The international gold price once surpassed $1,200 per ounce in December 2009,hitting a historic high without factoring in inflation. The gold was up 24.4 per cent by the end of 2009 registering its ninth consecutive annual gain. The price of gold was propelled by the depreciation of the greenback and worries on potential inflation. The continuous uptrend in price of the yellow metal reinforced bullish sentiment and provided more incentives for investors to speculate on gold. However,contrary to popular perception gold was actually a laggard in the precious metals universe during 2009. In fact,gold was not only the worst-performing precious metal (see table: Precious Metals Performance),it was also beaten by the equity markets under our coverage in 2009 (except US and Japan). Besides,the golds annual return last year was not spectacular as compared to the returns in previous years like 2002,2004 and 2005. Thus,the gold fever could be barely based on the expectations of rampant monetary inflation and the greenbacks loss of status as the worlds reserve currency. The fundamentals,however,do not support the rally of gold price. Here is an analysis that explains the main reason of the recent gold rally and why the price of gold is overvalued based on the fundamentals. Dollar depreciation & speculation The sharp increase of gold price in 2009 was primarily driven by dollar depreciation and speculation. Historically, the spot price of gold and the US dollar are negatively correlated. It is because the international gold price is denominated by the US dollar and gold is an alternative for the dollar as the worlds reserve currency. Since March 9,2009 when the US dollar index hit the years peak till end of October 2009,dollar-denominated gold price climbed 13.4 per cent,which was comparable to the 14.3 per cent decrease of the dollar index in the same period. On the other hand,gold price in euro and pound sterling dropped 2.7 per cent and 4.7 per cent respectively. It proved that the rally in gold price in that period was mainly driven by the dollar depreciation. In November 2009,speculation was the dominant force that spurred the price of gold. The rise in dollar-denominated gold price (16.3 per cent) far outpaced the decrease in the dollar index (2.5 per cent) in the month. Gold price denominated in euro and sterling also surged sharply by 13.9 per cent and 14.8 per cent,respectively,which broke away from their sluggish performance in the past six months. Double-digit increase in gold price for a single month is quite unusual. It implied that the speculation on gold was very rampant. Speculation dominant force for gold rally Data from the US Commodity Futures Trading Commission (CFTC) shows that the long position on gold futures contracts was dominated by the speculative demand in last year. As per the World Gold Council,a massive amount of speculative capital has entered into the gold exchange-traded fund (ETF) markets. In the first three quarters of 2009,the demand for gold ETFs surged a whopping 154 per cent year-on-year. This clearly implies that speculative demand was one of the major component of the total gold demand. Besides,the gold holdings of the worlds largest gold-backed ETF,the SPDR Gold Trust,increased significantly by 350 tonnes or 45 per cent to a record high of 1,133 tonnes in 2009. However,in 2010,the Trusts holdings in gold have been continuously dipping from its peak. This clearly implies that the potential upside on gold is limited. Gold fundamentals are still weak There are four main categories for gold demand jewellery,industrial,retail investment and ETF. Over the past ten years,the average annual total demand for gold hovered between 3,500 and 4,000 tonnes. Jewellery,which consistently accounts for over 60 per cent of the total gold demand,is a key component for underpinning the overall demand for gold. On the contrary,ETF constitutes only a small portion of the total demand (less than 10 per cent of the global total demand). Therefore,the demand of jewellery is probably the most crucial factor that influences gold price. High unemployment,negative income growth and rising family debt in developed countries suppressed the consumer demand for gold. Three out of four categories in gold demand (jewellery,industrial and retail investment) recorded a decline in the first three quarters of 2009,with ETF being the only component to register an increase. The decline in the gold demand was almost universal (except in China). In value terms,US is the largest market for gold jewellery,while in volume terms,India is the largest consumer. In the third quarter of 2009,jewellery demand in India dropped 21 per cent year-on-year. A downtrend in jewellery demand was also seen in other major consumer including US and Italy. Demand in both these countries dropped by 24 per cent and 20 per cent respectively from a year earlier. Economic growth is a leading indicator of jewellery demand. Historically,it gives a picture of where the jewellery demand is heading in next two to three quarters. As the global economy has just started to recover,it may take more time to see demand for real physical gold to pick up. Gold buying by central banks will not last Investors believe that buying of gold by central banks push gold prices upwards. Reserve Bank of India (RBI) purchased 200 tonnes from International Monetary Fund between October 19 and October 30,2009. In the last 30 years,it was the biggest purchase in such a short period by a single central bank. While investors expect more of such purchases by the central banks and in turn further rise in prices,this might not be totally true. In fact,purchase of gold by central banks cannot justify the high gold price because there were only a few central banks that participated in the market and the volume of such a transaction was insignificant. Relative to the average annual total demand of gold over the past ten years (about 3,500 to 4,000 tonnes),200 tonnes of gold is indeed negligible. Moreover,the planned sale of 403 tonnes of IMF gold still lacks buyers. After the purchase from India and Sri Lanka,IMF still has 200 tonnes of gold that is not sold. Moreover,dollar depreciation does not mean that central banks will buy gold for diversification. Lee Eung Baek,head of the Korean central banks reserves management department,said that the gold price is too expensive. He believed holding gold as part of reserves would make sense in meeting diversification purposes. However,there might not be many central banks that wish to balloon their holdings at the current gold price. He also saw an illusion in gold,implying that other central banks would not buy any assets that had little value with no cash return. The statement demystified the rumour that banks would continue to buy gold. Gold purchase from china could be smaller Besides,it is widely believed that Chinese central bank is eager to buy gold to diversify its foreign reserves. Many investors also believe China has been surreptitiously building its gold reserves without reporting the build-up as the central bank does not want to impact the gold market. In April 2009,Chinese central bank officially revealed that the countrys gold reserves rose from 600 tonnes in 2003 to 1,054 tonnes,making China the largest buyer of gold in 2009. It was the first public announcement on its gold holdings in the past six years. According to the World Gold Council,China announced that its gold reserves had increased by 454 tonnes since 2003. This means,the purchase took place over a six-year period from 2003 to 2009 rather than between 2008 and 2009,as the markets expect. It was a slow process through domestic secondary markets since Shanghai Gold Exchange was established in October 2002. Therefore,the actual average annual gold purchase from China could be much smaller than the market expected. Hu Xiaolian,a vice governor at the Peoples Bank of China,also warned that the gold bubble is forming. Diversification of foreign reserves is a long-term progress. Central banks need to consider the long-term benefits when deciding what to use as reserves. Thus,it is unrealistic to expect that central banks to keep buying gold for diversification especially when the gold price has been too high without the support of fundamentals. Downward risk is high for gold price Apart from being expensive,there are other negative factors as well that are weighing heavy on gold. The breakeven rate for 10-year US Treasury,which is an indicator of inflation expectation,was at moderate 2.3 per cent as of January 31,2010. In addition,as the global economy is recovering,investors have regained their risk appetite. Hence,the demand for riskier assets has increased. Therefore,we expect price of the yellow metal is likely to correct. A chart on the forward price of gold too substantiates this point. the forward rate of gold is continuously dropping since December 2009. It implies that the market,too,expects the price to drop in the future and thereby investors have been selling forward contracts. The decrease in gold forward rate may also reflect that investors have started taking into account the fundamentals of gold and negative factors such as the rate hike in US that can probably drag the price of gold down. Besides,investors should note that gold does not provide interest income. If the Federal Reserve starts raising interest rates,investors will re-embrace the US dollar and re-price gold. The gold price would then experience a nasty correction. The writer is a Research Manager at Fundsupermart.com
