The dangers of a more liquid gold market

With other safe haven assets looking increasingly risky, investors are turning to gold in unprecedented numbers – but a more liquid market may turn out to have pitfalls in the long term. By Alexander Campbell

To the alchemists, gold was the perfect metal – untarnished by time and impervious to fire and calamity. And while alchemy has been forgotten, gold is still showing many of the qualities the adepts admired: continuing to rise even as equity markets crashed and money markets floundered, the spot price of gold has now reached unprecedented highs, hitting $1,246.05 an ounce on June 25 (see figure 1).

Other asset classes remain volatile. Although the markets have calmed substantially since the peak of the crisis in late 2008, the Chicago Board Options Exchange’s Vix index, which measures volatility as implied by 30-day S&P option prices, hit an intra-day level of 48.2 points on May 21 – the highest level for 13 months. This compares with roughly 10–15 points in the three years leading up to the crisis. In comparison, gold is no more volatile now than it was before 2008. Sixty-day price volatility was 15.5472 on June 23 – roughly in the middle of the 10-point range it has occupied since 1999, with two exceptions in late 2006 and late 2008 (see figure 2).

The physical gold market, now as before, is dominated by the demand for jewellery. Of the 3,455.4 tonnes of identifiable demand in 2009, jewellery accounted for 1,758.9 tonnes, according to the World Gold Council (WGC), an industry association. The rest consists of investment demand – either directly purchased bar or coin, or the gold underlying exchange-traded products (ETPs) – and a small amount from dental and industrial users.

Significantly, gold supply has been tight. Central banks, which supplied hundreds of tonnes of gold a year to the market for most of the past two decades, have now switched from being net sellers to net buyers of gold, as many seek to balance out their swelling foreign exchange reserves and increase their holdings in less volatile assets to protect their reserves against possible depreciation. It may also serve to improve public trust in the stability of their central bank, the WGC speculates: “Citizens generally like the fact that their country holds gold reserves – gold’s long history, its physical presence and its reputation all contribute to this. Thus, the existence of gold reserves can increase public confidence in a central bank.”

The renewed 2009 Central Bank Gold Agreement, a five-year agreement signed by 19 central banks, set a 2,000-tonne limit on gold sales over the period, but this may be more than banks wish to sell in any case. Barclays Capital notes net sales by the official sector – which includes the International Monetary Fund, not part of the agreement – dropped from 174 tonnes in 2008 to an estimated 25 tonnes in 2009 and a forecast 15 tonnes in 2010.

Despite these moves, the crisis has caused a loss of confidence in central banks and governments, and this is feeding demand for gold from institutional and retail buyers as an investment – or a hedge against turbulence in other asset classes. And this, as much as the continuing demand for jewellery, has driven the price up, market observers say.

In a report published in June, Morgan Stanley economist Joachim Fels predicted the “confidence crisis in banks and sovereigns will ultimately morph into a crisis of confidence in the central banks that act as lenders of last resort to both banks and governments. Yes, central banks can extend unlimited amounts of credit to banks and governments. But they do so by issuing ever more of their own liabilities – money. And just as the trust in banks’ and governments’ liabilities eroded when they issued ever more, we believe the trust in money will erode if central banks issue ever more of it.” The result, he continued, is uncertainty in the foreign exchange markets – and a flight to safety in gold, pushing the price up.

This safe haven argument is widely accepted. “The main reason for the high price is the strength of investment demand, from both private and institutional investors,” says Philip Klapwijk, London-based chairman of the precious metals consultancy GFMS. “The net inflow in 2009 was $60 billion – we have seen nothing like that since 1980, and even then it was lower than in 2009.”

For some, gold is the last refuge of the risk-averse investor: the Greek debt crisis has undermined confidence in European sovereign bonds, and volatile foreign exchange markets make even US Treasury notes less attractive to non-US investors.

“To a significant extent, people are fleeing other safe havens,” Klapwijk continues. “There is a speculative effect as well – people trading on momentum – but speculative positions are short term and tend to rise and fall. The amount of investors concerned about the fundamentals is significantly higher.”

Overall investment in gold peaked in the first quarter of 2009, when total investor demand reached 827.3 tonnes, including 465.1 tonnes of ETP investment, according to the WGC.

