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The truth about gold

Image: AP Photo/Mark Lennihan

table of contents

a brief intro (3) what drives gold prices (7) but wait, thats not all (20) what about real interest rates (24) so where are prices going (29) everyone has an opinion (37) the actual production of gold (45) the Fed responds (52) appendix (58)

For thousands of years, gold has been used as a currency, investment, and commodity cementing its importance as an asset
4600 B.C.

Earliest evidence of gold used as jewelry China legalizes the use of gold as money Gold coins are minted by King Croesus (present day Turkey); Julius Caesar introduces a gold coin as common currency

1091 B.C.

560 B.C. to 400 A.D. 1284 to 1300 1511 to 1700

Venice and Great Britain issue the gold ducat and florin, respectively
Spain launches its hunt for gold and finds massive reserves in Brazil in 1700. By 1720 the country is producing more than 60% of the worlds supply Gold production begins in the U.S.



Gold rush gets underway in the U.S., with more than 300,000 people moving to California
The U.S. passes the Gold Standard Act The Gold Reserve Act of 1934 ends the minting of gold coins and raises the price of gold to $35 per ounce to trade in to the treasury (formerly set at $20.67) President Nixon ends the ability to trade U.S. dollars in for gold Gold sets a then-record high of $870 per ounce China becomes the worlds largest producer of gold after deregulating its market The first gold ETF begins trading The Great Recession in the U.S., and a larger global slowdown, push gold prices over $1,000 for the first time ever


1933 to 1937



2001 to 2007


2008 to 2010

Source: U.S. Global Investors

The price of gold remained unchanged following the Gold Reserve Act of 1934 (which set a fixed rate). But in the 70s the price of gold began fluctuating as markets set pricing PRICE OF GOLD (TROY OUNCE PER USD)

Chart: Eric Platt/Business Insider, Data: Bloomberg

Over the past five years, the price of gold has rallied to record highs, making it the center of the investment conversation

Chart: Eric Platt/Business Insider, Data: Bloomberg

Then, after hitting highs in 11, gold retreated. Where its going next is anyones guess

Chart: Eric Platt/Business Insider, Data: Bloomberg

So What Drives Gold Price Movements?

For some time, gold had been seen as an inflation hedge

For most of the 70s and 80s, gold seemed to be driven by inflation Since 2000, that correlation hasnt persisted

Chart: Eric Platt/Business Insider, Data: Bloomberg

In the last decade, booming demand from emerging markets has been a major driver
In 1999 Asia accounted for 39 percent of global gold demand
By 2010 the Asian market reached 57 percent of total market demand
Those increases are being driven by India, China, and Vietnam

Map by Eric Platt/Business Insider, Data from Google Maps

Over the past decade, gold prices have followed the uptick in Asian demand
GMOs Amit Bhartia and Matt Seto charted the two figures through 2010 the results highlight Asias importance in gold pricing

Source: GMO, GFMS Ltd., World Gold Council, Bloomberg

And gold has generally been bid up in overnight trading in Asia even as it sells off in London AM trade

Prices in India currently the worlds largest market are driven by consumers
Gold prices appreciate in November at the time of Dhanteras, the start of a fiveday gold buying period

However recently both countries have logged slower gold demand growth concurrent with golds sell off

Jewelry sales remain the largest input of gold demand, although it declined marginally year-on-year
Jewellery has been the prime source of demand for gold over many decades, and it remains in poll position. In 2010, it accounted for just over half of global demand and the trend has persisted this year. Consumer appetite is in evidence across the world, particularly in golds cultural heartlands, China and India. World Gold Council

Source: World Gold Council

Demand by central banks has also been a major driver now topping $82 billion
Growth has been driven by the rapid ascent in average prices year-on-year Investment, as a portion of overall demand, jumped 160 basis points to 40.3 percent of total demand in 2011

Source: World Gold Council

Geographically, the Pacific region accounts for a substantive 58.1 percent of global gold demand
(jewelry and investment)

Source: Thomson Reuters GFMS, World Gold Council

Central banks hold 30.9 thousand tons of gold in reserve

Top Countries Holding Gold (as of February 2012):
United States: 8,133.5 tonnes (74.5% of reserves) German: 3,396.3 tonnes (71.4% of reserves) Italy: 2,451.8 tonnes (71.0% of reserves) France: 2,435.4 tonnes (71.1% of reserves) China: 1,054.1 tonnes (1.6% of reserves)


Chart: Eric Platt/Business Insider, Data: World Gold Council

On the ETF investment side, more than half of all gold is held by the SPDR Gold Trust (GLD) at 41.1M troy ounces
Top ETF Holders of Gold (as of April, 30, 2012):
GLD: 41,099,101 troy ounces (53.8%) ZKB: 7,072,607 troy ounces (9.3%) IAU: 5,792,446 troy ounces (7.6%)


