Case for Under-performance of Gold as an Asset 2015

I contend that gold is going to continue exhibiting weakness against the dollar in value for much of 2015 and the downtrend will likely be a self-reinforcing process. Weakening of gold prices could lead to further reduction of speculative gold long positions and may lead to less demand for the metal from the traditional sources of demand further rein-forcing current downtrend.

Soros was right when he noted that gold has been losing its status as a safe haven after it failed to rally even when the Euro was on the verge of collapse and fed was still aggressively buying bonds. I shall try to explain why the trend has been so.

Prices in the market operate like an auction process. Commodity prices are influenced by supply and demand forces. When demand exceeds supply, prices rise and when supply exceeds demand, prices tend to fall. It is not always that straight forward, disequilibrium exists and prices do not have to necessarily reflect prevailing fundamentals. These price movements tend to have notable effects on the demand and supply constraints in the gold market.

Gold rose from around $457 in 2005 to a peak of circa $1921 at around 2011 and this has not been without substantial effects in the market. I recall early 2011 when it was peaking, those who were buying it defended it as the ultimate hedge against inflation justifiably so, rightfully so because it used to be highly responsive to market risks. Expectation of further rise in prices induced demand from funds, central banks and individuals, and increased demand created attractive prices for increased production. Gold ETFs were created and attracted a lot of interest as they had superior qualities relative to physical gold. They attracted are much less taxes than physical gold and are easier to quickly sell or buy.

The argument on the actual break even so far seems to be highly erratic. Just as in oil at present, when gold prices started falling, some participants made and have continued to make claims as to the break even prices for producers. Some claimed it was $1400, and when $1400 broke, they shifted to $1300 and closure of two big mines, prompted temporary price relief and now that it is trading below $1200, I am at least expecting a shift in the same.

I would not claim I have sufficient data to conclusively make a conclusion on the level of disequilibrium in gold prices that the gold market exhibits, but there are significant changes on the demand side that may precipitate some correction in gold prices or consolidation at least at lower levels.

A huge number of central banks base their portfolio allocations on security, liquidity and return. Gold is no longer viewed by central banks as to exhibiting the former qualities that made it favorable as an asset to hold relative to treasuries or equities. The change was well communicated by the Swiss Central Bank governor who recently noted.

“Gold typically performs poorly when it comes to liquidity and return, and on the security front, gold should be viewed critically in the context of investment policy. Although a certain diversification effect can come into play between gold and equities, I am sure you are also aware that the gold price is even slightly more volatile than equity prices. Just last year, this volatility made itself felt on our balance sheet. The collapse of the gold price in the spring of 2013 was responsible for a valuation loss of approximately CHF 15 billion.”

The Swiss Central Bank has for a period of time simply stopped buying gold and instead has been buying other assets and hence the reduction of it as a proportion of the total overall reserves. Although I am basing this assumption on a conjecture, if we see a similar trend among other central banks, we may see them continue reducing gold holding as a percentage of their reserves as well. Demand from Central Banks has been a strong source of demand in the metal.

Influence of the dollar on gold
Low interest US interest rates, quantitative easing and generally weaker dollar has supported gold over the past few years. Quantitative easing was ended this year and there are expectations that we may see rise in US interest rates coming year. There are general market expectations that divergence in central bank policies in Europe, Japan and US is going to push a lot of money into the dollar either through direct investments in dollars as financial assets or through bonds and treasuries/Equities and this is expected to result in further dollar rise in value. Rise in dollar value alone is likely to see value of gold against the dollar fall. Anticipation of rise in value of the dollar against domestic currencies and possible crisis could o see other central banks buy dollars to build up reserves and in the process push the dollar higher.

Geopolitics
Gold still responds to geopolitical development, instances of geopolitical risks have been resulting in increase in daily volatility but each time prices ease back down within a relatively short period of time aside from when it has been within a reasonable price corrections. There is a school of thought that seems to think that, just as in oil, weakening gold similar to oil puts Russia in an even worse situation and subsequently the Western allies may try to depress their prices. The Russian central bank has been buying gold from the country’s exporters which also accounted for over half of central bank purchases third quarter. They may however start selling to defend the Ruble

Conclusion
It’s highly likely that gold under performs as an asset coming year. Launch of quantitative easing from the ECB may provide temporary rally in prices, but since asset purchases are highly unlikely to include gold purchases, we may likely still see a dip towards $1080 then $1000 area. If prices trade below that level for some time it may prompt liquidation of positions by funds and other speculators in the market which may result in further slide lower. However, I will re-assess my view when prices break and close back above $1280 level but remain bearish until underlying trend turns positive.

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