Looking back to our June half-yearly gold report we would like to review our theory of coming price direction and see where we are currently in relation to gold prices and review the fundamentals we were watching. In the June report we wrote,
“With a move above 1,325 prices could run back up to the 1,500 level. After which we could likely see some consolidation, perhaps 1,300 – 1,500 before breaking above the 1,500 mark convincingly and running to record highs.”
We would like to reiterate this view to get long, now that prices have convincingly broken the 1,325 level. However, there is one adjustment to the above view, scrap the idea of consolidation under 1,500. The bull market is back on! From here we see prices moving higher than 1,500 and possibly very quickly.
A quick look at the technicals shows us a weekly RSI bouncing from under 30 with a double bottom. The last time we saw weekly RSI showing a double bottom from oversold levels was 2008 when the price bounced off US$681 an ounce during the GFC. The RSI at this time, however, was still above 30 and not as aggressively oversold as prices are now. The last time we saw a weekly RSI moving from similar extremes was actually when prices were overbought with the weekly RSI at 80 in 2011. When prices peaked at US$1,920 before selling to where we are now.
But enough with the technicals lets review the fundamentals from last article and see how things have progressed. We outlined the two key global economies as the spaces to watch for gold prices; economy number 1 the US and economy number 2 China.
Firstly the US, in June we mentioned improving US data as a major factor weighing on gold prices which is still current. However, the US economy is very sensitive post-GFC, particularly to the treasuries prices (interest rates). The US bellwether is the US equity market. The US equity market has hit record highs. The key factor which has driven US equity prices higher over the past four years has been low treasury prices, driven low by the Federal Reserve purchasing treasuries to keep yields low. This has in a sense been an artificial influence, not a natural free market of supply and demand. Treasuries have been paying less than the rate of inflation for the past 4 years which has forced investors into equity markets – it’s better to invest in a stock and receive dividends and potential growth than invest in bonds that pay less than inflation.
Somewhat ironically the second biggest purchaser after the Fed of US treasuries is China. Why does China invest heavily in US treasuries? China has in place what is called a currency-peg fixing the price of Yuan to the US dollar, currently just above 6 Yuan to 1 USD. The currency doesn’t float in the free market fluctuating in value like most other international currencies. The reason for this is to keep China’s exchange rate cheap relative to its largest export market (the US) keeping its manufactured goods globally competitive.
One disadvantage of this policy is that China has to keep its foreign exchange reserves offshore, to the sum of approximately US$3.5 trillion. The largest reserves in the world followed not very closely by Japan with $1.2 trillion. The US holds $147 billion 16th on the global scale. If China imports these currency reserves back into the Chinese economy and transfers this capital into Yuan it will destroy their currency peg and export advantage as the demand for Yuan will outweigh the demand for US dollars.
The reason China invests in the US Treasury market is because it is the only market large enough to absorb the bulk of this capital China needs to allocate to various offshore markets across the globe. Over the past 4 years China’s currency reserves being held in US treasuries have offered little more than liquidity with very low return on offer, not a market China has been overly enthusiastic about investing in but still forced to.
We accredited the sell-off in the first half of this year to weakness in China and strength in the US. Since then Chinese data has began to improve and in the US the bellwether (equities) really look like they are peaking out with P/E ratios above 5 year averages, growth prospects subdued and US equity market capitalisation at 115% of GDP or approximately $18T. The last two times in history US equity market capitalisation has been greater than US GDP where 1929 and 2007, perhaps a decent fundamental indicator the market is overbought.
US Treasury Yields
US treasury yields have also started rising reducing the value of US treasuries. It appears the speculative ‘fund’ side of the market, which was happy to ‘front-run’ Fed treasury purchases over the past 4 years, are largely holding short treasury positions or exiting these markets. What is interesting is to see that although treasury yields are rising the USD is not. Signalling that global currency reserves are transferring out of US assets and higher yields are not attracting buyers to treasury markets. The Federal Reserve is going to have a hard time finding additional buyers of treasuries, especially if China is trying its best to avoid this market. This could send rates in the US higher, pressuring equities and the US economic recovery.
Gold purchases from China were weaker at the back-end of last year but after the recent sell off, according to the World Gold Council, Chinese imports are on track to soar to a 1,000 tonnes for 2013, the highest level on record. China’s economy is also becoming more internally reliant with a growing services sector and a growing middle class. What this means is that moving forward they are less reliant on export markets to support the manufacturing base and economy. Over the past 10 years China has been increasingly building its gold reserves to likely become the world’s largest buyer of gold this year.
Freely floating a currency which is backed in part by an established and large gold reserve would give China an advantage as an importer as opposed to an exporter (similar to what the US has had since the 1940s). A currency that would make offshore labour cheap, imports cheap, accumulation of resources and offshore assets cheap. If this is not China’s plan then the continued increase in gold purchases could be evidence of China finding alternate ways of bring home some of these currency reserves without upsetting the currency-peg.
So to summarise the demand side of the gold market looks like the US powers-that-be are likely to keep the US dollar weak, creating demand for gold. The Chinese powers-that-be are also continuing to build their gold reserves, creating demand for gold.
Looking at the supply side of the market you only have to listen to any high-ranking executive of any gold mining company to hear the industry is pretty much destroyed if prices go much lower than current levels. Gold is an unrenewable resource and it is also precious or rare. Easy to access and cheap-production gold has been mined or is in the process of being mined. Because of its scarcity miners have to go deeper to retrieve the metal making the process more dangerous, longer and more expensive.
Mining costs have increased drastically in the past 10 years as has demand and while mining was viable when gold prices were $300 an ounce ten years ago, the majority of miners today are operating with costs just shy of US$1,000 per ounce.
For these reasons we are bullish on gold at current prices.
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