Why Gold will head lower. by Jean Jacques Chenier
The run-up in gold prices in recent years had all the features of a bubble. And now, like all asset-price surges that are divorced from the fundamentals of supply and demand, the gold bubble is deflating.
At the peak, gold bugs were happily predicting gold prices going to $2,000, $3,000, and even to $5,000 in a matter of years. But prices have moved mostly downward since then. In April, gold was selling for close to $1,300 per ounce at some point – and most of the time below $1400, an almost 30% drop from the 2011 high of $1,900.
There are many reasons why the bubble has burst, and why gold prices are likely to move much lower, toward $500 by 2015.
First, gold prices tend to spike when there are serious economic, financial, and geopolitical risks in the global economy. During the global financial crisis, the safety of bank deposits and government bonds was seriously in doubt.
But, even in that dire scenario, gold might be a dangerous investment. Indeed, at the peak of the global financial crisis in 2008 and 2009, gold prices fell sharply a few times. In an extreme credit crunch, leveraged purchases of gold cause forced sales, because any price correction triggers margin calls. As a result, gold can be very volatile – upward and downward – at the peak of a crisis.
Second, gold performs best when there is a risk of high inflation, as its popularity as a store of value increases. But, despite very aggressive monetary policy by many central banks – successive rounds of “quantitative easing” have doubled, or even tripled, the money supply in most advanced economies – global inflation is actually low and falling further.
The reason is simple: while base money is soaring, the velocity of money has collapsed, with banks hoarding the liquidity in the form of excess reserves. Ongoing private and public debt deleveraging has kept global demand growth below that of supply.
Thus, firms have little pricing power, owing to excess capacity, while workers’ bargaining power is low, owing to high unemployment. Moreover, trade unions continue to weaken, while globalization has led to cheap production of labor-intensive goods in China and other emerging markets, depressing the wages and job prospects of unskilled workers in advanced economies.
With little wage inflation, high goods inflation is unlikely. If anything, inflation is now falling further globally as commodity prices adjust downward in response to weak global growth. And gold is following the fall in actual and expected inflation.
Third, unlike other assets, gold does not provide any income. Whereas equities have dividends, bonds have coupons, and homes provide rents, gold is solely a play on capital appreciation. Now that the global economy is recovering, other assets – equities or even revived real estate – thus provide higher returns. Indeed, US and global equities have vastly outperformed gold since the sharp rise in gold prices in early 2009.
Fourth, gold prices rose sharply when real (inflation-adjusted) interest rates became increasingly negative after successive rounds of quantitative easing. The time to buy gold is when the real returns on cash and bonds are negative and falling. But the more positive outlook about the US and the global economy implies that over time the Federal Reserve and other central banks will exit from quantitative easing and zero policy rates, which means that real rates will rise, rather than fall.
Fifth, some argued that highly indebted sovereigns would push investors into gold as government bonds became more risky. But the opposite is happening now. Many of these highly indebted governments have large stocks of gold, which they may decide to dump to reduce their debts. Indeed, a report that Cyprus might sell a small fraction – some €400 million ($520 million) – of its gold reserves triggered a 13% fall in gold prices in April. Countries like Italy, which has massive gold reserves (above $130 billion), could be similarly tempted, driving down prices further.
Gold will be very volatile in the next few years and will trend lower over time as the global economy mends itself. The gold rush is over.
Jean Jacques Chenier
AA Management Managing Director
AA Management
The run-up in gold prices in recent years had all the features of a bubble. And now, like all asset-price surges that are divorced from the fundamentals of supply and demand, the gold bubble is deflating.
At the peak, gold bugs were happily predicting gold prices going to $2,000, $3,000, and even to $5,000 in a matter of years. But prices have moved mostly downward since then. In April, gold was selling for close to $1,300 per ounce at some point – and most of the time below $1400, an almost 30% drop from the 2011 high of $1,900.
There are many reasons why the bubble has burst, and why gold prices are likely to move much lower, toward $500 by 2015.
First, gold prices tend to spike when there are serious economic, financial, and geopolitical risks in the global economy. During the global financial crisis, the safety of bank deposits and government bonds was seriously in doubt.
But, even in that dire scenario, gold might be a dangerous investment. Indeed, at the peak of the global financial crisis in 2008 and 2009, gold prices fell sharply a few times. In an extreme credit crunch, leveraged purchases of gold cause forced sales, because any price correction triggers margin calls. As a result, gold can be very volatile – upward and downward – at the peak of a crisis.
Second, gold performs best when there is a risk of high inflation, as its popularity as a store of value increases. But, despite very aggressive monetary policy by many central banks – successive rounds of “quantitative easing” have doubled, or even tripled, the money supply in most advanced economies – global inflation is actually low and falling further.
The reason is simple: while base money is soaring, the velocity of money has collapsed, with banks hoarding the liquidity in the form of excess reserves. Ongoing private and public debt deleveraging has kept global demand growth below that of supply.
Thus, firms have little pricing power, owing to excess capacity, while workers’ bargaining power is low, owing to high unemployment. Moreover, trade unions continue to weaken, while globalization has led to cheap production of labor-intensive goods in China and other emerging markets, depressing the wages and job prospects of unskilled workers in advanced economies.
With little wage inflation, high goods inflation is unlikely. If anything, inflation is now falling further globally as commodity prices adjust downward in response to weak global growth. And gold is following the fall in actual and expected inflation.
Third, unlike other assets, gold does not provide any income. Whereas equities have dividends, bonds have coupons, and homes provide rents, gold is solely a play on capital appreciation. Now that the global economy is recovering, other assets – equities or even revived real estate – thus provide higher returns. Indeed, US and global equities have vastly outperformed gold since the sharp rise in gold prices in early 2009.
Fourth, gold prices rose sharply when real (inflation-adjusted) interest rates became increasingly negative after successive rounds of quantitative easing. The time to buy gold is when the real returns on cash and bonds are negative and falling. But the more positive outlook about the US and the global economy implies that over time the Federal Reserve and other central banks will exit from quantitative easing and zero policy rates, which means that real rates will rise, rather than fall.
Fifth, some argued that highly indebted sovereigns would push investors into gold as government bonds became more risky. But the opposite is happening now. Many of these highly indebted governments have large stocks of gold, which they may decide to dump to reduce their debts. Indeed, a report that Cyprus might sell a small fraction – some €400 million ($520 million) – of its gold reserves triggered a 13% fall in gold prices in April. Countries like Italy, which has massive gold reserves (above $130 billion), could be similarly tempted, driving down prices further.
Gold will be very volatile in the next few years and will trend lower over time as the global economy mends itself. The gold rush is over.
Jean Jacques Chenier
AA Management Managing Director
AA Management
