3 Questions About Gold

The ongoing weakness in the gold market led to a decline in shares of SPDR Gold, the world’s leading gold ETF, in the past several months. This weakness raises concerns whether this ETF could recover anytime soon. In order to get a better sense about the progress of gold and its future, let’s tackle three questions related to gold.

Does a potential spike in inflation remain a concern?

One of the reasons people hold on to gold investments such as GLD is to protect against a rise in inflation. During the past few years the U.S. inflation hasn’t changed and remained stable and, for the most part, was below the FOMC’s inflation target.

Also, the market expectations are for less than 2% in the coming years. The FOMC’s policy to expand its balance sheet resulted in a spike in the money base, as you can see in the chart below.

US MONEY BASE AND GOLDSource of data: Google finance and Federal Reserve website

This higher money base didn’t translate to a spike in the M1 or M3, and as such, the inflation didn’t pick up. The Fed’s past policy is likely to keep some investors holding on to gold, but for the most part, the demand for gold as an investment has fallen.  This is why the demand for gold in ETFs has tumbled down in the past couple of years. Moreover, since the beginning of the year, GLD’s gold hoards fell by 10%.  If the demand for gold as investment keeps falling, this is likely to further pressure down gold prices.

Is the FOMC’s policy still important for gold?

One way the FOMC may impact the direction of gold , now that the FOMC doesn’t have an asset purchase program, is with its expected rate hike. The timing for this move remains unclear – at least it depends who you ask. More dovish economists such as Paul Krugman suggest the FOMC won’t raise rates in 2015. Conversely, the current market expectations are for the middle of next year or even sooner.

The importance of the cash rate on gold could come via the potential direct and indirect impact.

The potential direct impact is that a higher cash rate could bring down any potential rise in inflation and thus reduce the demand for gold , which is considered by many a hedge against higher inflation.

The indirect impact could come via long term treasuries yields. This impact is related to the alternative value of holding gold, which I have talked about in a past post.

In either way, the effect remains the same: As cash rates go up, the price of gold is likely to come down. Since the market expectations suggest a rate hike in the coming months, any change from this estimate, could provide some backwind for gold.

Does the physical demand for gold important for gold?

I think this is one of the issues that remain in the back burner for GLD investors and, in my opinion, for good reason. The demand for gold has changed in the past few years due to shifts in the demand for the yellow metal in central and commercial banks, and changes in consumption in India, among the world’s leading importer of gold, due to rising and then falling import taxes on precious metals.

The chart below shows the developments in the demand for gold between the years 2009 and 2013.

gold demand for 2009-2013Source of data from Gold Council  

But the changes in the physical demand for gold for consumption (to make pretty jewellery) are less important for the direction of GLD. After all, the spike in GLD prices started following the 2008 economic meltdown — GLD reached its highest level of $183 back in September 2011 (around the time the leading credit rating agencies downgraded the U.S. federal government credit rating).

As you can see from the chart above, the sharp fall in the total demand for gold came from ETFs such as GLD during last year.  This is also the case this year. In the past three quarters the total demand for gold ETFs have contracted 83 tonnes of gold. Last year’s rise in the demand for gold in jewellery didn’t seem, at face value, to curb down the plunge in gold prices, which reflected in the fall in shares of GLD.

These questions aren’t the only ones worth asking but they cover issues that are important for bullion investors. Based on the above, it’s hard to see gold recovering anytime soon. There will need to be a sharp change in one of the issues listed above to result in an upward trend in gold , which, for now, doesn’t seem likely. For more: GLD: Will This ETF Continue to Fall?