Metals Commentary: Gold: Has The Recovery Begun?

Vancouver– The yellow metal might have underperformed over the last few months, but recent price increases have prompted analysts to predict at least a short-term rally for gold, whether or not major economies head into recession.

The last few months excluded, it has been a strong year for gold. In March, after a sustained climb, the precious metal broke the US$1,000-per-oz. barrier for three days. Through the middle of the year, the price stayed above US$850 per oz. A sudden drop in September foreshadowed the economic mayhem to come, but even then it spent much of the month near US$900.

But when the financial crisis hit for real in October, the price of gold fell along with everything else. After flirting with US$900 per oz. at the beginning of the month, the price collapsed, hitting its lowest level in over a year on Oct. 24 at US$712 per oz. Many investors were taken by surprise, having been told for years that when all else fails, people turn to gold as a secure investment.

The price of gold remained depressed for almost a month, during which time trading was highly volatile. But by mid-November the price started to climb back up, including a few record one-day gains. Now most research groups are predicting a slowly gaining, relatively stable gold price over the short term. As for the long term, predictions range from US$650 to above US$2,000 per oz. But to understand forecasts of what’s to come, one must first understand what just happened.

Key to gold’s poor performance over the last few months is the role of institutional players and investment funds. Faced with deteriorating balance sheets, institutions and funds needed cash and so they sold gold. In fact, they sold almost anything for which they could find buyers; gold can always be easily liquidated, so it got hit hard.

Adding to the apparent correlation between world equity markets and the price of gold, some wealthy investors and funds sold gold to meet margin calls, cover losses on major investments gone bad, or simply wind down and return initial cash contributions to investors. A few large banks even got into the gold-selling fray for the same reason: to raise needed capital and increase liquidity.

And even though the price of gold was down some 24% compared with its March high, other commodities — not to mention stocks — were down more, which meant gold sales were an avenue by which to minimize losses. As such, gold’s relatively strong performance made it more of a target.

It appears that the October-November wave of sustained liquidation of long gold futures has abated, likely because positions are exhausted. On the flipside, new buyers have emerged. One important buyer is the People’s Bank of China, which is considering increasing gold reserves nearly sevenfold from its current 600 to 4,000 tonnes to spread the risks in its huge foreign exchange holdings. And Indian jewelry demand remains strong.

Another major influence on the price of gold is the strength of the U. S. dollar. Very large injections of liquidity by the U. S. government have driven a recovery in the greenback of late, but this recovery is likely going to be short-lived. As Jeffrey Nichols, manager of American Precious Metals Advisors, puts it, “The U. S. government is printing money so fast, cash is not even a safe bet anymore. . . The massive infusion of liquidity is ultimately going to lead to a massive spike in capital flows and an upward pressure on inflation.”

Inflation is good for gold prices: it drives the value of the dollar down and so encourages people to seek a safer refuge for their savings. Gold is a classic safe haven. And with the U. S. Federal Reserve expected to cut interest rates to 0.75% from 1% in mid-December, bullion’s appeal is on the rise as an alternative investment to the U. S. currency.

Interestingly, deflation could also make gold attractive. Deflation is a persistent reduction in the general price level, not just for goods and services but also for most commodities, real estate, equities and other assets. It stems from declining demand and an unwillingness to spend.

During deflationary periods, savings — inclding safe-haven investments like gold — retain their value. As such, gold is well-positioned as both an inflation and deflation hedge.

Then there is the actual supply-demand side of the equation. Based in part on China’s plans for a strategic gold reserve, Wellington West Capital Markets is forecasting a structural deficit in gold supplies, which will push prices up.

The analysts behind the report — Catherine Gignac and Paolo Lostritto — note that investment demand for physical gold increased by 179% in the third quarter, compared with last year, and that bullion dealers in many parts of the world reported “severe stock shortages of bars and coins.”

And they believe the change will be significant: “Given the potential change in market fundamentals, we believe it is time investors revisit investing in the junior and intermediate gold producers.”

It seems some investors never stopped thinking of gold as a safe place to stow away money. According to the World Gold Council, demand for gold reached an all-time high of US$32 billion in the third quarter. The huge deleveraging of commodities by hedge funds and institutions more than offset the massive demand, hence the drop in price, but the demand means investors — including the all-important Indian jewelry market — took advantage of gold’s depressed price, buffered its drop, and in doing so set the stage for its rise.

So where is the price going from here? Predictions are all over the map.

“Gold is getting almost impossible to call, with daily price moves of US$20 per oz. no longer rare,” wrote analysts from Fortis Bank and the VM Group in a November research note. “We’re mildly bullish, as the dollar’s rally is likely to run out of steam. But when will that be?”

The group set its one-month forecast at US$730-820 per oz. Fortis then predicts a price of US$825 over 2009, falling to US$800 for 2010, and foresee a gold price of just US$650 from 2011 on.

Haywood Securities is pretty much on par with Fortis. Haywood’s analysts are more bullish on gold in 2009, forecasting an average price of US$900 per oz. But in 2010, they predict the price will fall to US$700 and agree with Fortis that in the long term, the price will settle to just US$650 per oz.

Genuity Capital Markets analysts see the future a bit differently: they are less bullish in the short term but more so in the long run. “With safe-haven buying of the U. S. dollar, unwinding of the long commodity trade, and plummeting inflation expectations expected to continue in the near term, it is increasingly difficult to remain overly bullish on bullion in the short term.”

Genuity’s analysts forecast gold prices of US$740 per oz. for 2009 and US$751 for 2010, with the average price rising some US$25 per year until 2013.

Resource Capital Research, an Australian group, has a slightly more bullish outlook. They see prices moving between US$750 and US$850 per oz. over the next month, moving up to US$900 an oz. in 2009. Nichols, the manager of American Precious Metals Advisors, predicts prices of US$1,000 per oz. “sooner rather than later,” but hesitates to be more specific.

One of the more bullish predictions, however, comes from the research branch of Citigroup (C-n), the American mega-bank that was gasping for air when the U. S. government handed it the largest bailout package in history: US$20 billion on top of the US$25 billion that bank picked up in October.

In a Nov. 26 research note, Citigroup chief technical strategist Tom Fitzpatrick argued for a bull gold market because of gold’s financial flexibility. He says if the recent monetary and fiscal bailouts successfully reflate the global economy, gold will benefit by acting as a hedge against inflation. On the other hand, if rescue plans fail and economic instability worsens, gold will see upside because of its safe-haven status.

“We continue to believe that a move of similar percentage to that seen in the 1976-80 bull market can be seen, which would suggest a price north of US$2,000 (per oz.),” Fitzpatrick wrote. He cautioned, though, that Citigroup is not forecasting an imminent move toward US$2,000; rather, it is a scenario likely to unfold in the next few years.