A paper gold rally – physical yet to engage

During 1Q16, physical demand for gold declined 23.8% compared to 1Q15 according to GFMS (1025 tonnes Vs 781 tonnes) yet gold prices rallied 22% – res ipsa loquitur.

Gold’s gain year-to-date is impressive – not to say exceptional – and gold bugs will heave a sigh of relief that it has behaved as it should in the face of what is clearly a vulnerable, even fragile macroeconomic outlook. However 2014 and 2015 saw similar rallies before momentum fade set in after Q1 in both years and hence not surprisingly confidence remains light, particularly in view of the size able 45% correction since 2011.

2016 is different

Yes, gold has seen a similar price action, but the drivers are not the same. The key physical gold markets in China and India are comparatively speaking absent and the erstwhile seller – the West – has turned buyer.  This is not a question of geography, but of motivation, form and tenure.

The correction lower from all time highs at $1922 in 2011 were driven by selling across the spectrum of the gold community in the West. European Central banks had already disgorged sizeable chunks of metal under the Washington Accord and then it was instititutional investors selling of ETFs (roughly 1000 tonnes), coupled by speculators on COMEX who sold their long futures positions and the market went into a rare net short position – and then there was cash-for-gold at the retail end – not in itself significant in size, but it underscored the West falling out of love with gold and cashing it in to sustain the consumption binge of the early 2000’s.

Never before was there such an epic movement of bullion from West to East in exchange for fripperies since the days of Marco Polo and the silk road.

This year on COMEX we have seen a battle royal between the longs and the shorts with the former winning out. The short covering has played a key role in taking the market through key technical levels and net longs stand at close to record highs. This should leave gold bulls – especially contrarians like myself – feeling distinctly uncomfortable. Meanwhile ETF flows have risen at record pace adding 330 tonnes in Q1 (compared to just 36 tonnes in Q1 2015). Now it could be argued that ETFs are paper or physical – this is irrelevant – what matters is how they behave and as we saw since 2011 these players can operate with the same short termism as speculators and rapidly reverse their positions. In short neither can be entirely trusted.

Meanwhile Indian buyers are absent as its government behaves as if it was at war with its gold community (and 3,000 years of history) through punitive taxes ; the market remains lacklustre with prices at a 2 1/2 year high in local terms and is not much helped by a poor monsoon and therefore harvest. The Chinese and indeed Russians meanwhile seem content to pick metal up on any price correction (more traditionally the Indian style) and not chasing the market higher – price supportive, but not a driver. GFMS reports that physical purchases for 1Q16 declined in India by nearly 65% compared to 1Q15.

So what has changed. There is growing perception in the West that Cental Banks may indeed be fallible and that the Keynesian experiment may have run its course – in short, the desire for sound money and by extension a growing concern about the increase in debt to resolve financial crisis is gaining currency. If fear is back in vogue then arguably it may less of a sustainable position then the motivation of many Eastern buyers which is simply as long term store of value.

For gold to see a sustained rally it needs to fire on more than one cylinder and physical players need to join the party. This in turn would put bullion onto the radar of institutional investors who are yet to be convinced that it really is an alternative to more traditional asset classes. This could then bring about the price elasticity – or buying on higher prices – that typified the last bull run. Or equally perhaps physical buyers do not turn up to the party in which case the speculators – sometimes described as behaving like 11 year olds high on e-numbers – could get bored and as easily reverse their positions.

Time will tell.

Ross Norman, CEO  of  Sharps Pixley 

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