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CHEUVREUXUNITED KINGDOM
Metals & Mining Sector
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NVESTMENT RECOMMENDATION
Strategically, gold is one of the two most important commodities (with crude oil) on the planet, but its role as theultimate store of value and method of payment has been forgotten by many investors
. The perception of gold hasbeen affected by the last remnants of a Gold Standard being as long ago as 1971, a 20-year bear market and persistentcentral bank selling. In a scenario of financial stability and fiscal prudence, gold's monetary role retreats into thebackground, but even then it never goes away.
In today's world of massive deficit spending, inflating currencies (i.e.excessive growth in the money supply) and financial imbalances, gold's monetary role is reasserting itself.Investment demand for gold is increasing and the remonetisation of gold has begun
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We are raising our mid-cycle gold price estimate from USD750/oz to USD900/oz. Covert selling (via central banklending) of gold has artificially depressed the price for about a decade, but Bank for International Settlements' dataon gold derivatives suggests its impact is on the wane
. Our USD900/oz mid-cycle estimate takes into account thelong-term average ratios between the gold price and the prices of oil and the Dow Jones Industrial Average. We also seethe possibility of a spike to USD2,000, or higher, if the story on diminished central bank gold reserves becomes widelyaccepted, if central banks in countries with large US dollar holdings compete to buy gold and diversify forex reserves awayfrom dollars and if the US economy slides into either high rates of inflation or deflation.
Central banks have loaned out 10,000–15,000 tonnes of their gold reserves, between a third and a half of thereported total
. Gold loaned by central banks to bullion banks or their counterparties is immediately sold into the physicalmarket for conversion into jewellery, etc. This creates a short position between the central bank and the bullion bank/itscounterparty. This short position is the foundation for the gold derivatives market which grew rapidly in the 1990s andcurrently has a notional value of c.USD300bn. Non-gold producers account for the majority of the short position and maynot be able to cover their shorts without causing a spike in the gold price.Since the mid-1990s, much of this gold lending has been aimed at suppressing the gold price. A low gold price has servedto:
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calm financial markets during several periods of financial crisis
in the last decade (e.g. Japan, Asian currencycrisis, Russia and LTCM);
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improve the perception of US monetary policy
; a low gold price suggests a benign inflation outlook, keeps USinterest rates low and is supportive of a stronger US dollar;
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prevent substantial losses in the gold derivatives market
(notably from the gold "carry trade").
The
leader in the fight to expose the suppression of the gold price is the Gold Anti-Trust Action Committee (GATA)
.GATA was established in 1999 in the US, but is little known outside the world of "gold bugs". Despite official denials, thereis much evidence to back the gold price suppression claims. Support for GATA has come from senior Russian officials.Our analysis confirms the view that central banks have loaned out 10,000-15,000 tonnes of gold, although the settlementof some of these lease contracts may be being made in cash rather than physical gold.
We estimate that there is a
substantial supply deficit in the gold market
of around 1,300 tonnes p.a. before any centralbank selling and perhaps 700 tonnes p.a. after the publicly announced sales, but before covert selling. This compares withworld gold mine output of only 2,500 p.a. Unlike their unlimited ability to create paper money, central banks' gold reservesare finite and the 7-10 year lead time on new mining projects rules out any quick fix. In addition, there is no way that themarket can accommodate renewed buying by central banks like Russia.
The
gold price acts as an early warning of potential crisis, such as rising inflationary/deflationary pressures andgeneral confidence in paper currency, especially the US dollar:
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Historically low real yields and accelerating growth in the money supply (currently 8%) suggest that the
Fed'smonetary tightening is largely illusory
. Indeed, while the Fed Funds has been hiked 325bp, the 10-year bondyield has declined by 7bp.
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