Chart: Eric Platt/Business Insider, Data: World Gold Council

And those ETFS have been increasing their investments in tandem with golds appreciation
Since 2003, there are now 21 major gold ETFs and ETNs

Source: World Gold Council

Those ETFs are focused in the U.S. and Europe

Largest North American ETF: GLD (NYSE) with 53.8% of total Largest European ETF: ZKB Gold ETF (SWX) with 8.9% of total Largest African ETF: NewGold (JSE) with 1.6% of total

Largest Asian ETF: Gold Benchmark ETS (IN) with 0.4% of total
Largest Australia/Pacific ETF: GBS (ASX) with 0.6% of total Largest Middle Eastern ETF: GOLDIST (ISE) 0.07% of total


Chart: Eric Platt/Business Insider, Data: World Gold Council

But thats not all that drives gold prices

Gold is also an expression of fear

The price of gold moves in tandem with the CBOEs VIX index
BI divided the spot price of gold by the spot price of gasoline to isolate gold movements from broad commodity rallies
(a measure of expected volatility in the S&P 500)

Chart: Eric Platt/Business Insider, Data: Bloomberg

And investors generally shift assets into gold ETFs when volatility peaks
Citi charted ETF flows to the VIX index and found some graphic corollary between the two

Investors moved to gold after a number of major events, including Lehman Brothers bankruptcy and the Sept. 11 attacks

And what about real interest rates?

Many economists have offered the premise that gold rallies when real interest rates fall below 2%
The real interest rate is simply the nominal interest rate minus inflation

They point to the 80s and 90s when the real interest rate ran mostly above 3%

When inflation began to cycle higher at the start of the 80s, golds ascent was cut short

That said, the recent run-up (2001-2011) in gold has yet to eclipse the highs hit at the beginning of the 80s when prices are adjusted for inflation

Chart: Eric Platt/Business Insider, Data: Bloomberg

Where Are Prices Going?

At the start of 2012, BI surveyed commodity experts and found an overwhelmingly high price targets even after the precious metal had sold off
LOW $1,850/oz. MEDIAN $1940 HIGH $2,200

The banks weigh in: DEUTSCHE BANK: Consequently, our strongest conviction trade remains long precious metals and specifically gold. In an environment where real interest rates are negative and the US equity risk premium is high we expect this will sustain strong private and public sector demand for gold. GOLDMAN SACHS: We expect gold prices to continue to climb given the current low level of US real interest rates. Further, with our US economics team forecasting slower US economic growth throughout 2012, we expect US real interest rates to remain lower for longer, supporting higher gold prices. MORGAN STANLEY: Beyond the safe haven status associated with uncertainty surrounding the European sovereign debt crisis, we also believe that: 1) the gold to oil ratio highlights that, on a long-term real purchasing power basis, gold is close to fair longterm value; and 2) the prospect of sustained negative real interest rates reduces the opportunity cost of holding non-yielding assets.
Estimates on this page as of 1/15/12

But since then, targets have been cut nearly across the board as gold faltered. Citi now predicts 2012 prices of $1,720 per troy ounce

Gold prices should remain supported given low real interest rates and continued financial interest from central banks and private investors. However, price action could be volatile as markets are caught between changing inflation and monetary policy expectations, political turnover and sudden demand for liquidity. - Citis Edward Morse

Photo by Christopher Furlong/Getty Images

Morgan Stanleys Hussein Allidina remains bullish on gold despite the likely end of QE. Morgan now projects a 2012 PT of $1,825 per troy ounce. We do not believe the removal of trades predicated on additional liquidity and further unconventional monetary policy signal the end of the bull market in gold. This 'liquidity trade' is only part of the investment case and has also been overwhelmingly focused in the paper gold market, rather than in the physical investment market. Indeed, the recent price weakness appears to have encouraged further physical demand for gold, reflected in heightened inflows into physical ETFs.

Image: Mario Tama/Getty Images

UBS, which used to have an above-consensus gold estimate, slashed its price target 18% at the end of the first quarter to $1679

UBS believes that capital flows are accelerating out of emerging markets and that tighter liquidity is hurting commodity demand. Furthermore, China has not been stimulating private construction, lowering commodity intensity. Coupled with the risk of a cyclical slowdown in the US that may trigger renewed credit stress, UBS has reduced its near-term commodity outlook. UBSs Brian MacArthur
Image: TwicePix/Wikimedia Commons

So how has it actually performed against other assets?

