Apr 21 2013

Why gold buyers are to blame for the decline of the yellow metal

By Kathleen Brooks, research director, Forex.com Why gold buyers are to blame for the decline of the yellow metal
Since the start of the year we have been expecting the gold price to fall. What we were not expecting was the speed and aggressiveness of the decline in the gold price. Gold had its largest one-day fall in its history, and so far attempts at recovery have been fairly moderate. What does this tell us, and where have all the gold bugs gone?

We have talked about the fundamental reasons to sell gold in the past: we are in a low inflation environment and since gold is a traditional inflation hedge, if inflation is low, why do you need gold?

Added to this, we are in a low interest rate environment, which means that the rate of return on fixed income products has been extremely low. This has enhanced the attractiveness of equities, which currently have a relatively high rate of return, and reduced the attractiveness of gold, which yields nothing.

Even gold's status as a safe haven has been called into question. For example, the recent sharp decline in gold was partly attributed to signs of economic weakness in the world's two largest economies - China and the US. In the past this may have driven flows into gold as investors looked for somewhere safe to put their money. Not so anymore.

The influence of traditional gold drivers seems to be waning, but this has happened over a period of time, for example, we have had low yields for five years and inflation hasn't been a threat for a long time, so why the sudden decline in the yellow metal?

This is where you have to look beyond the fundamentals of the gold price and instead look at the dynamics of the gold market that have changed dramatically in recent years. Ten years ago saw the launch of the world's first exchange traded gold fund (ETF). That was back in 2003 when the price of gold was less than USD 400 per ounce. After the recent decline, the price of an ounce of gold is still USD 1,000 above this level. Since then there have been approx. 140 new ETFs enter the market backed by the gold price and assets under management are roughly USD 130 billion. Now gold ETFs rival central banks in terms of their holdings of the precious metal, in fact they fall just behind the US, Germany and the IMF, and are ahead of Italy and France.

The benefits of this ETF explosion has been the "democratization" of gold investing, as ETFs are a low cost way to get exposure to this asset class for the average investing public. The downside is that the sharp increase of small scale investors in the gold market has made the precious metal more volatile.

In the past central banks were the big holders of gold. Central banks don't change their asset allocations of gold very often, in other words they are invested in gold for the long term. However. Holders of ETFs are much more nimble than central banks. They can buy and sell quickly and easily, and change their gold holdings based on economic fundamentals, news and their own financial needs. Thus, gold has become more like the equity market, and at the moment it's like an equity that nobody wants.

So where can gold go from here? If the ETF community have been dumping gold in favour of higher yielding stocks, then we could see the gold price remain constrained for some time, at least until central banks start raising rates, making investors less sensitive to yields and potentially investing in gold as an alternative asset class.

Gold could also be a victim of its own success. It has reaped hefty profits for those who have been invested in gold-backed ETF's in recent years. Thus, it is at risk of being used as an ATM - giving investors easy access to cash, which they can then use to invest elsewhere.

Overall, the yellow metal could find it hard to rally from here for the medium-term. The traditional drivers of gold: inflation hedge, safe heaven etc. have less of an impact on the gold price in an environment where it is widely held, and the majority owners are no longer stable central banks. The gold market has become more dynamic in recent years; the downside of this is that gold is no longer a one-way bet, but is vulnerable to bouts of volatility like equities.

Disclaimer: The information and opinions in this report are for general information use only and are not intended as an offer or solicitation with respect to the purchase or sale of any currency or CFD contract. All opinions and information contained in this report are subject to change without notice. This report has been prepared without regard to the specific investment objectives, financial situation and needs of any particular recipient. Any references to historical price movements or levels is informational based on our analysis and we do not represent or warrant that any such movements or levels are likely to reoccur in the future. While the information contained herein was obtained from sources believed to be reliable, the author does not guarantee its accuracy or completeness, nor does the author assume any liability for any direct, indirect or consequential loss that may result from the reliance by any person upon any such information or opinions.

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