The sector as a whole, however, has seen demand fluctuate wildly from quarter to quarter – after the rush into ETPs at the height of the crisis in late 2008 and early 2009, demand fell away again for the rest of the year. Barclays Capital analysts expect the full year to see only 500 tonnes of exchange-traded fund (ETF) investment, compared with 613 tonnes in 2009. The largest gold-backed fund is the SPDR Gold Trust, an ETF run by Boston-based State Street Global Advisors and listed on the NYSE Arca exchange. The fund has grown steadily since inception in 2004 and now holds net assets of 1,298.53 tonnes in gold – its total net asset value puts it second in size only to the SSGA SPY fund, based on the S&P 500 index of US equities.

While inflow may have slowed this year, ETFs reached a new record in terms of size in early 2010 – 1,768 tonnes of gold, the bulk of which is the SPDR Gold Trust. Jason Toussaint, head of exchange-traded gold at the WGC, believes ETF inflow represents the arrival of a new class of gold investors. “Bullion was previously an over-the-counter private transaction. ETFs have democratised gold investment by removing the barriers to entry.” Buying physical gold entails transport, storage and insurance, and ETFs avoid these issues, as well as providing more transparent pricing and giving investors more comfort they will be able to exit their positions quickly.

Issuers report both retail and institutional buyers are showing increased interest in ETFs. In the US, physical gold is valued as protection against hyperinflation, bank failure or even the general breakdown of society. “The sense that some investors only trust a gold holding if they can see it and touch it is a clear indication some investors are buying gold as a hedge against a full-scale financial crisis and currency debasement,” wrote UBS commodity analysts in June.

But increased confidence in the more convenient physically backed ETFs (in other words, funds that hold physical gold in their own vaults rather than gaining exposure to gold through derivatives or investments in gold equities) means US retail buyers are now moving into this market as well.

In Europe, the interest is coming mainly from institutional buyers – although not from the pension sector. Pension funds have increased their exposure to commodities, but not by massive amounts compared with the rest of their portfolio, says Alistair MacDonald, a senior investment consultant at pension specialist Towers Watson. In general, they have done so through commodity indexes rather than seeking exposure to gold specifically.

For European pension schemes, the current lack of confidence in government bonds as a safe haven is balanced by the advantage of liability matching: even if bonds drop in value, the fund’s liabilities, discounted using bond yields, will drop along with them, he points out. A drop in gold, on the other hand, has no such silver lining – and, historically speaking, once macroeconomic worries ease, gold has tended to drop rather fast. “People talk about gold as the ultimate safe haven, but in order for that to work you need to have bought it well before people start to get worried. If you buy at current prices and things return to normal, it could be a very costly experience.”

If it is true the growth of ETFs has opened up gold demand to a much wider range of investors, what effects will this have on the long-term dynamics of the market? Although gold hasn’t become noticeably more volatile yet, Klapwijk warns it could in the future – ETF investors might leave en masse if the gold price starts to fall, driving it down still further. “The gold investor market has broadened, and it could grow further through increased ease of access. The question is, at what point does this become an overhang and actually drive prices down? If there are fundamental changes in the gold market, ETFs are as easy to sell as they are to buy.”

But Suki Cooper, precious metals analyst at Barclays Capital, believes the ETF boom will be good for the stability of the yellow metal. She points out the gold futures market on Comex, not the ETF market, is the natural home of short-term speculative investment. “Investor interest expressed through Comex non-commercial positions tends to be more speculative, dynamic and short term in nature. Recently, price drops have also been accompanied by hefty long liquidation, such as the price decline in early February this year [when prices fell 3.5% during the week to February 9], which was accompanied by a drop of the equivalent of more than 70 tonnes of exposure in Comex positions,” she says.

ETPs were previously home to speculators, but this is changing, she adds: “Before 2009, ETP flows suggested an element of interest was speculative and short term, with price dips resulting in not only a drop in non-commercial Comex positions but also a corresponding drop in ETPs. However, since last year, gold ETP interest has proved more sticky and longer term in nature, with weaker prices flushing out a smaller share. Thus, growth in longer-term investment demand is likely to provide support to prices, more so than growth in short-term tactical investment growth such as Comex non-commercial positions.”