First, a look at gold prices fluctuated next to crude oil

Chart: Eric Platt/Business Insider, Data: Bloomberg

In nominal value, markets have kept up with increases in gold prices


Chart: Eric Platt/Business Insider, Data: Bloomberg

But over the past decade, the price of gold has far outpaced U.S. house prices
After hitting highs in 2006, the S&P Case-Shiller Index has lagged gold price increases

Chart: Eric Platt/Business Insider, Data: Bloomberg

And everyone has an opinion

Warren Buffett
Gold, however, has two significant shortcomings, being neither of much use nor procreative. True, gold has some industrial and decorative utility, but the demand for these purposes is both limited and incapable of soaking up new production. Meanwhile, if you own one ounce of gold for an eternity, you will still own one ounce at its end.
Image: Michael Loccisano/Getty Images

Ben Bernanke
"Gold standards are far from perfect monetary systems have to go to South Africa and dig up tons of gold, and move it to New York and put it in the basement of the Federal Reserve bank of New York."

Image: Mark Wilson/Getty Images

Ron Paul
What did the Romans do to their currency? The Byzantine Empire had a gold standard for a thousand years and they did quite well and they didnt fight wars. But the Roman empire eventually destroyed their currency. They put in wage and price controls before they diluted the metals. They inflated. They thought wealth could come by fooling the people.

Image: T.J. Kirkpatrick/Getty Images

Peter Schiff
Whats so appealing about gold is that it does have intrinsic value. Its paper money, its the dollar and the euro that ultimately have no intrinsic value. They are just pieces of paper with numbers written on them. The government can put any number they want on that paper, but gold is real. The government cant create gold out of thin air, it has to be mined. The big picture is all bullish for gold.
Image: Jessica Hill/AP Images

Jim Grant
uncomplicated formula, and all you have to do is divide one by n. And n, Im glad you ask, n is the worlds trust in the institution of paper money and in the capacity of people like Ben Bernanke to manage it. So the smaller n, the bigger the price. One divided by a receding number is the definition of a bull market.
Image: Bebeto Matthews/AP Images

To me the gold price takes the form of a very

Nouriel Roubini
But, since gold has no intrinsic value, there are significant risks of a downward correction. Eventually, central banks will need to exit quantitative easing and zero-interest rates, putting downward pressure on risky assets, including commodities. Or the global recovery may turn out to be fragile and anemic, leading to a rise in bearish sentiment on commodities and in bullishness about the US dollar.
Image: Chiang Ying-ying/AP Images

John Maynard Keynes

The choice of gold as a standard of value is chiefly based on tradition. In the days before the evolution of Representative Money, it was natural, for reasons which have been many times told, to choose one or more of the metals as the most suitable commodity for holding a store of value or a command of purchasing power.
Image: AP

So how do you actually mine gold? (and who does it?)

Gold mining is intense (heres a very quick explainer)

2. Explosives are used to unearth ground in tandem with workers checking the walls
5. The mining company then ships the rough bars to a refiner where the bars will be melted down

1. Mine is excavated, elevator shaft installed, cooling systems set up, etc.

3. Materials are sent up to ground level where a sieve filters gold from excess earth

6. The refiner reworks the gold into a bar over 99% purity, stamps with a unique identifier and ships to its final owner

4. Particles are then smelted together to about 90% purity

Image: CNBC

The physical production of gold is not central to the U.S. or Europe in fact, countries like China, Russia, and Australia are huge producers

And production does not simply mean mining scrap supply/recycled gold accounts for more than a third of the worlds supply

Increased production of gold will be driven by two new large projects in Latin America
(+): Pascua Lama on the Chilean-Argentinean border and Pueblo Viejo in the Dominican Republic; as well as increases in Mexico and Brazil (-): Declines at Yanacocha and Lagunas Norte in Peru

Map by Eric Platt/Business Insider, Data from Google Maps

These three miners are some of the largest in the industry




UBS recently cut guidance on many gold mining companies because of the weakness in commodity prices
EPS price targets are now on average 37 percent lower than earlier this year

And theres not that much gold in the world

According to Warren Buffett, if you were to pack all the gold in the world into a cube, it would measure 68 feet on any given size

Thats slightly shorter than a tennis courts length

Image: Julian Finney/Getty Images

The Fed responds

After repeated attacks in 2012 to end the Fed and return to a gold standard, Ben Bernanke hosted a lecture series at GWU heres what he said:

Image: Federal Reserve Bank

One of the big problems: the U.S. would be exposed to bad policies of other countries using the gold standard

Image: Federal Reserve Bank

Also, investors can attack the commodity, causing huge fluctuations

Image: Federal Reserve Bank

And lastly, a gold standard can cause huge medium term issues
The Fed pointed to a global shortage of gold in the 19th century that hurt farmers who faced declining crop prices, but non-fluctuating mortgage and debt payments

Image: Federal Reserve Bank

Thats it. Questions:


APPENDIX: Historical Gold Demand

Source: LBMA, Thomson Reuters GFMS, World Gold Council