Apr 21 2013
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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.
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?
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.
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