies in the ratio 40% US dollars, 40% Euros and 20% Yen. At current prices the sale of the gold makes a loss of just over 11.5 billion US dollars. It is not easy to estimate the interest we would have received on the money but I estimate that at around 2.5 billion US dollars. So Brown’s bottom currently has an opportunity cost of around US $ 9 billion by my reckoning.
Last year central banks sold only 246 tonnes of gold according to the FT which was the lowest for some time. Sadly it means that they are heavy sellers at low prices and minor sellers at high prices. It is fortunate for them that they do not have to make a living doing this,although of course it is very unfortunate for their respective taxpayers.
I still feel as I did back on the 13th May that fear and uncertainty are the main drivers behind the advance in the gold price. The recent additional spur was the fact that the ECB began sovereign bond purchases which meant that no-one really believed anymore that it was a spiritual follower of the policies of the German Bundesbank. In case you were not sure on this count the fact that it appears that the current Bundesbank chairman Axel Weber voted against the move should make it clear. So as people lose faith in other investments they cling again to gold. For mankind as a whole if you accept my analysis the rise the price of gold is something of a defeat.
The European Central Bank deposit facility
Euro zone banks are parking record sums overnight at the European Central Bank in the latest sign of fear and uncertainty across the 16 countries which make up the euro zone.Use of the ECB’s deposit facility rose to 316.4 billion Euros this week which even exceeded levels seen after the collapse of Lehman Brothers in September 2008.
What does this mean?
It means that banks in the euro zone are turning down potentially higher interest rates from other banks because they are afraid of counter-party risk. I wrote on the rise in Libor rates on the 28th May which is another function of this environment but this rise in deposits at the ECB is a clear sign that banks are nervous of other banks exposure to sovereign debt in the euro zone. So instead they get less interest but a safer counter-party.
The ECB is supposed to be unwinding its extraordinary monetary stimulus measures during this summer. But we can see that there are still problems within the euro zone banking system. Of course it Securities Market Programme (QE) is an extension of extraordinary monetary measures as is the resumption of swaps arrangements with the American Federal Reserve. It also recently weakened its collateral rules. These are not quite what I would call an unwinding!
Also there are issues for the ECB’s bond buying programme to address. You see the ten-year bond yields of Greece (8.23%),Portugal(5.13%) and Ireland(5.11%) have started to move higher again. It would appear that the moment the ECB stops buying these bond markets are rather friendless. This of course only adds to sovereign debt fears.However something worse has also happened as Italian and Spanish ten-year government bond yields have risen to 4.30% and 4.56% which is virtually where they were on May 7th before the new euro zone rescue schemes began. As I wrote in my articles on her on the 24th and 31st of May there are particular worries for Spain and her banking sector. This poses a new problem for the ECB as of course the Spanish (and the Italian) government bond market is much larger than Greece Portugal or Ireland’s.
A curious fact
I discovered recently from watching the BBC programme QI that mobile phones are now recycled for the gold in them as the rising price makes this economic. The curious fact is that pound for pound there is more gold in a mobile phone that there is in gold ore according to the programme.